[House Hearing, 106 Congress]
[From the U.S. Government Publishing Office]
REVENUE PROVISIONS IN PRESIDENT'S FISCAL YEAR 2000 BUDGET
=======================================================================
HEARING
before the
COMMITTEE ON WAYS AND MEANS
HOUSE OF REPRESENTATIVES
ONE HUNDRED SIXTH CONGRESS
FIRST SESSION
__________
MARCH 10, 1999
__________
Serial 106-21
__________
Printed for the use of the Committee on Ways and Means
U.S. GOVERNMENT PRINTING OFFICE
58-945 CC WASHINGTON : 2000
------------------------------------------------------------------------------
For sale by the U.S. Government Printing Office
Superintendent of Documents, Congressional Sales Office, Washington, DC 20402
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 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
WES WATKINS, Oklahoma LLOYD DOGGETT, Texas
J.D. HAYWORTH, Arizona
JERRY WELLER, Illinois
KENNY HULSHOF, Missouri
SCOTT McINNIS, Colorado
RON LEWIS, Kentucky
MARK FOLEY, Florida
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
Advisories announcing the hearing................................ 2
WITNESSES
U.S. Department of the Treasury, Hon. Donald C. Lubick, Assistant
Secretary, Tax Policy, accompanied by Hon. Jonathan Talisman,
Deputy Assistant Secretary, Tax Policy......................... 13
______
Alliance of Tracking Stock Stakeholders, Robert Hernandez....... 149
American Association of Educational Service Agencies, Rene
``Jay'' Bouchard............................................... 193
American Bar Association, Stefan F. Tucker....................... 54
American Institute of Certified Public Accountants, David A.
Lifson......................................................... 71
American Society of Association Executives, Michael S. Olson..... 90
Bouchard, Rene ``Jay,'' Steuben-Allegany Counties; Steuben-
Allegany Board of Cooperative Educational Services; American
Association of Educational Service Agencies; and National Rural
Education Association.......................................... 193
Business Council for Sustainable Energy, Michael Marvin......... 170
Chicago School Reform Board of Trustees, Gery Chico.............. 184
Clark/Bardes, W.T. Wamberg....................................... 143
Employee Stock Ownership Plans Association, Delores L. ``Dee''
Thomas......................................................... 176
Etheridge, Hon. Bob, a Representative in Congress from the State
of North Carolina.............................................. 6
Ewing & Thomas, Inc., Delores L. ``Dee'' Thomas.................. 176
Hernandez, Robert, Alliance of Tracking Stock Stakeholders, and
USX Corporation................................................ 149
Hill, J. Eldred, III, Unemployment Insurance Institute........... 181
Kies, Kenneth J., PricewaterhouseCoopers LLP.................... 101
Lifson, David A., American Institute of Certified Public
Accountants.................................................... 71
Marvin, Michael, Business Council for Sustainable Energy......... 170
National Rural Education Association, Rene ``Jay'' Bouchard..... 193
Olson, Michael S., American Society of Association Executives.... 90
PricewaterhouseCoopers LLP, Kenneth J. Kies...................... 101
Sinclaire, William T., U.S. Chamber of Commerce.................. 65
Steuben-Allegany Board of Cooperative Educational Services, and
Steuben-Allegany Counties, Rene ``Jay'' Bouchard............... 193
Thomas, Delores L. ``Dee,'' Ewing & Thomas, Inc., and Employee
Stock Ownership Plans Association.............................. 176
Tucker, Stefan F., American Bar Association...................... 54
Unemployment Insurance Institute, J. Eldred Hill III............. 181
U.S. Chamber of Commerce, William T. Sinclaire................... 65
USX Corporation, Robert Hernandez................................ 149
Weinberger, Mark A., Washington Counsel, P.C.................... 132
Wamberg, W.T., Clark/Bardes...................................... 143
SUBMISSIONS FOR THE RECORD
America's Community Bankers, statement........................... 205
American Bankers Association, statement.......................... 213
American Council of Life Insurance, statement.................... 216
American Insurance Association, statement........................ 220
American Network of Community Options and Resources, Annandale,
VA, statement.................................................. 224
American Payroll Association, American Society for Payroll
Management, American Trucking Association, National Association
of Manufacturers, National Federation of Independent Business,
National Retail Federation, Service Bureau Consortium, Society
for Human Resource Management, U.S. Chamber of Commerce, UWC,
Inc., joint letter............................................. 228
American Petroleum Institute, statement.......................... 229
American Public Power Association, statement and attachment...... 235
American Society for Payroll Management, joint letter (See
listing under American Payroll Association).................... 228
American Trucking Association, joint letter (See listing under
American Payroll Association).................................. 228
Associated Builders and Contractors, Inc., Rosslyn, VA,
Christopher T. Salp, letter.................................... 237
Association for Advanced Life Underwriting, joint statement...... 355
Association for Play Therapy, Fresno, CA, William M. Burns,
letter......................................................... 238
Association of International Automobile Manufacturers, Inc.,
Arlington, VA, statement....................................... 238
Beard, Daniel P., National Audubon Society, statement............ 375
Bond Market Association, statement............................... 239
Bryan Cave LLP, Richard C. Smith, Phoenix, AZ, statement......... 288
Burns, William M., Association for Play Therapy, Fresno, CA,
letter......................................................... 238
Business Insurance Coalition, et al., joint statement............ 249
Business Roundtable, Thomas Usher, statement..................... 252
Carter, Judy, R&D Credit Coalition, and Softworks, Alexandria,
VA, joint statement............................................ 389
Central & South West Corporation, Dallas, TX, statement.......... 254
Coalition for the Fair Taxation of Business Transactions,
statement...................................................... 257
Coalition of Mortgage REITs, et al., joint statement............. 266
Coalition of Service Industries:
statement and attachment..................................... 270
et al., joint statement...................................... 273
Coalition to Preserve Employee Ownership of S Corporations,
statement...................................................... 275
Committee of Annuity Insurers, statement and attachment.......... 278
Committee to Preserve Private Employee Ownership, statement...... 283
Conservation Trust of Puerto Rico, San Juan, Puerto Rico,
statement...................................................... 287
Economic Concepts, Inc., Phoenix, AZ, Richard C. Smith, joint
statement...................................................... 288
Edison Electric Institute, statement............................. 290
Employer-Owned Life Insurance Coalition, statement............... 294
Equipment Leasing Association, Arlington, VA, statement.......... 299
Financial Executives Institute, statement........................ 302
General Motors Corporation, statement............................ 311
Governors' Public Power Alliance, Lincoln, NE, statement......... 317
Interstate Conference of Employment Security Agencies, Inc., and
Service Bureau Consortium, Inc., joint letter.................. 319
Investment Company Institute, statement.......................... 320
Large Public Power Council, statement............................ 328
M Financial Group, Portland, OR, statement....................... 331
Management Compensation Group, Portland, OR, statement........... 335
Massachusetts Mutual Life Insurance Company, Springfield, MA,
statement...................................................... 339
McCrery, Hon. Jim, a Representative in Congress from the State of
Louisiana, statement and attachment............................ 343
McVey, Ross J., Telephone & Data Systems, Inc., Middleton, WI,
letter......................................................... 418
Mechanical-Electrical-Sheet Metal Alliance, statement............ 345
Merrill Lynch & Co., Inc., statement............................. 347
National Association of Life Underwriters, and Association for
Advanced Life Underwriting, joint statement.................... 355
National Association of Manufacturers:
(See listing under American Payroll Association)............. 228
statement.................................................... 358
National Association of Real Estate Investment Trusts, Steven A.
Wechsler, statement............................................ 366
National Audubon Society, Daniel P. Beard, statement............. 375
National Federation of Independent Business, joint letter (See
listing under American Payroll Association).................... 228
National Mining Association, statement........................... 376
National Retail Federation, joint letter (See listing under
American Payroll Association).................................. 228
Niche Marketing, Inc., Costa Mesa, CA, Richard C. Smith, joint
statement...................................................... 288
PricewaterhouseCoopers Leasing Coalition, statement.............. 378
R&D Credit Coalition, Judy Carter, joint statement............... 389
Salp, Christopher T., Associated Builders and Contractors, Inc.,
Rosslyn, VA, letter............................................ 237
Sanders, Hon. Bernie, a Representative in Congress from the State
of Vermont, statement.......................................... 394
SC Group Incorporated, El Paso, TX, joint statement.............. 403
Securities Industry Association, statement....................... 395
Security Capital Group Incorporated, Santa Fe, NM, and SC Group
Incorporated, El Paso, TX, joint statement..................... 403
Service Bureau Consortium, Inc.:
joint letter (See listing under American Payroll Association) 228
joint letter................................................. 319
Smith, Richard C., Bryan Cave LLP, Phoenix, AZ, Niche Marketing,
Inc., Costa Mesa, CA, Economic Concepts, Inc., Phoenix, AZ,
joint statement................................................ 288
Society for Human Resource Management, joint letter (See listing
under American Payroll Association)............................ 228
Softworks, Alexandria, VA, Judy Carter, joint statement.......... 389
Stock Company Information Group, statement and attachment........ 405
Tax Council, statement........................................... 408
Telephone & Data Systems, Inc., Middleton, WI, Ross J. McVey,
letter......................................................... 418
United States Telephone Association, statement................... 421
U.S. Chamber of Commerce, joint letter (See listing under
American Payroll Association).................................. 228
Usher, Thomas, Business Roundtable, statement.................... 252
UWC, Inc., joint letter (See listing under American Payroll
Association)................................................... 228
Washington Counsel, P.C., LaBrenda Garrett-Nelson, and Mark
Weinberger, statement.......................................... 423
Wechsler, Steven A., National Association of Real Estate
Investment Trusts, statement................................... 366
REVENUE PROVISIONS IN PRESIDENT'S FISCAL YEAR 2000 BUDGET
----------
WEDNESDAY, MARCH 10, 1999
House of Representatives,
Committee on Ways and Means,
Washington, DC.
The Committee met, pursuant to notice, at 11:30 a.m., in
room 1100, Longworth House Office Building, Hon. Bill Archer
(Chairman of the Committee) presiding.
[The advisories announcing the hearing follow:]
ADVISORY
FROM THE COMMITTEE ON WAYS AND MEANS
FOR IMMEDIATE RELEASE CONTACT: (202) 225-1721
February 18, 1999
No. FC-7
Archer Announces Hearing on
Revenue Provisions in President's
Fiscal Year 2000 Budget
Congressman Bill Archer (R-TX), Chairman of the Committee on Ways
and Means, today announced that the Committee will hold a hearing on
revenue provisions in President Clinton's fiscal year 2000 budget
proposals. The hearing will take place on Wednesday, March 10, 1999, in
the main Committee hearing room, 1100 Longworth House Office Building,
beginning at 10:00 a.m.
Oral testimony at this hearing will be from both the U.S.
Department of the Treasury and public witnesses. Any individual or
organization not scheduled for an oral appearance may submit a written
statement for consideration by the Committee or for inclusion in the
printed record of the hearing.
BACKGROUND:
On February 1, President Clinton submitted his fiscal year 2000
budget to the Congress. This budget submission contains numerous
revenue provisions; some of these were included in previous budget
submissions, but many are new. Among the new items in the budget are
several general and specific provisions intended to address corporate
tax shelters. The hearing will give the Committee the opportunity to
consider carefully these revenue initiatives.
In announcing the hearing, Chairman Archer stated: ``I am
disappointed that the President provides no meaningful tax relief in
his budget for Americans, caught in the tax trap, who are working more
and paying even higher taxes. Instead, his budget contains 81
provisions to increase taxes by more than $82 billion over the next
five years. At a time when the Federal Government is collecting more
taxes than it needs, the President should not be asking the Congress to
adopt proposals that would further increase the tax burden on the
American people.''
FOCUS OF THE HEARING:
The Committee will focus on the revenue proposals contained in
President Clinton's fiscal year 2000 budget. With respect to the
Administration's tax shelter proposals, the Committee invites
additional or alternative suggestions to constrain inappropriate
corporate tax sheltering activity without impeding legitimate business
transactions.
DETAILS FOR SUBMISSIONS OF REQUESTS TO BE HEARD:
Requests to be heard at the hearing must be made by telephone to
Traci Altman or Pete Davila at (202) 225-1721 no later than the close
of business, Friday, February 26, 1999. The telephone request should be
followed by a formal written request 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. The staff of
the Committee will notify by telephone those scheduled to appear as
soon as possible after the filing deadline. Any questions concerning a
scheduled appearance should be directed to the Committee on staff at
(202) 225-1721.
In view of the limited time available to hear witnesses, the
Committee may not be able to accommodate all requests to be heard.
Those persons and organizations not scheduled for an oral appearance
are encouraged to submit written statements for the record of the
hearing. All persons requesting to be heard, whether they are scheduled
for oral testimony or not, will be notified as soon as possible after
the filing deadline.
Witnesses scheduled to present oral testimony are required to
summarize briefly their written statements in no more than five
minutes. THE FIVE-MINUTE RULE WILL BE STRICTLY ENFORCED. The full
written statement of each witness will be included in the printed
record, in accordance with House Rules.
In order to assure the most productive use of the limited amount of
time available to question witnesses, all witnesses scheduled to appear
before the Committee are required to submit 300 copies, along with an
IBM compatible 3.5-inch diskette in WordPerfect 5.1 format, of their
prepared statement for review by Members prior to the hearing.
Testimony should arrive at the Committee office, room 1102 Longworth
House Office Building, no later than March 8, 1999. Failure to do so
may result in the witness being denied the opportunity to testify in
person.
WRITTEN STATEMENTS IN LIEU OF PERSONAL APPEARANCE:
Any person or organization wishing to submit a written statement
for the printed record of the hearing should submit six (6) single-
spaced copies of their statement, along with an IBM compatible 3.5-inch
diskette in WordPerfect 5.1 format, with their name, address, and
hearing date noted on a label, by the close of business, Wednesday,
March 24, 1999, 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 200 additional copies for this
purpose to the Committee office, room 1102 Longworth House Office
Building, by close of business the day before the hearing.
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 submitted on an IBM compatible 3.5-inch diskette in WordPerfect 5.1
format, typed in single space and may not exceed a total of 10 pages
including attachments. 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, company, address, telephone and fax numbers where the witness or
the designated representative may be reached. 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.
*** NOTICE--Change in Time ***
ADVISORY
FROM THE COMMITTEE ON WAYS AND MEANS
FOR IMMEDIATE RELEASE CONTACT: (202) 225-1721
March 5, 1999
No. FC-7-Revised
Time Change for Full Committee Hearing on
Wednesday, March 10, 1999,
on Revenue Provisions in President's
Fiscal Year 2000 Budget
Congressman Bill Archer (R-TX), Chairman of the Committee on Ways
and Means, today announced that the full Committee hearing on revenue
provisions in President Clinton's fiscal year 2000 budget proposals,
previously scheduled for Wednesday, March 10, 1999, at 10:00 a.m., in
the main Committee hearing room, 1100 Longworth House Office Building,
will begin instead at 11:30 a.m.
All other details for the hearing remain the same. (See full
Committee press release No. FC-7, dated February 18, 1999.)
Chairman Archer. The Committee will come to order.
This afternoon's hearing has been called to review the
revenue proposals contained in President Clinton's budget for
the fiscal year beginning October 1. A hearty welcome to our
guests and to Secretary Lubick. I thank all of you for joining
us.
According to the nonpartisan Joint Committee on Taxation,
the White House proposes an $89 billion tax increase over the
next 10 years. The budget contains 47 tax reduction proposals
totaling $82 billion, but it also includes 75 tax hikes, which
raise $172 billion. The combination of the two is a net $89
billion tax hike.
With a multitrillion dollar surplus projected as far as the
eye can see, it is hard to understand why anyone would want to
raise taxes on any entity or individual in this country. As for
the proposed tax cuts, they most definitely complicate the
Code. If you are a nonsmoker who drives a fuel-efficient car
from your rooftop solar-equipped home to your specialized small
business investment company where you work, you get a tax cut.
However, given how difficult the tax forms are to fill out,
I'm not sure that taxpayers will welcome those ideas. On the
other hand, accountants, tax lawyers, and social engineers will
be most happy, I'm sure.
On the tax side, where they are raised, the budget contains
dozens of tax-hike repeats which have already been met with the
massive bipartisan opposition of most Ways and Means Members.
In fact, of the 75 hikes in the budget, 34 provisions worth
$132 billion are old news.
Let's not go down that road again.
There are, however, some ideas that we will explore. The
area of corporate tax shelters is one field that merits review.
I have already announced my support for a school construction
initiative. I intend to pursue other areas on which we can
build common ground.
On balance, however, this budget would make April 15th a
bigger headache for the taxpayers. Higher taxes, bigger
headaches, more complexity. I intend to pursue a different
course to lower taxes, to close unintended loopholes and abuses
and anachronisms on the way to a simpler and a fairer code.
And I look forward to working with all Members of the
Committee to get this job done.
[The opening statement follows:]
Statement of Hon. Bill Archer, a Representative in Congress from the
State of Texas
Good morning.
Today's hearing has been called to review the revenue
proposals contained in the President Clinton's budget for the
fiscal year beginning October 1st, a little less than seven
months away.
Welcome to our guests and to Secretary Lubick. Thank you
for joining us.
According to the non-partisan Joint Committee on Taxation,
the White House proposes an $89 billion tax increase over the
next ten years. The budget contains forty-seven tax reduction
proposals worth $82.1 billion, but it also includes seventy-
five tax hikes which raise $171.8 billion. The combination of
the two is the $89 billion tax hike.
With a multi-trillion dollar surplus projected as far as
the eye can see, it's hard to understand why anybody would want
to raise taxes on anyone.
As for the proposed tax cuts, they sure complicate the
code. If you're a non-smoker, who drives a fuel-efficient car
from your rooftop solar-equipped home to your specialized small
business investment company where you work, you get a tax cut.
However, given how difficult the tax forms are to fill out, I'm
not sure that taxpayers will welcome these ideas. On the other
hand, accountants, tax lawyers, and social engineers will find
much to approve.
On the tax hike side, the budget contains dozens of tax
hike repeats which have already met with the massive bipartisan
opposition of most Ways and Means members. In fact, of the
seventy-five tax hikes in the budget, 34 provisions worth $132
billion are old news. Let's not go down that road again.
There are, however, some ideas we will explore. The area of
corporate tax shelters is one field which merits review. I have
already announced my support for a school construction
initiative. I intend to pursue other areas on which we can
build common ground.
On balance however, this budget would make April 15th a
bigger headache for the taxpayers. Higher taxes, bigger
headaches, more complexity...I intend to pursue a different
course to lower taxes, to close legitimate loopholes and
anachronisms, on the way to a simpler, fairer code.
I look forward to working with all Members of the Committee
to get the job done.
Chairman Archer. I yield to the other gentleman from Texas
on the Committee for any statement he might like to make in
behalf of the Minority.
Mr. Doggett. Thank you, Mr. Chairman. I am ready to move
onto the hearing.
Chairman Archer. All right. We will commence then with our
first witness, who is one of our colleagues, our friend and
Member Bob Etheridge from North Carolina. Congressman
Etheridge, we are happy to have you before us. We would
encourage you to limit your verbal presentation to 5 minutes,
and without objection, your entire printed statement will be
inserted in the record.
So you may proceed.
STATEMENT OF HON. BOB ETHERIDGE, A REPRESENTATIVE IN CONGRESS
FROM THE STATE OF NORTH CAROLINA
Mr. Etheridge. Thank you, Mr. Chairman. And I want to thank
you and Ranking Member Rangel and the other Members of the
Committee for allowing me this opportunity this afternoon. I do
appreciate your courtesies of giving me the opportunity to
present my views on the revenue provisions of the President's
proposal fiscal year 2000 budget. And as you have just said, I
understand you are going to adhere to the 5-minute rule, and I
am going to try stick to it and move very quickly.
So I am going to focus my portion of the testimony this
afternoon on the President's revenue proposals regarding school
construction and modernization. And it is an issue that at the
same time is near and dear to my heart and certainly is
important to my district in North Carolina because, as you
know, prior to my election to the people's House, I had served
8 years, which is two terms, as the elected State
superintendent in my State. Prior to that I had the distinct
privilege of spending 10 years in the State House, where I
chaired the appropriations Committee for 4 years. And prior to
that, I was a county commissioner for 4 years, for 2 years of
which I had been chair.
So throughout my political career, I have been involved in
this issue of building schools and helping improve the quality
of education for all of our children. And it is important to
all of us.
Across America today, there are 53 million children
attending school. Too many of these children are not being
educated in the kind of quality, well-equipped facilities where
discipline and order foster academic achievement.
For many years, our Nation's school children have gone to
classes in trailers, in closets, overstuffed and rundown
classrooms. The nonpartisan General Accounting Office has
determined that there exists somewhere in the neighborhood of
$112 billion in school construction needs in America right now.
That does not measure the impact of enrollment growth.
We now have more children in our public schools than at any
time in our Nation's history, including the height of the baby
boom. As the children of the baby boomers themselves now begin
to reach school age, the resulting baby-boom echo is putting
tremendous pressure on our educational facilities in every
State and in every community.
That is why the administration's proposal, sponsored in the
House by my friend Mr. Rangel, is critically needed as a policy
innovation for the dawn of the new millennium. The Rangel
School Modernization Act will utilize the resources of the
Federal Government to leverage investments that localities
across the country are struggling to make to modernize their
school infrastructure.
The Rangel bill, of which I am a strong supporter and an
original cosponsor, will provide Federal tax credits to bond
holders to finance approximately $22 billion in school
construction bonds across America. The bonds under this bill
will be allocated among the States on an income-formula basis
and to the largest school districts whose aging infrastructure
presents a serious need for school modernization.
In my district, the problem is somewhat different.
Communities throughout the Second District in North Carolina
are growing by leaps and bounds, and our schools are bursting
at the seams. Local community leaders are scrambling to find
creative solutions to the problem of explosive growth, and they
need our help, and they need it now.
For example, just this past week, I visited Wake Forest-
Rolesville High School in Wake County, which is one of the
larger counties in my district. There teachers and students are
struggling mightily against the constraints of overcrowding to
achieve the shared goal of quality education. But in Wake
County, we are adding anywhere from 3,500 to 4,500 students per
year to a school system that is really hurting.
The county has grown by more than 33.8 percent since 1990,
and counties throughout my district have grown by anywhere from
20 to 30 percent. These localities simply do not have the means
to build schools fast enough to have first-class facilities.
To complement the Rangel bill, I have written and
introduced H.R. 996, the Etheridge School Construction Act,
which will provide tax credits to leverage $7.2 billion in
school construction bonds for localities suffering from the ill
effects of burdensome growth.
I am proud that this bill has 67 cosponsors, many of whom,
Mr. Chairman, are on this Committee. And I invite other Members
to join me.
For example, Texas qualifies for $840 million under H.R.
996, and I ask permission to submit the entire list for the
record.
Chairman Archer. Without objection, so ordered.
Mr. Etheridge. In conclusion, there is no reason why school
construction should be a partisan issue. Indeed, I would argue
that our children's future is the last thing that should be
left to the mercy of partisan politics.
Earlier this century, the men and women who have been
called the greatest generation came home from World War II and
put their shoulders to the wheel, built schools, gave us the
kind of economy we are now enjoying. We have the opportunity,
Mr. Chairman, to do the same.
Now we have a chance, as we move to the 21st century and
emerge from the cold war to make the new millennium a
millennium of education for all children.
[The prepared statement and attachment follow:]
Statement of Hon. Bob Etheridge, a Representative in Congress from the
State of North Carolina
Thank you Mr. Chairman, Ranking Democrat, my good friend
Charlie Rangel, and all the committee Members for allowing me
to testify here this morning.
I appreciate your courtesy of giving me the opportunity to
present my views on the revenue provisions of the President's
proposed Fiscal Year 2000 budget. I understand the five-minute
rule will be strictly enforced, and therefore I would like to
focus my testimony on the President's revenue proposal
regarding school construction and modernization. It is an issue
that is at the same time near and dear to my heart and
absolutely critical to the Congressional District I represent.
Prior to my election to the People's House in 1996, I
served eight years as the two-term North Carolina
Superintendent of public schools, which is a statewide elected
position in my state. Earlier, I had served in the state
legislature as the chairman of the Appropriations Committee and
on the county commission in my home of Harnett County. So I
have a rather unique perspective as someone who has struggled
with this issue at each of the different levels of government.
Throughout my years in public office, building schools and
improving education for our children has been my life's work.
Across the country today, there are 53 million children
attending school in America's classrooms. Far too many of these
children are not being educated in modern, well-equipped
facilities where discipline and order foster academic
achievement. For many of our nation's schoolchildren, class is
being taught in a trailer or in a closet or in an overstuffed
or run-down classroom. The nonpartisan Government Accounting
Office has determined there exists nationwide $112 billion in
school construction needs just to accommodate today's
enrollment levels.
We now have more children in our public schools than at any
time in our nation's history, including the height of the Baby
Boom. As the children of the Baby Boomers themselves now begin
to reach school age, the resulting ``Baby Boom Echo'' is
putting tremendous pressure on our educational facilities.
This is why the Administration's proposal, sponsored in the
House by my good friend Mr. Rangel, is a critically needed
policy innovation for the dawn of the next century. The Rangel
School Modernization Act will utilize the resources of the
federal government to leverage investments that localities
across the country are struggling to make to modernize their
school infrastructure. The Rangel bill, of which I am a strong
supporter and an original cosponsor, will provide federal tax
credits to bond holders to finance $22 billion in school
construction bonds throughout the country. The bonds under the
Rangel bill will be allocated among the states on an income-
based formula and to the largest school districts where aging
infrastructure presents a serious need for school
modernization.
In my district, the problem is somewhat different.
Communities throughout the Second Congressional District are
growing by leaps and bounds, and our schools are bursting at
the seams. Local community leaders a scrambling to find
creative solutions to the problem of explosive growth, and they
need our help.
For example, earlier this week, I visited Wake Forest-
Rolesville High School in Wake County in my district. There the
teachers and students are struggling mightily against the
constraints of overcrowding to achieve the shared goal of
quality education. But in Wake County, we are adding 3500 to
4500 students per year to the school system. The county has
grown by more than 29.4 percent since 1990, and counties
throughout my district have experienced growth of 20 to 30
percent. These localities simply do not have the means to build
the schools fast enough to provide this generation of
schoolchildren a first-class education.
To complement the Rangel bill, I have written and
introduced H.R. 996, the Etheridge School Construction Act,
which will provide tax credits for $7.2 billion in school
construction bonds for localities suffering the ill effects of
boundless growth. I am proud to have Mr. Rangel and a number of
my colleagues from this committee among the bill's 67
cosponsors, and I invite all the Members of the committee to
sign on to H.R. 996. I have here a list that may interest you.
These are the allocation amounts of what the individual states
would get from my bill. For example, Texas qualifies for $840
million under H.R. 996. I ask permission to submit the entire
list for the record.
In conclusion, there is no reason why school construction
should be a partisan issue. Indeed, I would argue that our
children's future is the last thing that should be left to the
mercy of partisan politics. Earlier this century, the men and
women who have been called ``The Greatest Generation,''
resolved after winning World War II to invest in children and
in the education of those children. That collective decision
ushered in an era of economic prosperity, relative
international peace and human progress that is unrivaled in the
history of God's creation. We are the direct beneficiaries of
that foresight, commitment and investment. As we emerge from
the Cold War and enter a new millenium, I challenge this
committee and this Congress to exercise the same patriotic
devotion to our duty to provide for stronger future generations
by coming together across party lines to pass common sense,
visionary legislation like the Rangel School Modernization Act
and the Etheridge School Construction Act.
Thank you, Mr. Chairman. I would be happy to answer any
questions.
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Chairman Archer. Thank you, Congressman Etheridge. Are
there any questions for Congressman Etheridge? Mr. Weller.
Mr. Weller. Thank you, Mr. Chairman. And Mr. Etheridge, I
welcome you to the Committee and glad you are here today.
Mr. Etheridge. Thank you, Mr. Weller.
Mr. Weller. Also want to point out, of course, you are
talking today of course about school construction, and that is
not really a partisan issue, as you point out. Both Chairman
Archer and a number of Republicans have initiated school
construction initiatives.
I know Representative Dunn and I have a tax simplification
package, and we set aside $3 billion for school construction in
our package. So I think clearly there is a bipartisan agreement
that we want to do something. And, of course, the mechanics of
doing that will be part of the process this year.
I think I would also like to point, as you note, education
is important. And this Committee has made education pretty
important here. We provided this year around April 15th there
will be hundreds of thousands, if not millions, of Americans
who will be taking advantage of the student loan interest
deduction, a thousand-dollar deduction, that they will have
thanks to this Committee, which enacted in the last couple of
years.
And also education savings accounts for those who want to
save for their children. There is more we need to do but----
You know, the issue today before this Committee is the over
$170 billion in tax increases that the administration has
proposed. And from your point of view, of course, the
administration has proposed, I think, about $176 billion in tax
hikes as part of their budget to pay for school construction.
And there are other initiatives they discuss in the budget.
And I was wondering, what are your thoughts about the $176
billion in tax hikes that are in the administration's budget?
Do you support those?
Mr. Etheridge. Well, let me say I appreciate what this
Committee has done. What you did last year, and what we all
voted on to make education available for children who go to the
universities because that is important.
Today, I am talking about those who want to get their start
and make sure they show up at a school in a quality environment
to learn because there are communities, even though they have
certain resources, and they are taxed to the extent and in many
cases they can't meet those needs. So I think we have a chance,
at the Federal level now, to form a partnership, not unlike
what we have done in so many other areas when we have the
resources to do it.
The whole issue of tax increases and tax reductions are
issues that we all have to come together and work and jointly
decide whether or not they fit our priorities.
But I happen to believe the issue of opportunities for
children are opportunities we have a chance to claim and deal
with.
Mr. Weller. Reclaiming my time, Representative. I think we
agree. As I stated earlier, education is a priority, and in the
administration's budget they propose $176 billion in tax
increases, new taxes, on products important to your State and
others. And I was just wondering, do you support--can you pick
out one or two you think to be appropriate pay-fors to pay for
the administration's school construction budget, something you
think is an appropriate offset, something you would recommend.
Mr. Etheridge. I have listed offsets in the proposal, Mr.
Weller, that I laid out. There are definite proposals in there.
There is one tax that I will not support, and I have already
made public that. And that is another increase in the cigarette
tax because that has a definite impact directly on my district.
Mr. Weller. That is about a third of the President's tax
hike.
Mr. Etheridge. Not sure what that number is.
Mr. Weller. The President also proposes as part of his pay-
fors for his budget, about $9 billion in Medicare cuts to our
local hospitals and $140 million in new taxes on our health-
care providers. Do you feel those are appropriate pay-fors for
a school construction initiative?
Mr. Etheridge. Well, I didn't list any of those, I would
say, in my proposal. Those proposals, they will have to be
decided before any Committee. But the ones I laid out have
nothing to do with Medicare and Medicare issues.
Mr. Weller. So then you oppose the President's cuts in
Medicare reimbursements to hospitals and oppose the
administration's tax increase.
Mr. Etheridge. And I can assure you, my hospitals are not
happy with it either.
Mr. Weller. All right. Well thank you, Representative.
Chairman Archer. If there are no further questions for
Congressman Etheridge, we thank you for your appearance and for
your presentation.
Mr. Etheridge. Thank you, sir.
Chairman Archer. Our next witness is Assistant Secretary of
the Treasury, Hon. Don Lubick, who is no stranger to our
Committee. We are happy to have you with us today, and pleased
to receive your verbal testimony. Without objection, your
entire printed statement, will be inserted in the record.
Welcome, you may proceed.
STATEMENT OF HON. DONALD C. LUBICK, ASSISTANT SECRETARY, TAX
POLICY, U.S. DEPARTMENT OF THE TREASURY; ACCOMPANIED BY HON.
JONATHAN TALISMAN, DEPUTY ASSISTANT SECRETARY, TAX POLICY
Mr. Lubick. Thank you, Mr. Chairman. I appreciate as usual
the----
Chairman Archer. Mr. Lubick, if I may, I should have also
introduced and welcomed Jonathan Talisman, who is the Deputy
Assistant Secretary for Tax Policy with the Treasury. We are
happy to have you with us today too.
Mr. Talisman. Thank you, Mr. Chairman.
Chairman Archer. All right, Mr. Lubick.
Mr. Lubick. As you have noted, Mr. Chairman, there is a lot
of baggage that we are carrying. So it takes two of us.
[Laughter.]
I always appreciate the rather kind treatment that I get
here, even though I know occasionally you may disagree with
something that I advocate. So appreciate that as well. And it
goes for all the Members of the Committee.
I would like to address today the revenue provisions
included in the President's Fiscal 2000 budget.
The Nation has moved from an era of large annual budget
deficits to an era of budget surpluses, which are projected to
continue for many, many years. This has resulted from the
fiscal policy of the last 6 years, the economy it helped
produce, and the ongoing interaction between the two.
Rather than facing an annual requirement to reduce the
deficit, we now have before us the opportunity to face the
serious challenges for generations to come by making wise
policy choices. These challenges lie primarily in the area of
the economic and fiscal pressures created by the retirement
baby-boom generation. Meeting those challenges is exactly what
the President's budget does.
The core of the budget is fiscal discipline and thereby
increased national savings in order to promote continuing
economic growth and retirement security in the years ahead.
The President's proposal is to commit 62 percent of the
unified surplus for the next 15 years to Social Security. This
is an infusion of $2.76 trillion to the trust fund, in addition
to the $2.7 trillion of forecast off-budget surplus generated
by payroll taxes in excess of receipts for the next 15 years,
which would go to Social Security anyway.
The infusion, including increased rates of return from
investing about 20 percent of the 62 percent of the unified
surplus in equities, will extend the predicted period of
solvency for the trust fund from 2032 to 2055. The remaining 20
years to reach 75 years of solvency will require tough
decisions to be made jointly by the President and Congress.
An additional 15 percent of the surplus would be allocated
to Medicare, and the President also proposes to devote 12
percent of the surplus to a program to encourage saving through
USA Accounts. The majority of workers would receive an
automatic contribution, and in addition, those who make
voluntary contributions could receive a matching contribution
to their USA Account.
The matching contribution would be more progressive than
current tax subsidies for retirement savings, helping most the
workers who most need to increase retirement savings.
By creating a retirement savings program for working
Americans with individual and government contributions, all
Americans will become savers and enjoy a more financially
secure retirement.
The remaining 11 percent would be allocated to other
priorities, including defense funding.
Finally, the budget insists that none of the surpluses be
used at all until we have put Social Security on a sound
financial footing for the long term.
I would like to address primarily today the package of
about $34 billion in targeted tax reductions, which I would
like to summarize briefly. They include increased funding for
education, including tax credit bond programs totaling $25
billion to spur State and local government investment in
elementary and secondary schools, expansion of the current law
incentive for employer-provided educational assistance and a
number of other items.
There are measures to make child care affordable by
expanding the current child- and dependent-care credit and by
providing a new employer credit to promote employee child care.
There are provisions to provide tax relief for individuals
with long-term care needs or those who care for others with
such needs, and to workers with disabilities. There are
measures to promote health insurance coverage for employees of
small business. There are incentives to promote the livability
and revitalization of urban and rural communities, a tax credit
to attract new capital to businesses located in low-income
communities--expansion of the current law--low-income housing
credit, and $3.6 billion in tax incentives to promote energy
efficiency and reduce greenhouse gases.
There are several provisions to expand and simplify and
increase the portability of retirement savings mechanisms. We
have been in discussions with your Members, Congressmen Portman
and Cardin, to deal with that problem.
We have proposed the extension of a recently enacted
provision that prevents the nonrefundable tax credits, such as
the education credit and the child credits, from being affected
by the alternative minimum tax. I know that is a problem you
concerned yourself with much recently.
And we proposed extenders of several tax provisions, such
as the R&D tax credit, the work opportunity and welfare-to-work
credits and the brownfields expensing program.
And there are also some provisions that would simplify the
administration of the tax laws.
Mr. Chairman, sound fiscal policy demands that these
proposals be fully funded, so the President's budget includes a
package of revenue offsets that would fully offset our targeted
tax incentives. Our revenue offsets would curtail corporate tax
shelters and close loopholes in the tax law in the areas of
financial products, corporate taxes, pass-through entities, tax
accounting, cost recovery, insurance to exempt organizations,
State and gift taxation, and a number of others.
Let me focus for a moment on proposals in our package that
we believe will curtail significantly the development,
marketing, and purchase of products designed to produce a
substantial reduction in a corporation's tax liability.
The administration believes that there has been an increase
in the use of corporate tax shelters and is concerned about
this proliferation for several reasons. Corporate tax shelters
reduce the corporate tax base. Moreover, they erode the
integrity of the tax system as a whole. The view that large,
well-advised corporations can and do avoid their legal tax
liabilities by engaging in transactions unavailable to most
other taxpayers may lead to a perception of unfairness and if
unabated, may lead to a decrease in voluntary compliance.
Finally, the significant resources used to create,
implement, and defend complex sheltering transactions are
better used in more productive activities.
To date, most attacks on corporate tax shelters have been
targeted at specific transactions and have incurred on an ad
hoc, after-the-fact basis through legislative proposals,
administrative guidance, and litigation.
At the Treasury Department, a number of actions have been
taken to address corporate tax shelters. We have made
legislative proposals aimed at corporate-owned life insurance,
which awaits action by the Congress, section 357(c) abuses,
which has been advanced in both chambers, and liquidating
REITs, real estate investment trusts, which were enacted last
year.
On the regulatory front, we have issued guidance such as
the notice on step-down preferred, fast-paced, slow-pay
transactions, and at litigation, we have won two important
cases, ACM, and ASA.
But we often hear that we are only hitting the tip of the
iceberg.
Addressing corporate tax shelters on a transaction-by-
transaction ad hoc basis raises certain concerns. First, it is
not possible to identify and address all current and future
sheltering transactions. Taxpayers with an appetite for
corporate tax shelters will simply move from those transactions
that are specifically prohibited by the new legislation to
other transactions, the treatment of which is less specified.
Second, legislating on a piecemeal basis further
complicates the Code, and seemingly calls into question the
viability of common-law tax doctrines such as sham transaction,
business purpose, economic substance, and substance over form.
Finally, using a transactional legislative approach to
corporate tax shelters may embolden some promoters and
participants to rush shelter products to market in the belief
that any reactive legislation would be applied only on a
prospective basis.
Mr. Chairman, we are gratified by recent statements that
you have made supporting the need to address this problem. I
won't go further by saying you have committed to anything in
particular, but we are very pleased that you recognize that
there is a problem to be addressed. We also want to thank the
Members of this Committee for addressing specific corporate tax
shelters that we or others have brought to their attention.
In addition, we are pleased that numerous tax practitioners
and representatives even of Fortune 500 companies have spoken
to us expressing their support for taking action. The
administration, therefore, proposes several remedies to curb
the growth of corporate shelters.
First, we propose more general remedies to deter
corporations from entering into any sheltering transactions.
These proposals would disallow any tax benefit created in a
corporate tax shelter and would address common characteristics
found in corporate tax shelters.
In addition, we propose specific remedies for certain
transactions that we have already identified as being used to
shelter improperly corporate income from Federal taxation.
Also, all the parties to a structured transaction under our
proposals, would have an incentive to assure that the
transaction comports with established principles.
The Treasury Department recognizes that this more general
approach to corporate tax shelters raises certain concerns.
Applying various substantive and procedural rules to a
corporate tax shelter for a tax-avoidance transaction requires
definitions of such terms. As described in greater detail in
our written testimony, the administration's proposals define
these terms.
Critics of the proposals have suggested that these
definitions are too broad or may create too much uncertainty
and thus may inhibit otherwise legitimate transactions. The
Treasury Department does not intend to affect any legitimate
transaction. Let me state, however, that the definition we have
proposed is similar to existing articulations of various
judicial doctrines and may be viewed as largely enforcing the
judicially created concept of economic substance that obtains
in under current law.
The definition of corporate tax shelter, as used in our
proposals, is narrower and, therefore, less uncertain than
other definitions and formulations, which are part of our
present legal treatment used in the Code and judicial
interpretations of its provisions. We strike no new ground in
defining the nature of tax shelters.
Taxpayers and practitioners have lived with the concepts
our definitions embody, as they have been enunciated by the
courts since the twenties. A measure of uncertainty is not only
inevitable but perhaps desirable to prevent over-aggressive
tax-avoidance scheming.
We ask practitioners to come forward with examples of
legitimate tax planning that would be jeopardized by our
definition.
Mr. Chairman, Members of the Committee, we will respond and
work with this Committee to refine our definition in a manner
that will protect from penalty any legitimate, normal, course-
of-business transactions. I also want to mention that our
budget contains a number of provisions that would close
loopholes in the Code. They have great merit. They are
discussed fully in my prepared remarks, which I appreciate your
including in the record.
In conclusion, Mr. Chairman and Members of the Committee,
the administration looks forward to working with you as you
examine our proposals. We hope that you reach the conclusion
that they are all meritorious, and that this Committee will
approve them.
Mr. Talisman and I stand at the ready to attempt to answer
any questions you may have.
[The prepared statement follows:]
Statement of Hon. Donald C. Lubick, Assistant Secretary, Tax Policy,
U.S. Department of the Treasury
Mr. Chairman, Mr. Rangel, and Members of this committee, it
is a pleasure to speak with you today about the President's FY
2000 budget.
The nation has moved from an era of large annual budget
deficits to an era of budget surpluses for many years to come.
This has resulted from the fiscal policy of the last six years,
the economy it helped produce, and the ongoing interaction
between the two. Rather than facing an annual requirement to
reduce the deficit, we now have before us the opportunity to
face the serious challenges for generations to come by making
wise policy choices. These challenges lie primarily in the area
of the economic and fiscal pressures created by the retirement
of the baby boom generation. Meeting those challenges is
exactly what the President's budget does. The core of this
budget is fiscal discipline, and thereby increased national
savings, in order to promote continuing economic growth and
retirement security in the years ahead.
In 1992, the deficit reached a record of $290 billion, the
Federal debt had quadrupled during the preceding twelve years,
and both the deficit and debt were projected to rise
substantially. The deficit binge has left us with publicly held
debt of $3.7 trillion, and an annual debt service requirement
that amounts to 15 percent of the budget. Now however, for the
next 15 years, OMB forecasts cumulative unified surpluses of
over $4.85 trillion.
It is important to note that transformation from deficits
to surpluses has come about concurrent with tax burdens on
typical working families being at record lows for recent
decades. For a family of four with a median income, the federal
income and payroll tax burden is at its lowest level in 21
years, in part because of the child tax credit enacted in the
1997 balanced budget plan. For a family of four with half the
median income, the income and payroll tax burden is at its
lowest level in 31 years, in part because of the 1993 expansion
of the Earned Income Tax Credit for fifteen million families as
well as the 1997 enactment of the child tax credit. And for a
family of four with double the median income, the federal
income tax burden is at its lowest level since 1973. While
overall tax revenues have risen as a percentage of GDP, that is
in part because higher income individuals have had large
increases in incomes, resulting from, among other things,
bonuses based on high stock prices and increased realizations
of capital gains, and in part because of increased corporate
earnings.
The President's proposal is to commit 62 percent of the
unified surplus for the next 15 years to Social Security. This
is an infusion of $2.8 trillion to the trust fund in addition
to the $2.7 trillion of forecast off-budget surpluses generated
by payroll taxes in excess of benefit payments. This infusion,
including increased rates of return from investing one-fifth of
the 62 percent of the unified surplus in equities, will push
back the date of trust fund exhaustion from 2032 to 2055.
Closing the remaining gap and thus assuring solvency over 75
years will require tough decisions to be made jointly by the
President and Congress.
An additional 15 percent of the surplus would be allocated
to Medicare. The President also proposes to devote 12 percent
of the unified surplus to establishing a new system of
Universal Savings Accounts. These accounts would provide a tax
credit to millions of American workers to help them save for
their retirement. A majority of workers could receive an
automatic contribution. In addition, those who make voluntary
contributions could receive a matching contribution to their
USA account. The matching contribution would be more
progressive than current tax subsidies for retirement savings--
helping most the workers who most need to increase retirement
savings. By creating a retirement savings program for working
Americans with individual and government contributions, all
Americans will become savers and enjoy a more financially
secure retirement.
The remaining 11 percent would be allocated to other
priorities, including increased defense spending. Finally, the
budget insists that none of the surpluses be used at all until
we have put Social Security on sound financial footing for the
long-term.
When President Clinton was elected, publicly held debt
equaled 50 percent of GDP. As a result of the President's plan,
by 2014, publicly held debt will decline to about 7 percent of
GDP. This reduction in debt will have three effects. First, the
government will not have to refinance as much federal debt and
thereby will consume less of national savings, thus making
capital more readily available to the private sector. That, in
turn, will reduce interest rates and increase confidence in the
economy, increasing economic growth, job creation and standards
of living. Second, debt service costs will decline
dramatically. When the President came into office debt service
costs of the federal government in 2014 were projected to
constitute 27 percent of the federal budget. Under the
President's proposal, and because of the progress we have made
to date, we estimate the debt service costs will be 2 percent
of the federal budget in 2014. Third, the decrease in debt
means the federal government will have a greatly improved
capacity to access external capital should the need arise.
This is not the time, with the economy running so well, for
major tax cuts that are not offset by other measures. Public
debt reduction is an opportunity that we should not squander,
and it will reap broader and more permanent economic prosperity
than any tax cut could. Public debt reduction has many of the
economic effects of a tax cut, but maintains the fiscal
discipline necessary to meet future challenges. It is the only
responsible course to take.
Targeted incentives
Thus, the President's Budget also proposes a fully funded
package of about $34 billion in targeted tax reductions,
including provisions to rebuild the nation's schools, make
child and health care more affordable, revitalize communities,
provide incentives for energy efficiency, promote retirement
savings, provide for tax simplification, and extend expiring
provisions.
More specifically, to enhance productivity and maintain our
country's competitive position in the years ahead, and to
provide relief for working families, the Administration
proposes:
increased funding for education, including tax
credit bond programs totaling $25 billion to spur State and
local government investment in elementary and secondary
schools, expansion of the current-law tax incentive for
employer-provided educational assistance, simplification and
expansion of the deduction allowed for student loan interest
payments, tax-free treatment for certain education awards, and
a tax credit for certain workplace literacy and basic education
programs;
measures to make child care more affordable, by
expanding the current-law child and dependent care tax credit
and by providing a new employer credit to promote employee
child care;
providing tax relief (in the form of a $1,000
credit) to individuals with long-term care needs, or who care
for others with such needs, and to workers with disabilities;
measures to promote health insurance coverage for
employees of small businesses;
incentives to promote the livability and
revitalization of urban and rural communities, including a tax
credit bond program totaling $9.5 billion to help States and
local governments finance environmental projects, a tax credit
to attract new capital to businesses located in low-income
communities, expansion of the current-law low-income housing
tax credit program, and $3.6 billion in tax incentives to
promote energy efficiency and reduce greenhouse gases;
several provisions to expand, simplify, and
increase the portability of retirement savings mechanisms, and
to make it easier for individuals to save for retirement on
their own; and
extension of a recently enacted provision that
allows individuals to claim nonrefundable tax credits--such as
the education credits and the $500 child credit--without being
affected by the alternative minimum tax; and
extension of several tax provisions that are
scheduled to expire, including the R&E tax credit, work
opportunity and welfare-to-work tax credits, and the so-called
``brownfields'' expensing provision.
The President's plan also includes a package of provisions
that would simplify the administration of the Federal tax laws.
The following is a more detailed summary of the tax
incentive provisions included in the President's plan.
1. MAKE HEALTH CARE MORE AFFORDABLE
Long-term care and disabled workers credits.--Deductions
available under current law for long-term care and work-related
impairment expenses do not benefit taxpayers who claim the
standard deduction and, even if a taxpayer itemizes deductions,
do not cover all formal and informal costs of providing
assistance to individuals with long-term care needs or to
disabled individuals who work. In recognition of such formal
and informal long-term care costs and their effect on a
taxpayer's ability to pay taxes, the President's plan would
allow taxpayers to claim a new long-term care credit of $1,000
if the taxpayer, a spouse, or an individual receiving support
from (or residing with) the taxpayer has ``long-term care
needs.'' An individual generally would have ``long-term care
needs'' if unable for at least six months to perform at least
three activities of daily living without substantial assistance
from another individual, or if unable to perform at least one
activity of daily living or certain age appropriate activities
due to severe cognitive impairment.
In addition, the President's plan would help compensate
taxpayers with disabilities for costs associated with work
(e.g., personal assistance or special transportation) by
allowing taxpayers with earned income to claim a $1,000 credit
if the taxpayer is unable for at least 12 months to perform at
least one activity of daily living without substantial
assistance from another individual.
To claim one (or possibly both) of the credits, taxpayers
would be required to obtain a physician's certification to
demonstrate the required level of long-term care needs, but
would not be required to substantiate any particular out-of-
pocket expenses. The proposed credits would be phased out--in
combination with the current-law $500 child credit--for certain
higher-income taxpayers.
Small business health plans.--The President's plan would
make health care costs more affordable by assisting small
businesses in their efforts to provide health insurance to
employees. Small businesses generally face higher costs than do
larger employers in providing health plans to their employees,
which has led to a significantly higher percentage of small
business employees being uninsured compared to the national
average. Health benefit purchasing coalitions pool employer
workforces and provide an opportunity to purchase health
insurance at a reduced cost, but such coalitions have been
hindered by limited access to capital. In response, the
President's plan includes a special, temporary rule that would
allow tax-exempt private foundations to make grants or loans
prior to January 1, 2004, to qualified health benefit
purchasing coalitions to support the coalition's initial
operating expenses.
Moreover, the President's plan would allow employers that
have fewer than 50 employees and that did not have an employee
health plan during 1997 or 1998 to claim a 10-percent credit
for certain premium payments made for employee health insurance
purchased through a qualified coalition. The proposed credit
would be allowed for health plans established before January 1,
2004, and would be allowed for contributions made during the
first 24 months that an employer purchases health insurance
through a qualified coalition.
2. EXPAND EDUCATION INITIATIVES
School construction and modernization.--Because many school
systems lack sufficient fiscal capacity to respond to aging
school buildings and growing enrollments, the President's plan
includes a new tax credit bond program that would leverage
Federal support to spur new State and local investment in
elementary and secondary school modernization. Under this
program, State and local governments (including U.S.
possessions) would be authorized to issue up to $22 billion of
``qualified school modernization bonds'' ($11 billion in each
of 2000 and 2001). One half of the $22 billion cap would be
allocated among the 100 school districts with the largest
number of children living in poverty and up to 25 additional
school districts with particular needs of assistance. The
remaining half of the $22 billion cap would be allocated among
the States and Puerto Rico. In addition, $400 million of bonds
($200 million in each of 2000 and 2001) would be allocated for
construction and renovation of Bureau of Indian Affairs funded
schools.
A holder of these bonds would receive annual Federal income
tax credits, set according to market interest rates by the
Treasury Department, in lieu of interest being paid by the
State or local government. At least 95 percent of the bond
proceeds of a qualified school modernization bond must be used
(generally within 3 years of the date of issuance) to finance
public school construction or rehabilitation pursuant to a plan
approved by the Department of Education. Issuers would be
responsible for repayment of principal after a maximum term of
15 years.
The President's plan also provides for expansion of the
current-law ``qualified zone academy bond'' program, by
authorizing the issuance of an additional $2.4 billion of such
bonds and allowing the bond proceeds to be used for new school
construction.
Other education incentives.--To expand educational
opportunities throughout a taxpayer's lifetime, the President's
budget plan also includes the following provisions that build
on current-law tax incentives for education: (1) extend section
127 exclusion for employer-provided educational assistance
through the end of the year 2001 and expand the exclusion to
apply to graduate-level courses (currently, the exclusion is
limited to undergraduate courses beginning before June 1,
2000); (2) eliminate the current-law rule under section 221
that limits deductible student loan interest to interest paid
only during the first 60 months that interest payments are
required on a loan (this will simplify greatly the student loan
interest deduction provision); (3) eliminate tax liability when
Federal student loan balances are canceled after the student
finishes making income-contingent payments on the loan; (4)
provide tax-free treatment for certain awards under the
National Health Service Corps scholarship and loan repayment
programs, the Armed Forces Health Professions scholarship and
loan repayment programs, and the Americorps loan repayment
program; (5) provide for an allocated tax credit to encourage
corporate sponsorship of qualified zone academies in designated
empowerment zones and enterprise communities; and (6) allow
employers to claim a 10-percent credit (up to $525 per eligible
employee) for certain workplace literacy programs that provide
basic skills instruction at or below the level of a high school
degree or English literacy.
3. MAKING CHILD CARE MORE AFFORDABLE
Increase, expand and simplify the child and dependent care
tax credit.--Many working parents cannot find affordable and
safe child care. The needs of moderate-income families can best
be served through an expansion of the current-law child and
dependent care tax credit, which was last increased in 1982.
The President's plan would increase the maximum credit rate
from 30 percent to 50 percent, and would extend eligibility for
the maximum credit rate to taxpayers with adjusted gross
incomes of $30,000 (rather than $10,000 as under current law).
The new 50-percent credit rate would be phased down gradually
for taxpayers with adjusted gross incomes between $30,000 and
$59,000. The credit rate would be 20 percent for taxpayers with
adjusted gross incomes over $59,000.
In addition, to enable parents to make the best choices for
caring for their infants, who require special care and
attention, the President's plan would further expand the
eligibility for the child and dependent care tax credit.
Parents with infants under the age of one would be eligible for
an additional credit amount, even if the parent stays at home
to care for the infant rather than working outside the home and
incurring out-of-pocket child care expenses. Under the
proposal, a taxpayer who resides with his or her infant under
the age of one would be deemed to have child care expenses of
$500 ($1,000 for two or more infants under the age of one).
Taxpayers residing with children under the age of one who also
incur out-of-pocket child care expenses in order to work would
simply add such out-of-pocket expenses to the deemed $500 (or
$1,000) of child care expenses, and would then calculate the
section 21 credit by multiplying deemed and actual out-of-
pocket child care expenses by the applicable 20- to 50-percent
credit rate.
The President's plan would simplify eligibility for the
credit by eliminating the complicated household maintenance
test under current law (except that a married taxpayer filing a
separate return would still have to meet the current-law
household maintenance test in order to qualify for the credit).
In addition, to ensure that the credit retains its value over
time, certain credit parameters would be indexed for inflation.
Employer-provided child care credit.--As part of the
Administration's comprehensive initiative to address child care
needs of working families, the President's plan would allow
employers to claim a credit equal to 25 percent of expenses
incurred to build or acquire a child care facility for employee
use, or to provide child care services to children of employees
directly or through a third party. Employers also would be
entitled to a credit equal to 10 percent of expenses incurred
to provide employees with child care resource and referral
services. A taxpayer's total credit could not exceed $150,000
per taxable year.
4. INCENTIVES TO REVITALIZE COMMUNITIES
Better America Bonds.--Conventional tax-exempt bonds may
not provide a deep enough subsidy to induce State and local
governments to undertake environmental projects with diffuse
public benefits. Accordingly, the President's plan includes a
new tax credit bond program, under which States and local
governments (including U.S. possessions and Native American
tribal governments) would be authorized to issue an aggregate
of $9.5 billion of ``Better America Bonds.'' Similar to the
President's school modernization bond proposal (discussed
above) and the current-law qualified zone academy bonds,
holders of such bonds would receive annual Federal income tax
credits in lieu of interest being paid by the State or local
government. At least 95 percent of the bond proceeds must be
used (generally within 3 years of the date of issuance) to
finance projects to protect open spaces or accomplish certain
other qualified environmental purposes. The Environmental
Protection Agency would allocate bond authority to particular
environmental projects based on a competitive application
process. Issuers of the bonds would be responsible for
repayment of principal after a maximum term of 15 years.
New Markets Tax Credit.--Businesses located in low-income
urban and rural communities often lack access to sufficient
equity capital. To attract new capital to these businesses,
taxpayers would be allowed a credit against Federal income
taxes for certain investments made to acquire stock (or other
equity interests) in a community development investment entity
selected by the Treasury Department to receive a credit
allocation. The Treasury Department would authorize selected
community development entities to issue up to a total of $6
billion of equity interests with respect to which investors
could claim a credit equal to approximately 25 percent (in
present-value terms) of the investment.
Under the proposal, selected community development
investment entities, in turn, would be required to use the
investment proceeds to provide loans or equity capital to
qualified active business located in low-income communities.
Such businesses generally would be required to satisfy the
requirements for ``enterprise zone businesses'' under current
law and must be located in census tracts with either (1)
poverty rates of at least 20 percent or (2) median family
income which does not exceed 80 percent of metropolitan area
family income (or 80 percent of non-metropolitan statewide
family income in the case of a non-metropolitan census tract).
There would be no requirement that employees of a qualified
active business be residents of a low-income community.
Increase low-income housing tax credit per capita cap.--
Most State agencies receive more qualified proposals for low-
income rental housing than can be undertaken with the current-
law State limitation for the low-income housing tax credit.
This limitation has not changed since it was established in
1986. Accordingly, the President's plan would increase the
current-law $1.25 per capita limitation for the low-income
housing tax credit to $1.75 per capita. This increase would
allow additional low-income housing to be provided but still
would require that State agencies choose projects that meet
specific housing needs.
Other provisions.--As additional incentives to revitalize
communities, the President's plan would (1) enhance the
current-law provisions that allow certain investment gains to
be rolled over on a tax-free basis to purchase stock in a
specialized small business investment company (SSBIC) and that
provide a partial capital gains exclusion for the sale of such
stock held for more than five years; and (2) provide that
businesses located in the two new empowerment zones, with
respect to which the zone designation takes effect on January
1, 2000 (i.e., Cleveland and Los Angeles), will be eligible to
claim the empowerment zone wage credit for the full, ten-year
period of zone designation, as is the case with the original
nine empowerment zones designated in 1994.
5. ENERGY EFFICIENCY AND ENVIRONMENTAL IMPROVEMENT
In an effort to improve the environment, the President's
budget proposes $3.6 billion in tax incentives to promote
energy efficiency and to reduce emissions of greenhouse gases.
Energy-efficient buildings would be encouraged by a tax
credit of up to $2,000 for the purchase of highly energy-
efficient new homes, and by a 10 or 20 percent credit (subject
to a cap) for the purchase of certain energy-efficient building
equipment (fuel cells, electric heat pump water heaters,
natural gas heat pumps, electric heat pumps, natural gas water
heaters, and advanced central air conditioners). The credit for
energy-efficient homes would apply to purchases in calendar
years 2000 through 2004 and the credit for energy-efficient
building equipment would apply to purchases in calendar years
2000 through 2003.
Transportation-related incentives would encourage the
purchase of electric vehicles and highly energy-efficient
hybrid vehicles. The current-law credit of up to $4,000 for the
purchase of a qualifying electric vehicle would be extended
through 2006, and a new credit of up to $4,000 would be allowed
in calendar years 2003 through 2006 for purchases of fuel-
efficient hybrid vehicles.
The Administration's budget proposals would also promote
increased energy efficiency through the use of combined heat
and power (CHP) technologies by allowing an 8-percent
investment tax credit for qualifying CHP equipment placed in
service in calendar years 2000 through 2002.
Finally, tax incentives would be provided for the increased
use of renewable energy sources: a credit of up to $2,000 would
be allowed for solar photovoltaic equipment placed in service
during calendar years 2000 through 2006 and of up to $1,000 for
solar hot water heating systems placed in service during
calendar years 2000 through 2005. In addition, the current-law
tax credit for electricity produced from wind or biomass would
be extended for five years. For this purpose, eligible biomass
sources would be expanded to include certain biomass derived
from forest-related resources and agricultural sources, and a
reduced credit would be allowed for co-firing biomass in coal
plants.
6. EXPANDED RETIREMENT SAVINGS, SECURITY, AND PORTABILITY
With changing demographics, it is especially important to
increase retirement savings. Much of the legislation enacted in
recent years has been successful in expanding retirement
savings, providing incentives to individuals and employers.
Approximately two-thirds of the retirement savings in this
country (exclusive of annuity contracts) is employer-provided
retirement savings. Employer-provided pensions currently
benefit 50 million workers. The President's budget encourages
savings through employer-provided plans.
While the employer system is strong, we cannot be content.
Half of all American workers--more than 50 million people--have
no pension plan at all. Women have less pension coverage than
men. Only 30 percent of all women aged 65 or older were
receiving a pension in 1994 (either worker or survivor
benefits) compared to 48 percent of men. An increasingly mobile
workforce makes accumulating and managing retirement benefits
more difficult. Workers frustrated by keeping track of their
various retirement accounts are tempted to cash out their
retirement benefits and spend these all important savings on
current consumption. Two-thirds of workers receiving a lump sum
distribution from a pension plan do not roll over the
distribution into retirement savings.
We need to continue to promote retirement savings by
enacting pension legislation to expand the number of people who
will have employer-provided pensions, by simplifying the
pension laws for business, by improving pension funding and
making pensions more secure and portable for workers.
The President's budget includes several incentives to
encourage the provision of retirement benefits by small
business. First, a three-year tax credit is provided to
encourage small businesses to set up retirement programs.
Second, to make it easier for workers to make contributions to
Individual Retirement Accounts (IRAS), employers would be
encouraged to offer payroll deduction programs. Third, the
President's plan provides a simplified defined benefit-type
plan for small business, known as the ``SMART Plan.'' The
Administration's proposal is similar in many respects to the
bipartisan ``SAFE plan'' proposal of Representatives Earl
Pomeroy and Nancy Johnson. The SMART (Secure Money Annuity or
Retirement Trust) plan combines many of the best features of
defined benefit and defined contribution plans and provides
another easy-to-administer pension option for small businesses.
Most nondiscrimination rules and a number of other pension plan
requirements would be waived for this new plan. SMART plans
would be an option for most small businesses with 100 or fewer
employees that do not offer (and have not offered during the
last 5 years) a defined benefit or money purchase plan.
Employers choosing a SMART plan would make contributions for
all eligible workers (over 21 with at least $5,000 in W-2
earnings with the employer in that year and in two preceding
consecutive years). Participants would be guaranteed a minimum
annual benefit upon retirement, but could receive a larger
benefit if the return on plan investments exceeds specified
conservative assumptions (i.e., a 5 percent rate of return).
The SMART benefit would generally be guaranteed by the Pension
Benefit Guaranty Corporation, at a reduced premium.
To make it easier to consolidate retirement savings, the
President's budget provides rules to permit eligible rollover
distributions from a qualified retirement plan to be rolled
over into a Section 403(b) tax-sheltered annuity or visa versa;
to allow rollovers from non qualified deferred compensation
plans of state or local government (Section 457 plans) to be
rolled over into an IRA; to permit rollovers of IRAs into
workplace retirement plans; to allow rollovers of after-tax
contributions to new employer's defined contribution plan or an
IRA if separate tracking of after-tax contribution is provided;
to allow the Thrift Savings Plan (a retirement savings plan for
federal government employees) to accept tax-free rollovers from
private plans; and to allow employees of state and local
governments to use funds in their retirement plans to purchase
service credits in new plans without a taxable distribution.
This allows teachers who often move between state and school
districts in the course of their careers to more easily earn a
pension reflecting a full career of employment in the state in
which they end their career.
7. EXTENSION OF EXPIRING PROVISIONS
The President's plan includes the extension of several
important tax incentive provisions that are scheduled to expire
in 1999, including (1) a one-year extension of the R&E tax
credit to apply to qualified research conducted before July 1,
2000 (and extension of the credit to qualified research
conducted in Puerto Rico), and (2) one-year extensions of the
work opportunity tax credit and welfare-to-work tax credit to
cover employees who begin work before July 1, 2000.
The President's plan also proposes extending through the
year 2001 the recently enacted tax credit for the first-time
purchase of a principal residence in the District of Columbia
(which currently is scheduled to expire at the end of the year
2000).
In addition, the President's plan would make permanent the
so-called ``brownfields'' provision, which allows taxpayers to
treat certain environmental remediation expenditures that would
otherwise be chargeable to capital account as deductible in the
year paid or incurred. The ``brownfields'' provision currently
is scheduled to expire at the end of the year 2000.
AMT Relief
Of particular importance to individual taxpayers, the
Administration proposes to extend, for two years, the provision
enacted in 1998 that allows an individual to offset his or her
regular tax liability by nonrefundable tax credits--such as the
education credits and the child credit--regardless of the
amount of the individual's tentative minimum tax. The
Administration is concerned that the individual alternative
minimum tax (AMT) may impose financial and compliance burdens
upon taxpayers that have few tax preference items and were not
the originally intended targets of the AMT. In particular, the
Administration is concerned that the individual AMT may act to
erode the benefits of nonrefundable tax credits that are
intended to provide relief for middle-income taxpayers. During
the proposed extension period, the Administration hopes to work
with Congress to develop a longer-term solution to the
individual AMT problem.
8. SIMPLIFICATION PROVISIONS
The President's plan includes several other provisions that
would simplify the administration of Federal tax laws. These
provisions would: (1) extend the current-law rule for farmers
to all self-employed individuals that allows individuals to
elect to increase their self-employment income for purposes of
obtaining social security coverage; (2) provide statutory
hedging and other rules (generally codifying rules previously
promulgated by the Treasury Department) to ensure that business
property is treated as ordinary property; (3) clarify rules
relating to certain disclaimers by donees of gifts or bequests;
(4) simplify the foreign tax credit limitation for dividends
from so-called ``10/50 companies''; (5) eliminate the U.S.
withholding tax on distributions from U.S. mutual funds that
hold substantially all of their assets in cash or U.S. debt
securities (or foreign debt securities that are not subject to
withholding tax under foreign law); (6) expand the declaratory
judgment relief available under current-law to charities to all
organizations seeking tax-exempt status under section 501(c);
and (6) simplify the active trade or business requirement for
tax-free corporate spin-offs. The Administration hopes to work
with the Congress to develop and enact additional, appropriate
simplification measures.
9. MISCELLANEOUS PROVISIONS
Other targeted tax incentives included in the President's
plan include a proposed extension and modification of the
current-law Puerto Rico economic-activity credit, to provide a
more efficient and effective tax incentive for the economic
development of Puerto Rico.
In addition, to reduce the burdens faced by displaced
workers, the President's plan would exclude up to $2,000 of
certain severance payments from the income of the recipient.
This exclusion would apply to payments received by an
individual who was separated from service in connection with a
reduction in the employer's work force, but only if the
individual does not attain employment within six months of the
separation from service at a compensation level that is at
least 95 percent of the compensation the individual received
before the separation from service and only if total severance
payments received by the individual do not exceed $75,000.
To address the financial troubles of the steel industry,
the President's plan would extend to 5 years the carryback
period for the net operating loss (NOL) of a steel company. An
eligible taxpayer could elect to forgo the 5-year carryback and
apply the current-law carryback rules. The benefit proposed
would feed directly into a financially troubled steel company's
cash flow, providing immediate needed relief.
10. ELECTRICITY RESTRUCTURING
Restructuring the electric industry to encourage retail
competition promises significant economic benefits to both
business and household consumers of electricity. In order to
reap the benefits of restructuring, steps must be taken to
provide a level playing field for investor-owned and publicly-
owned electric systems as well as to provide relief from the
rules governing private use of tax-exempt bond-financed
electric facilities in appropriate circumstances. The
President's plan provides that no new facilities for electric
generation or transmission may be financed with tax-exempt
bonds. Distribution facilities may continue to be financed with
tax-exempt bonds subject to existing private use rules.
Distribution facilities are facilities operating at 69
kilovolts or less (including functionally related and
subordinate property). In order to develop efficient
nondiscriminatory transmission services, publicly-owned
electric utility companies may be required to turn the
operation of their transmission facilities over to independent
systems operators or use those facilities in a manner that may
violate the private use rules. In addition, as traditional
service areas of both investor-owned and publicly-owned systems
are opened to retail competition, the latter may find it
necessary to enter into contracts with private users of
electricity in order to prevent their generation facilities
from becoming stranded costs. Without relief from the private
use rules, publicly-owned electric systems may not choose to
open their service areas to competition or to allow their
transmission facilities to be operated by a private party.
In response, the President's plan provides that bonds
issued to finance transmission facilities prior to the
enactment of legislation to implement restructuring would
continue their tax-exempt status if private use results from
action pursuant to a Federal order requiring non-discriminatory
open access to those facilities. In addition, bonds issued to
finance generation or distribution facilities issued prior to
enactment of such legislation would continue their tax-exempt
status if private use results from retail competition, or if
private use results from the issuer entering into a contract
for the sale of electricity or use of its distribution property
that will become effective after implementation of retail
competition. Sale of facilities financed with tax-exempt bonds
to private entities would continue to constitute a change in
use. Bonds issued to refund, but not advance refund, bonds
issued before enactment of legislation implementing
restructuring would be permitted.
Finally, the President's plan would amend the rules
applicable to nuclear decommissioning funds in order to address
issues raised by the restructuring of the electric industry.
Revenue offsets
Our revenue offsets would curtail corporate tax shelters,
and close loopholes in the tax law in the areas of financial
products, corporate taxes, pass-through entities, tax
accounting, cost recovery, insurance, exempt organizations,
estate and gift taxation, taxation of international
transactions, pensions, compliance, and others. These offsets
generally would be effective with respect to a future date
(e.g., date of first committee action, or date of enactment).
We look forward to working with the committee to develop
grandfather rules where appropriate.
Corporate Tax Shelters
The Administration believes there has been an increase in
the use of corporate tax shelters and is concerned about this
proliferation for several reasons. First, corporate tax
shelters reduce the corporate tax base. Congress intended
corporations to be a source of Federal revenue in enacting the
various provisions of the corporate income tax. Questionable
transactions that reduce corporate tax liability frustrate this
intent. Moreover, corporate tax shelters erode the integrity of
the tax system as a whole. A view that well-advised
corporations can and do avoid their legal tax liabilities by
engaging in transactions unavailable to most other taxpayers
may lead to a perception of unfairness and, if unabated, may
lead to a decrease in voluntary compliance. Finally, the
significant resources used to create, implement and defend
complex sheltering transactions are better used in productive
activities. Similarly, the IRS must expend significant
resources to combat such transactions.
To date, most attacks on corporate tax shelters have been
targeted at specific transactions and have occurred on an ad-
hoc, after-the-fact basis--through legislative proposals,
administrative guidance, and litigation. At the Treasury
Department, a number of actions have been taken to address
corporate tax shelters. For example, we've made legislative
proposals aimed at section 357(c) basis creation abuses, which
has advanced in both chambers, and liquidating REITs, which was
enacted last year. On the regulatory front, we have issued
guidance, such as the notice on stepped-down preferred, fast-
pay, slow-pay transactions, and in litigation, we've won two
important cases--ACM and ASA. But we often hear that we are
only hitting the tip of the iceberg.
Addressing corporate tax shelters on a transaction-by-
transaction, ad hoc basis, however, raises certain concerns.
First, it is not possible to identify and address all current
and future sheltering transactions. Taxpayers with an appetite
for corporate tax shelters will simply move from those
transactions that are specifically prohibited by the new
legislation to other transactions the treatment of which is
less clear. Second, legislating on a piecemeal basis further
complicates the Code and seemingly calls into question the
viability of common law tax doctrines such as sham transaction,
business purpose, economic substance and substance over form.
Finally, using a transactional legislation approach to
corporate tax shelters may embolden some promoters and
participants to rush shelter products to market on the belief
that any retroactive legislation would be applied only on a
prospective basis.
The primary goal of any corporate tax shelter is to
eliminate, reduce, or defer corporate income tax. To achieve
this goal, corporate tax shelters are designed to manufacture
tax benefits that can be used to offset unrelated income of the
taxpayer or to create tax-favored or tax-exempt economic
income. Most corporate tax shelters rely on one or more
discontinuities in the tax law, or exploit a provision in the
Code or Treasury regulations in a manner not intended by
Congress or the Treasury Department.
Corporate tax shelters may take several forms. For this
reason, they are hard to define. However, corporate tax
shelters often share certain common characteristics. For
example, through hedges, circular cash flows, defeasements, or
other devices, corporate participants in a shelter often are
insulated from any risk of economic loss or opportunity for
economic gain with respect to the sheltering transaction. Thus,
corporate tax shelters are transactions without significant
economic substance, entered into principally to achieve a
desired tax result. Similarly, the financial accounting
treatment of a shelter generally is significantly more
favorable than the corresponding tax treatment; that is, the
shelter produces a tax ``loss'' that is not reflected as a book
loss. However, the corporate tax shelter may produce a book
earnings benefit by reducing the corporation's effective tax
rate.
Corporate tax shelter schemes often are marketed by their
designers or promoters to multiple corporate taxpayers and
often involve property or transactions unrelated to the
corporate participant's core business. These two features may
distinguish corporate tax shelters from traditional tax
planning.
Many corporate tax shelters involve arrangements between
corporate taxpayers and persons not subject to U.S. tax such
that these tax indifferent parties absorb the taxable income
from the transaction, leaving tax losses to be allocated to the
corporation. The tax indifferent parties in effect ``rent''
their tax exempt status in return for a accomodation fee or an
above-market return on investment. Tax indifferent parties
include foreign persons, tax-exempt organizations, Native
American tribal organizations, and taxpayers with loss or
credit carryforwards.
Taxpayers entering into corporate tax shelter transactions
often view such transactions as risky because the expected tax
benefits may be successfully challenged. To protect against
such risk, purchasers of corporate tax shelters often require
the seller or a counterparty to enter into a tax benefit
protection arrangement. Thus, corporate tax shelters are often
associated with high transactions costs, contingent or
refundable fees, unwind clauses, or insured results.
These themes run through our budget proposals and, we hope,
help us to focus on finding broader, ex ante solutions to the
corporate tax shelter problem.
The Administration therefore proposes several remedies to
curb the growth of corporate tax shelters. We propose more
general remedies to deter corporations from entering into any
sheltering transactions. These proposals would disallow any tax
benefit created in a corporate tax shelter, as so defined, and
would address common characteristics found in corporate tax
shelters as described above. Also, all the parties to a
structured transaction would have an incentive, under our
proposals, to assure that the transaction comports with
established principles.
The Treasury Department recognizes that this more general
approach to corporate tax shelters raises certain concerns.
Applying various substantive and procedural rules to a
``corporate tax shelter'' or a ``tax avoidance transaction''
requires definitions of such terms. As described in greater
detail below, the Administration's proposals define these
terms. Critics of the proposals have suggested that these
definitions are too broad or may create too much uncertainty
and thus may inhibit otherwise legitimate transactions. The
Treasury Department does not intend to affect legitimate
business transactions and looks forward to working with the
tax-writing committees in refining the corporate tax shelter
proposals. However, some level of uncertainty is unavoidable
with respect to complex transactions. In addition, the
definition of corporate tax shelter as used in our proposals is
narrower and therefore less uncertain than other definitions
and formulations used in the Code. Moreover, the definition we
have proposed is similar to existing articulations of various
judicial doctrines and may be viewed as largely enforcing the
judicially-created concept of economic substance of current
law. Finally, some amount of uncertainty may be useful in
discouraging taxpayers from venturing to the edge, thereby
risking going over the edge, of established principles.
The Administration's proposals that generally would apply
to corporate tax shelters are:
Deny certain tax benefits in tax avoidance transactions.--
Under current law, if a person acquires control of a
corporation or a corporation acquires carryover basis property
of a corporation not controlled by the acquiring corporation or
its shareholders, and the principal purpose for such
acquisition is evasion or avoidance of Federal income tax by
securing certain tax benefits, the Secretary may disallow such
benefits to the extent necessary to eliminate such evasion or
avoidance of tax. However, this current rule has been
interpreted narrowly. The Administration proposes to expand the
current rules to authorize the Secretary to disallow a
deduction, credit, exclusion, or other allowance obtained by a
corporation in a tax avoidance transaction.
For this purpose, a tax avoidance transaction would be
defined as any transaction in which the reasonably expected
pre-tax profit (determined on a present value basis, after
taking into account foreign taxes as expenses and transaction
costs) of the transaction is insignificant relative to the
reasonably expected tax benefits (i.e., tax benefits in excess
of the tax liability arising from the transaction, determined
on a present value basis) of such transaction. In addition, a
tax avoidance transaction would be defined to cover
transactions involving the improper elimination or significant
reduction of tax on economic income. The proposal would not
apply to tax benefits clearly contemplated by the applicable
current-law provision (e.g., the low-income housing tax
credit).
Modify substantial understatement penalty for corporate tax
shelters.--The current 20-percent substantial understatement
penalty imposed on corporate tax shelter items can be avoided
if the corporate taxpayer had reasonable cause for the tax
treatment of the item and good faith. The Administration
proposes to increase the substantial understatement penalty on
corporate tax shelter items to 40 percent. The penalty will be
reduced to 20 percent if the corporate taxpayer discloses to
the National Office of the Internal Revenue Service within 30
days of the closing of the transaction appropriate documents
describing the corporate tax shelter and files a statement
with, and provides adequate disclosure on, its tax return. The
penalty could not be avoided by a showing of reasonable cause
and good faith. For this purpose, a corporate tax shelter would
be defined as any entity, plan, or arrangement (to be
determined based on all the facts and circumstances) in which a
direct or indirect corporate participant attempts to obtain a
tax benefit in a tax avoidance transaction.
Deny deductions for certain tax advice and impose an excise
tax on certain fees received.--The proposal would deny a
deduction for fees paid or accrued in connection with the
promotion of corporate tax shelters and the rendering of
certain tax advice related to corporate tax shelters. The
proposal would also impose a 25-percent excise tax on fees
received in connection with the promotion of corporate tax
shelters and the rendering of certain tax advice related to
corporate tax shelters.
Impose excise tax on certain rescission provisions and
provisions guaranteeing tax benefits.--The Administration
proposes to impose on the purchaser of a corporate tax shelter
an excise tax of 25 percent on the maximum payment to be made
under the arrangement. For this purpose, a tax benefit
protection arrangement would include certain rescission
clauses, guarantee of tax benefits arrangement or any other
arrangement that has the same economic effect (e.g., insurance
purchased with respect to the transaction).
Preclude taxpayers from taking tax positions inconsistent
with the form of their transactions.--Under current law, if a
taxpayer enters into a transaction in which the economic
substance and the legal form are different, the taxpayer may
take the position that, notwithstanding the form of the
transaction, the substance is controlling for Federal income
tax purposes. Many taxpayers enter into such transactions in
order to arbitrage tax and regulatory laws. Under the proposal,
except to the extent the taxpayer discloses the inconsistent
position on its tax return, a corporate taxpayer, but not the
Internal Revenue Service, would be precluded from taking any
position (on a tax return or otherwise) that the Federal income
tax treatment of a transaction is different from that dictated
by its form, if a tax indifferent person has a direct or
indirect interest in such transaction.
Tax income from corporate tax shelters involving tax-
indifferent parties.--The proposal would provide that any
income received by a tax-indifferent person with respect to a
corporate tax shelter would be taxable, either to the tax-
indifferent party or to the corporate participant.
The Administration also proposes to amend the substantive
law related to specific transactions that the Treasury
Department has identified as giving rise to corporate tax
shelters. No inference is intended as to the treatment of any
of these transactions under current law.
Require accrual of income on forward sale of corporate
stock.--There is little substantive difference between a
corporate issuer's current sale of its stock for a deferred
payment and an issuer's forward sale of the same stock. In both
cases, a portion of the deferred payment compensates the issuer
for the time-value of money during the term of the contract.
Under current law, the issuer must recognize the time-value
element of the deferred payment as interest if the transaction
is a current sale for deferred payment but not if the
transaction is a forward contract. Under the proposal, the
issuer would be required to recognize the time-value element of
the forward contract as well.
Modify treatment of built-in losses and other attribute
trafficking.--Under current law, a taxpayer that becomes
subject to U.S. taxation may take the position that it
determines its beginning bases in its assets under U.S. tax
principles as if the taxpayer had historically been subject to
U.S. tax. Other tax attributes are computed similarly. A
taxpayer may thus ``import''' built-in losses or other
favorable tax attributes incurred outside U.S. taxing
jurisdiction (e.g., from foreign or tax-exempt parties) to
offset income or gain that would otherwise be subject to U.S.
tax. The proposal would prevent the importation of attributes
by eliminating tax attributes (including built-in items) and
marking to market bases when an entity or an asset becomes
relevant for U.S. tax purposes. This proposal would be
effective for transactions in which assets or entities become
relevant for U.S. tax purposes on or after the date of
enactment.
Modify treatment of ESOP as S corporation shareholder.--
Pursuant to provisions enacted in 1996 and 1997, an employee
stock ownership plan (ESOP) may be a shareholder of an S
corporation and the ESOP's share of the income of the S
corporation is not subject to tax until distributed to the plan
beneficiaries. The Administration proposes to require an ESOP
to pay tax on S corporation income (including capital gains on
the sale of stock) as the income is earned and to allow the
ESOP a deduction for distributions of such income to plan
beneficiaries.
Prevent serial liquidation of U.S. subsidiaries of foreign
corporations.--Dividends from a U.S. subsidiary to its foreign
parent corporation are subject to U.S. withholding tax. In
contrast, if a domestic corporation distributes earnings in a
tax-free liquidation, the foreign shareholder generally is not
subject to any withholding tax. Some foreign corporations
attempt to avoid dividend withholding by serially forming and
liquidating holding companies for their U.S. subsidiaries. The
proposal would impose withholding tax on any distribution made
to a foreign corporation in complete liquidation of a U.S.
holding company if the holding company was in existence for
less than five years. The proposal would also achieve a similar
result with respect to serial terminations of U.S. branches.
Prevent capital gains avoidance through basis shift
transactions involving foreign shareholders.--To prevent
taxpayers from attempting to offset capital gains by generating
artificial capital losses through basis shift transactions
involving foreign shareholders, the Administration proposes to
treat the portion of a dividend that is not subject to current
U.S. tax as a nontaxed portion and thus subject to the basis
reduction rules applicable to extraordinary dividends. Similar
rules would apply in the event that the foreign shareholder is
not a corporation.
Limit inappropriate tax benefits for lessors of tax-exempt
use property.--The Administration is concerned that certain
structures involving tax-exempt use property are being used to
generate inappropriate tax benefits for lessors. The proposal
would deny a lessor the ability to recognize a net loss from a
leasing transaction involving tax-exempt use property during
the lease term. A lessor would be able to carry forward a net
loss from a leasing transaction and use it to offset net gains
from the transaction in subsequent years. This proposal would
be effective for leasing transactions entered into on or after
the date of enactment.
Prevent mismatching of deductions and income inclusions in
transactions with related foreign persons.--The Treasury
Department has learned of certain structured transactions
designed to allow taxpayers inappropriately to take advantage
of the certain current-law rules by accruing deductions to
related foreign personal holding company (FPHC), controlled
foreign corporation (CFC) or passive foreign investment company
(PFIC) without the U.S. owners of such related entities taking
into account for U.S. tax purposes an amount of income
appropriate to the accrual. This results in an improper
mismatch of deductions and income. The proposal would provide
that deductions for amounts accrued but unpaid to related
foreign CFCs, PFICs or FPHCs would be allowable only to the
extent the amounts accrued by the payor are, for U.S. tax
purposes, reflected in the income of the direct or indirect
U.S. owners of the related foreign person. The proposal would
contain an exception for certain short term transactions
entered into in the ordinary course of business.
Restrict basis creation through section 357(c).--A
transferor generally is required to recognize gain on a
transfer of property in certain tax-free exchanges to the
extent that the sum of the liabilities assumed, plus those to
which the transferred property is subject, exceeds the basis in
the property. This gain recognition to the transferor generally
increases the basis of the transferred property in the hands of
the transferee. If a recourse liability is secured by multiple
assets, it is unclear under current law whether a transfer of
one asset where the transferor remains liable is a transfer of
property ``subject to the liability.'' Similar issues exist
with respect to nonrecourse liabilities. Under the
Administration's proposal, the distinction between the
assumption of a liability and the acquisition of an asset
subject to a liability generally would be eliminated. The
transferor's recognition of gain as a result of assumption of
liability would not increase the transferee's basis in the
transferred asset to an amount in excess of its fair market
value. Moreover, if no person is subject to U.S. tax on gain
recognized as the result of the assumption of a nonrecourse
liability, then the transferee's basis in the transferred
assets would be increased only to the extent such basis would
be increased if the transferee had assumed only a ratable
portion of the liability, based on the relative fair market
values of all assets subject to such nonrecourse liability.
Modify anti-abuse rule related to assumption of
liabilities.--The assumption of a liability in an otherwise
tax-free transaction is treated as boot to the transferor if
the principal purpose of having the transferee assume the
liability was the avoidance of tax on the exchange. The current
language is inadequate to address the avoidance concerns that
underlie the provision. The Administration proposes to modify
the anti-abuse rule by deleting the limitation that it only
applies to tax avoidance on the exchange itself, and changing
``the principal purpose'' standard to ``a principal purpose.''
Modify corporate-owned life insurance (COLI) rules.--In
general, interest on policy loans or other indebtedness with
respect to life insurance, endowment or annuity contracts is
not deductible unless the insurance contract insures the life
of a ``key person'' of a business. In addition, the interest
deductions of a business generally are reduced under a
proration rule if the business owns or is a direct or indirect
beneficiary with respect to certain insurance contracts. The
COLI proration rules generally do not apply if the contract
covers an individual who is a 20-percent owner of the business
or is an officer, director, or employee of such business. These
exceptions under current law still permit leveraged businesses
to fund significant amounts of deductible interest and other
expenses with tax-exempt or tax-deferred inside buildup on
contracts insuring certain classes of individuals. The
Administration proposes to repeal the exception under the COLI
proration rules for contracts insuring employees, officers or
directors (other than 20-percent owners) of the business. The
proposal also would conform the key person exception for
disallowed interest deductions attributable to policy loans and
other indebtedness with respect to life insurance contracts to
the 20-percent owner exception in the COLI proration rules.
Other Revenue Provisions
In addition to the general and specific corporate tax
shelter proposals, the Administration's budget contains other
revenue raising proposals that are designed to remove
unwarranted tax benefits, ameliorate discontinuities of current
law, provide simplification and improve compliance. Some of
these proposals are described below.
Proposals Relating to Financial Products
The proposals relating to financial products narrowly
target certain transactions and business practices that
inappropriately exploit existing tax rules. Three of the
proposals address the timing of income from debt instruments.
Other proposals address specific financial products
transactions that are designed to achieve tax results that are
significantly better than the results that would be obtained by
entering into economically equivalent transactions. At the same
time, a number of these proposals contain provisions that are
designed to simplify existing law and provide relief for
taxpayers in cases where the literal application of the
existing rules can produce an uneconomic result.
Mismeasurement of economic income.--The tax rules that
apply to debt instruments generally require both the issuer and
the holder of a debt instrument to recognize interest income
and expense over the term of the instrument regardless of when
the interest is paid. If the debt instrument is issued at a
discount (that is, it is issued for an amount that is less than
the amount that must be repaid), the discount functions as
interest--as compensation for the use of money. Recognizing
this fact, the existing tax rules require both parties to
account for this discount as interest over the life of the debt
instrument.
The Administration's budget contains three proposals that
are designed to reduce the mismeasurement of economic income on
debt instruments: (1) a rule that requires cash-method banks to
accrue interest income on short-term obligations, (2) rules
that require accrual method taxpayers to accrue market
discount, and (3) a rule that requires the issuer in a debt-
for-debt exchange to spread the interest expense incurred in
the exchange over the term of the newly-issued debt instrument.
Specific transactions designed to exploit current rules.--
There are a number of strategies involving financial products
that are designed to give a taxpayer the ``economics'' of a
particular transaction without the tax consequences of the
transaction itself. For example, so-called ``hedge fund swaps''
are designed to give an investor the ``economics'' of owning a
partnership interest in a hedge fund without the tax
consequences of being a partner. These swaps purportedly allow
investors to defer the recognition of income until the end of
the swap term and to convert ordinary income into long-term
capital gain.
Another strategy involves the used of structured financial
products that allow investors to monetize appreciated financial
positions without recognizing gain. If a taxpayer holds an
appreciated financial position in personal property and enters
into a structured financial product that substantially reduces
the taxpayer's risk of loss in the appreciated position, the
taxpayer may be able to borrow against the combined position
without recognizing gain. Under current law, unless the
borrowing is ``incurred to purchase or carry'' the structured
financial product, the taxpayer may deduct its interest expense
on the borrowing even though the taxpayer has not included the
gain from the appreciated position.
The Administration's budget contains proposals that are
designed to eliminate the inappropriate tax benefit these
transactions create. The ``constructive ownership'' proposal
would limit the amount of long-term capital gain a taxpayer
could recognize from a hedge fund swap to the amount of long-
term capital gain that would have been recognized if the
investor had invested in the hedge fund directly. Another
proposal would clarify that a taxpayer cannot currently deduct
expenses (included interest expenses) from a transaction that
monetizes an appreciated financial position without triggering
current gain recognition.
Proposals Relating to Pass-through Entities
There are five coordinated proposals relating to basis
adjustments and gain recognition in the partnership area. The
proposals have three purposes: simplification, rationalization,
and prevention of tax avoidance. The proposals accomplish these
goals through a variety of means. In one proposal, the ability
of taxpayers to elect whether or not to adjust the basis of
partnership assets is eliminated in a situation where the
election is leading to tax abuses. In another proposal, we
would limit basis adjustments with respect to particular types
of property, which enables us, in a different proposal, to
repeal a provision that has been widely criticized as overly
complex and irrational.
In addition to the partnership proposals, two REIT
proposals are included in the budget. One proposal allows REITs
to conduct expanded business activities in situations where a
corporate level tax will be collected with respect to such
activities. The other REIT proposal limits closely held REITs,
which have been the primary vehicle for carrying out such
corporate tax shelters as step-down preferred stock and the
liquidating REIT transactions.
A final proposal in the pass-through area would impose a
tax on gain when a large C corporation converts to an S
corporation.
Proposals Relating to Corporate Provisions
The corporate proposals focus on a developing trend in
structuring dispositions of assets or stock that technically
qualify as tax-free transactions, but circumvent the repeal of
General Utilities by allowing corporations to ``sell''
appreciated property without recognizing any gain. There has
been a proliferation of highly publicized transactions in which
corporations exploit the purposes of the tax-free
reorganization provisions, (i.e., to allow a corporation to
change its form when the taxpayer's investment remains in
corporate solution), to maximize their ability to cash out of
their investments and minimize the amount of tax paid. In
addition, the corporate proposals attempt to simplify the law
and prevent whipsaw of the government in certain tax-free
transactions.
Modify tax-free treatment for mere adjustments in form.--In
order for an acquisition or distribution of appreciated assets
to qualify as wholly or partly tax-free, the transaction must
satisfy a series of relatively stringent requirements. If the
transaction fails to satisfy the requirements, it will be taxed
in accordance with the general recognition principles of the
Code. After the repeal of General Utilities, there are few
opportunities to dispose of appreciated assets without a tax
liability, and our proposals would help to ensure that those
remaining exceptions to the repeal of General Utilities are not
circumvented. The provisions of the Code that allow for tax-
free treatment date back to the early years of the tax system
and did not contemplate the creative tax planning that has
taken place in the last several years. As a result, many of the
corporate tax provisions have been manipulated, resulting in
avoidance of tax.
The Administration's budget contains several proposals that
are designed to eliminate opportunities under current law for
corporations to achieve tax-free treatment for transactions
that should be taxable. The proposals include (1) modifying the
``control'' test for purposes of tax-free incorporations,
distributions and reorganizations to include a value component
so that corporations may not ``sell'' a significant amount of
the value of the corporation while continuing to satisfy the
current law control test that focuses solely on voting power,
(2) requiring gain recognition upon the issuance of ``tracking
stock'' or a recapitalization of stock or securities into
tracking stock, and (3) requiring gain recognition in
downstream transactions in which a corporation that holds stock
in another corporation transfers its assets to that corporation
in exchange for stock.
Preventing taxpayers from taking inconsistent positions in
certain nonrecognition transactions.--No gain or loss is
recognized upon the transfer of property to a controlled
corporation in exchange for stock. There is an inconsistency in
the treatment by the Internal Revenue Service and the Claims
Court as to the treatment of a transfer of less than all
substantial rights to use intangible property. Accordingly,
transferor and transferee corporations have taken the position
that best achieves their tax goals. The proposal would
eliminate this whipsaw potential by treating any transfer of an
interest in intangible property as a tax-free transfer and
requiring allocation of basis between the retained rights and
the transferred rights based upon respective fair market
values.
Proposals Relating to Tax Accounting and Cost Recovery
The Administration's budget contains measures that are
principally designed to improve measurement of income by
eliminating methods of accounting that result in a
mismeasurement of economic income or provide disparate
treatment among similarly situated taxpayers.
Repeal installment method for accrual basis taxpayers.--The
proposal would repeal the installment method of accounting for
accrual method taxpayers (other that those taxpayers that
benefit from dealer disposition exceptions under current law)
and eliminate inadequacies in the installment method pledging
rules in order to better reflect the economic results of a
taxpayer's business during the taxable year.
Apply uniform capitalization rules to tollers.--To
eliminate the disparate treatment between manufacturers and
tollers and better reflect the income of tollers, the proposal
would require tollers (other than small businesses) to
capitalize their direct costs and an allocable portion of their
indirect costs to property tolled.
Provide consistent amortization periods for intangibles.--
To encourage the formation of new businesses, the proposal
would allow a taxpayer to elect to deduct up to $5,000 each of
start-up and organizational expenditures. Start-up and
organizational expenditures not currently deductible would be
amortized over a 15-year period consistent with the
amortization period for acquired intangibles.
Clarify recovery period of utility grading costs.--The
proposal would clarify and rationalize current law by assigning
electric and gas utility clearing and grading costs incurred to
locate transmission and distribution lines and pipelines to the
class life assigned to the benefitted assets, giving these
costs a recovery period of 20 years and 15 years, respectively.
The class life assigned to the benefitted assets is a more
appropriate estimate of the useful life of these costs, and
thus will improve measurement of the utility's income.
Deny change in method treatment to tax-free formations.--
The proposal would eliminate abuses with respect to changes in
accounting methods by expanding the transactions to which the
carryover of method of accounting rules apply to include tax-
free contributions to corporations and partnerships.
Deny deduction for punitive damages.--The deductibility of
punitive damage payments under current law undermines the role
of such damages in discouraging and penalizing certain
undesirable actions or activities. The proposal would disallow
any deduction for punitive damages to conform the tax treatment
to that of other payments, such as penalties and fines, that
are also intended to discourage violations of public policy.
Disallow interest on debt allocable to tax-exempt
obligations.--Under current law, security dealers and financial
intermediaries other than banks are able to reduce their tax
liabilities inappropriately through double Federal tax benefits
of interest expense deductions and tax-exempt interest income,
notwithstanding that they operate similarly to banks. The
proposal would eliminate the disparate treatment between banks
and financial intermediaries, such as security dealers and
other financial intermediaries, by providing that a financial
intermediary investing in tax-exempt obligations would be
disallowed deductions for a portion of its interest expense
equal to the portion of its total assets that is comprised of
tax-exempt investments.
Eliminate the income recognition exception for accrual
method service providers.--Under current law, accrual method
service providers are provided a special exception to the
general accrual rules that permit them, in effect, to reduce
current taxable income by an estimate of future bad debt
losses. This method of estimation results in a mismeasurement
of a taxpayer's economic income and, because this tax benefit
only applies to amounts to be received for the performance of
services, discriminates in favor of service providers. The
proposal would repeal the special exception for accrual method
service providers.
Repeal lower-of-cost-or-market inventory accounting
method.--The allowance of write-downs under the lower-of-cost
or market (LCM) method or subnormal goods method is an
inappropriate exception from the realization principle and is
essentially a one-way mark-to-market method that understates
taxable income. The proposal would repeal the LCM and subnormal
goods methods.
Proposals Relating to Insurance
The Administration's budget contains proposals to more
accurately measure the economic income of insurance companies
by updating and modernizing certain provisions of current law.
The proposals would (1) require recapture of policyholder
surplus accounts, (2) modify rules for capitalizing policy
acquisition costs of life insurance companies, and (3) increase
the proration percentage for property casualty (P&C) insurance
companies.
Between 1959 and 1984, stock life insurance companies
deferred tax on a portion of their profits. These untaxed
profits were added to a policyholders surplus account (PSA). In
1984, Congress precluded life insurance companies from
continuing to defer tax on future profits through PSAs.
However, companies were permitted to continue to defer tax on
their existing PSAs. Most pre-1984 policies have terminated so
there is no remaining justification for allowing these
companies to continue to defer tax on profits they earned
between 1959 and 1984.
Under current law, pursuant to a provision enacted in 1990,
insurance companies capitalize varying percentages of their net
premiums for certain types of insurance contracts, and
generally amortize these amounts over 10 years (five years for
small companies). These capitalized amounts are intended to
serve as proxies for each company's actual commissions and
other policy acquisition expenses. However, data reported by
insurance companies to State insurance regulators each year
indicates that the insurance industry is capitalizing less than
half of its policy acquisition costs, which results in a
mismatch of income and deductions. The Administration proposes
that insurance companies be required to capitalize modified
percentages of their net premiums for certain lines of
business.
In computing their underwriting income, P&C insurance
companies deduct reserves for losses and loss expenses
incurred. These loss reserves are funded in part with the
company's investment income. In 1986, Congress reduced the
reserve deductions of P&C insurance companies by 15 percent of
the tax-exempt interest or the deductible portion of certain
dividends received. In 1997, Congress expanded the 15-percent
proration rule to apply to the inside buildup on certain
insurance contracts. The existing 15-percent proration rule
still enables P&C insurance companies to fund a substantial
portion of their deductible reserves with tax-exempt or tax-
deferred income. Other financial intermediaries, such as life
insurance companies, banks and brokerage firms, are subject to
more stringent proration rules that substantially reduce or
eliminate their ability to use tax-exempt or tax-deferred
investments to fund currently deductible reserves or deductible
interest expense.
Proposals Relating to International Provisions
The Administration's budget contains proposals designed to
ensure that economically similar international transactions are
taxed in a similar manner, prevent manipulation and
inappropriate use of exemptions from U.S. tax, allocate income
between U.S. and foreign sources in a more appropriate manner,
and determine the foreign tax credit in a more accurate manner.
Specific proposals include:
Expand section 864(c)(4)(B) to interest and dividend
equivalents.--Under U.S. domestic law, a foreign person is
subject to taxation in the United States on a net income basis
with respect to income that is effectively connected with a
U.S. trade or business (ECI). The test for determining whether
income is effectively connected to a U.S. trade or business
differs depending on whether the income at issue is U.S. source
or foreign source. Only enumerated types of foreign source
income--rents, royalties, dividends, interest, gains from the
sale of inventory property, and insurance income--constitute
ECI, and only in certain circumstances. The proposal would
expand the categories of foreign-source income that could
constitute ECI to include interest equivalents (including
letter of credit fees) and dividend equivalents in order to
eliminate arbitrary distinctions between economically
equivalent transactions.
Recapture overall foreign losses upon disposition of CFC
stock.--If deductions against foreign income result in (or
increase) an overall foreign loss which is then set against
U.S. income, current law has recapture rules that require
subsequent foreign income or gain to be recharacterized as
domestic. Recapture can take place when directly-owned foreign
assets are disposed of. However, there may be no recapture when
stock in a controlled foreign corporation (CFC) is disposed of.
The proposal would correct that asymmetry by providing that
property subject to the recapture rules upon disposition would
include stock in a CFC.
Amend 80/20 company rules.--Interest or dividends paid by a
so-called ``80/20 company'' generally are partially or fully
exempt from U.S. withholding tax. A U.S. corporation is treated
as an 80/20 company if at least 80 percent of the gross income
of the corporation for the three year period preceding the year
of a dividend is foreign source income attributable to the
active conduct of a foreign trade or business (or the foreign
business of a subsidiary). Certain foreign multinationals
improperly seek to exploit the rules applicable to 80/20
companies in order to avoid U.S. withholding tax liability on
earnings of U.S. subsidiaries that are distributed abroad. The
proposal would prevent taxpayers from avoiding withholding tax
through manipulations of these rules.
Modify foreign office material participation exception.--In
the case of a sale of inventory property that is attributable
to a nonresident's office or other fixed place of business
within the United States, the sales income is generally treated
as U.S. source. The income is treated as foreign source,
however, if the inventory is sold for use, disposition, or
consumption outside the United States and the nonresident's
foreign office or other fixed place of business materially
participates in the sale. Income that is treated as foreign
source under this rule is not treated as effectively connected
with a U.S. trade or business and is not subject to U.S. tax.
The proposal would provide that the foreign source exception
shall apply only if an income tax equal to at least 10 percent
of the income from the sale is actually paid to a foreign
country with respect to such income.
Stop abuses of CFC exception under section 833.--A foreign
corporation is subject to a four-percent tax on its United
States source gross transportation income. The tax will not
apply if the corporation is organized in a country (an
``exemption country'') that grants an equivalent tax exemption
to U.S. shipping companies or is a controlled foreign
corporation (the ``CFC exception''). The premise for the CFC
exception is that the U.S. shareholders of a CFC will be
subject to current U.S. income taxation on their share of the
foreign corporation's shipping income and, thus, the four-
percent tax should not apply if the corporation is organized in
an exemption country. Residents of non-exemption countries,
however, can achieve CFC status for their shipping companies
simply by owning the corporations through U.S. partnerships.
The proposal would stop this abuse by narrowing the CFC
exception.
Replace sales-source rules with activity-based rules.--If
inventory is manufactured in the United States and sold abroad,
Treasury regulations provide that 50 percent of the income from
such sales is treated as earned by production activities and 50
percent by sales activities. The income from the production
activities is sourced on the basis of the location of assets
held or used to produce the income. The income from the sales
activity (the remaining 50 percent) is sourced based on where
title to the inventory transfers. If inventory is purchased in
the United States and sold abroad, 100 percent of the sales
income generally is deemed to be foreign source. These rules
generally produce more foreign source income for Unites States
tax purposes than is subject to foreign tax and thereby allow
U.S. exporters that operate in high-tax foreign countries to
credit tax in excess of the U.S. rate against their U.S. tax
liability. The proposal would require that the allocation
between production activities and sales activities be based on
actual economic activity.
Modify rules relating to foreign oil and gas extraction
income.--To be eligible for the U.S. foreign tax credit, a
foreign levy must be the substantial equivalent of an income
tax in the U.S. sense, regardless of the label the foreign
government attaches to it. Current law recognizes the
distinction between creditable taxes and non-creditable
payments for specific economic benefit but fails to achieve the
appropriate split between the two in a case where a foreign
country imposes a levy on, for example, oil and gas income
only, but has no generally imposed income tax. The proposal
would treat as taxes payments by a dual-capacity taxpayer to a
foreign country that would otherwise qualify as income taxes or
``in lieu of'' taxes, only if there is a ``generally applicable
income tax'' in that country. Where the foreign country does
generally impose an income tax, as under present law, credits
would be allowed up to the level of taxation that would be
imposed under that general tax, so long as the tax satisfies
the new statutory definition of a ``generally applicable income
tax.'' The proposal also would create a new foreign tax credit
basket for foreign oil and gas income.
Miscellaneous revenue proposals
The President's budget also includes miscellaneous revenue
proposals, many of which were proposed in prior budgets. Some
of these proposals are: (1) taxing the investment income of
trade associations, (2) the repeal of the percentage depletion
for non-fuel minerals mined on Federal lands, (3) the
reinstatement of the oil spill excise tax, with an increase in
the full funding limitation from $1 billion to $5 billion, (4)
a modification of the FUTA deposit requirement, (5)
simplification of the foster child definition for purposes of
the earned income tax credit, (6) an excise tax on the purchase
of structured settlements, (7) several proposals to improve
compliance, (8) repeal of the de minimis rental income rule,
and (9) certain pension and compensation-related provisions.
The budget proposals also include various other provisions that
affect receipts. These are the reinstatement of the
environmental tax imposed on corporate taxable income ($2.7
billion), reinstatement of the Superfund excise taxes ($3.8
billion), and receipts from tobacco legislation ($34.5
billion). The budget also converts a portion of the aviation
excise taxes into cost-based user fees and replaces the Harbor
Maintenance Tax with a user fee.
In conclusion, Mr. Chairman and Mr. Rangel, and members of
this committee, the Administration looks forward to working
with you as you examine our proposals. We want to thank you for
your comments about our corporate tax shelter proposals, and
your willingness to listen.
Chairman Archer. Mr. Lubick, thank you for condensing the
recommendations for tax changes. Had you gone into detail on
all of them, you probably would have consumed the better part
of the day, and maybe not even then have completed all of them.
I couldn't help but think as I listened to you that you
have portrayed exactly why I think we have to abolish the
income tax. We have an endless stream of efforts that come
forward every year to close quote ``loopholes,'' to find some
way to make the tax clearer while adding many additional
complications. It seems like every additional complication that
we add creates the need for more complications as the private
sector's brilliant and creative minds go to work on all the
complexities.
So I regret that today is not the day that we are going to
mark up a bill to abolish the income tax.
Mr. Lubick. Well, I had hoped I would not lead you to that
conclusion, Mr. Chairman.
Chairman Archer. Unfortunately, this is not the day. So we
do have to discuss the complexities of what you have
recommended, and the areas where we believe you are on the
right track. There are a few proposals in your budget
recommendations, and we certainly want to work with you to see
that the laws are changed.
You are right, probably, about 5 percent of the time, we
are glad to work with you within that framework.
Mr. Lubick. That's one of the best batting averages I have
had in my experience here. [Laughter.]
Chairman Archer. I want the Members to have plenty of time
to inquire, and I'm going to try to keep mine as brief as
possible. There are a couple of things I did want to ask you.
Does the administration have a fundamental objection to
broad-based tax relief?
Mr. Lubick. No, Mr. Chairman. Actually, we think if the
relief is framed, first of all, that it be fiscally
responsible, second that it be fair and equitable, that it be--
that it not complicate the Code--we are certainly responsive to
that. There are, however, a number of constraints we have. We
think it is important at the start to deal with the problem of
putting Social Security on a sound basis. I know you have
endorsed that concept as well.
And when that is done, there are other very, very pressing
needs to be addressed both in terms of retirement, encouraging
savings for retirement by that part of our population that is
not adequately able to do it now. So that is why we have
proposed that when that Social Security problem is solved that
part of the surplus be used for that.
And ultimately, there are a host of very crying needs that
should be addressed. You have enumerated a number of them. From
time to time, you have talked about the alternative minimum
tax, but all in all, I think there certainly is room at the
proper time, if done in the proper way, to have general relief.
Chairman Archer. Within the constraints, of course, which
have been stated before this Committee by the representatives
of the administration as to the overall budget. Presently, you
have opted for targeted tax cuts rather than any sort of broad-
based tax relief. And so I just wanted to be sure that you
didn't have some inherent objection to broad-based tax relief.
Mr. Lubick. Well, certainly not. But at the present time we
are operating under budget constraints as you are more aware
than I. If there are particular pressing needs, basically the
only way that they can be addressed is through the tax system
today. The question of spending programs to deal with these
problems is really practically out of the question. And so
there has been this great pressure over the last decade to use
the tax system, which, as you have pointed out, has put a
strain on it.
At this time, in the areas I have outlined, where we have
addressed it, we have come to the conclusion that there are
indeed special exigencies that would require some sort of
action. And that is why we proposed to enact them on a fully
funded basis. I think you would doubtless agree that your
general abhorrence of tax increases does not extend to a
situation where deficiencies in the Code have to be rectified,
things that you never intended should be cleaned up, and that,
of course, will in effect raise revenue from those persons that
were taking undue advantage of the Code.
So you are not proposing an enactment of a static
situation. So we have tried to identify those situations in
providing the funding for the targeted tax relief that we think
is appropriate in a way that would not do violence to your
general predilection, which we share, against tax increases.
We haven't, for example, proposed general changes,
increases in rates. We haven't proposed restrictions, or
cutbacks on longstanding deductions or credits or exclusions.
You have pointed out that this involves a significant number of
proposals, each of which is, in terms of the universe of
taxation, somewhat not cosmic. But I think if we get to a
situation where we have dealt with the most pressing problems,
then it is time to consider broader and more expensive changes
in the tax system as well as the new rules of the game that are
going to operate both as to spending and taxation when we are
over those hurdles.
Chairman Archer. Mr. Lubick, I am trying to keep my time as
short as possible to permit the other Members to inquire. I
asked one question and it has taken quite a long time to pursue
that question.
Suffice it to say that within the constraints that you
mention, you opted in your budget for targeted tax relief. This
means that the administration has decided where resources
should be put rather than broad-based tax relief, where the
taxpayers would make the decision as to what they thought the
priorities were. That is clear in your budget.
Let me get back to the next issue to which you lead me.
Your budget does not provide any net tax relief. That is
apparent on the face of it.
Mr. Lubick. Although we have a proposal after the----
Chairman Archer. No. But in your budget there is no net tax
relief.
Mr. Lubick. You are correct.
Chairman Archer. Rather it raises on a net basis $89
billion in net revenues, irrespective of how you describe them.
And yet, it is also a fact that in your budget and under
current law, the Federal Government is taxing a higher
percentage of GDP than in peacetime history for this country.
People are paying those taxes. The burden of those taxes
must be borne by increased prices of goods and services in this
country. They have to be recovered. And it is built into every
single product and service that we buy.
I am concerned about whether you view this high level of
taxes with any kind of alarm. I am particularly curious as to
why your budget proposes an $89 billion net increase in tax
revenues at a time that we are projecting surpluses. Do you
believe that the level of taxes as a percentage of GDP is too
low?
Do you really think that the highest peacetime level of
taxes in this country's history is too low and therefore you
need another $89 billion of new revenues?
Mr. Lubick. Mr. Chairman, I believe it is fair to say that
the amount of revenues taken, and I deal with the Federal
Government only, as we have no control over the States or
localities, but you are correct that as calculated, the
percentage of revenue over GDP is about 20.6 percent.
Chairman Archer. Almost 21 percent at the Federal level.
Mr. Lubick. However, within a couple of years, it slated to
decline to 20 percent because of provisions that have already
been enacted. But there are several aspects to this.
First of all----
Chairman Archer. OK, but you want to increase that
percentage before it shows any decline? You don't think that is
enough? You think that the revenue percentage is too low so you
want to increase it by $89 billion?
Mr. Lubick. Well, one of the things, of course, that I
think if you are talking about our wish list, you do have to
take into account the reductions that we are proposing
following the Social Security, which I think would, in great
measure, if not entirely, offset that. So I don't think there
is anything inherent in our proposals that calls for putting a
greater burden of taxation at the Federal level on the American
people.
In point of fact, we do not. So that the long-range
proposal, taking into account everything that we have proposed,
would be the other way around.
But I think it should be noted that for most Americans, the
level of taxation at the present time is the lowest it has been
in long-term memory. For a median-income family of four, the
Federal income plus payroll tax burden, that is including both
the employer and the employee shares of the payroll tax, is
lower today than at any time in the past 21 years.
The Federal income tax burden alone for the median-income
is lower than at any time in the past 30 years.
Chairman Archer. Yes, I am aware of that claim, and it has
been presented to us on several occasions by representatives of
the administration. Yet it does not take into account that the
Federal tax burden is hidden in the price of all our goods and
services.
And the poor pay the most. They just don't know it.
Sadly, I hear you saying, as a representative of the
administration, that the highest peacetime tax take in history,
as a percent of GDP, which must be borne by all Americans is
still not high enough. Furthermore, you have to increase it on
a net basis of $89 billion. I just find that difficult to come
to grips with.
But I have used up more than my time. So I recognize Mr.
Crane for inquiry.
Mr. Crane. Thank you very much, Mr. Chairman. I'm having a
hearing in April on Customs, including user fees, but I have a
couple of questions for you today. In the President's budget,
he has proposed increasing the passenger processing fee paid by
travelers arriving by commercial aircraft and vessels from $5
to $6.40 and removing exemptions from the fee.
According to the administration, this would partially
offset Customs costs associated with processing air and sea
passengers, but many people believe that the $5 fee is already
too high and is more than Customs' actual costs in processing
arriving travelers. Can you explain the basis for the increased
fee?
Mr. Lubick. Well, it is my understanding, Mr. Crane, that
this is essentially a user fee, which is designed to recover
the full costs of the services provided by the U.S. Customs
Service and to recover it on a more uniform basis. It is my
understanding that the $5 fee currently does not recover the
full costs. The $6.40 is the amount that would cover all
services that should be subject to the fee. And even that does
not cover the administrative cost. This is based on our
calculation of reimbursement for the costs of direct services
for a clearly identifiable set of beneficiaries.
That is the definition of a user fee as opposed to a tax.
It is designed to impose upon those who clearly, identifiably
benefiting from the service and who should bear the cost rather
than the taxpayers as a whole.
Mr. Crane. So you are saying it is absolutely a user fee
only and it is because of the cost that you have defined?
Mr. Lubick. That is my understanding. I am not prepared to
give you an accountant's eye view of it, but I believe that the
Customs Service will be able to substantiate that.
Mr. Crane. Well, may I ask of you then, could you put
something in writing for me just to verify the position that
you have taken on that one.
Second question. The President has proposed charging an
access fee for the use of Customs' automated systems to offset
the cost of modernizing Customs automation. The trade industry
believes that it has been paying for Customs modernization
automation in other user fees, the merchandise, rather,
processing fees and believes that the assessment of an access
fee is excessive and should not be borne by the industry.
How will the fee be set, and will this be applied to the
use of Customs automation for merchandise originating from
NAFTA countries?
Mr. Lubick. Mr. Crane, again I think, this was designed to
cover the investment that the Customs Service has to make to
install its newly automated system. The current system is over
15 years old, has suffered many brownouts and breakdowns. The
estimated cost of the investment is about a billion dollars
over the next 4 years, and the fees will only recover a part of
these costs, about a $160 million a year, or about $640 million
over the next 4 years. The remaining costs we hope to recover
internally through savings. So it is the same basis.
Mr. Crane. Thank you. I yield back the balance of my time.
Chairman Archer. Mr. Doggett.
Mr. Doggett. Thank you, Mr. Chairman. Mr. Secretary, Forbes
magazine in December, not normally a major critic of the
corporate community in America, as I'm sure you are aware, ran
a cover story on tax-shelter hustlers, pointing out that
respectable accountants are peddling dicey corporate tax
loopholes.
I wanted to inquire of you concerning how serious a problem
this is.
Mr. Lubick. Well I have stated how serious we think it is--
very serious. Mr. Talisman, who is accompanying today has been
spending virtually full time in the preparation of an analysis
of this subject, which we will release in the very near future,
when it is completed. And perhaps he wants to address his view
on the seriousness of it because he has been down there in the
foxholes. I don't know what has been running over his feet.
Mr. Doggett. That would be fine.
Mr. Talisman. Mr. Doggett, we believe it is a very serious
problem for the reasons articulated in Don's oral testimony and
written testimony. One, it undermines the integrity of the
system when products are being promoted to large corporations
merely to avoid tax with no economic substance.
Second, it will cause other taxpayers to view the system as
unfair, which obviously may undermine the voluntary compliance
system. Also, we think that the resource allocation both from
the outside practitioners and others who are promoting these is
not a wise use, a productive use of resources.
Mr. Doggett. By resources, you mean basically that some of
the brightest minds in the country devote their every waking
hour to trying to avoid paying the taxes that ordinary
taxpayers have to pay.
Mr. Talisman. Correct. And also because we at the Treasury
and Internal Revenue Service spend a great deal of resources
tracking down these shelters and then having to shut them down
on an ex post basis, and litigating cases for many years
involving tax shelters.
Mr. Doggett. So the taxpayer who doesn't get to take
advantage of these high-flying schemes, pays for it twice by
having to pay taxes that someone else is not paying and then by
having to pay for the enforcement resources necessary to try to
ferret out these schemes?
Mr. Talisman. That is correct.
Mr. Doggett. Now the Forbes magazine article suggested that
the size of the dimensions of this problem may exceed $10
billion in tax a year. Is that a fair estimate?
Mr. Talisman. Well, the answer to your question is, is that
it is very difficult to put a firm estimate on the amount of
revenue that is being lost to the system.
However, there have been several shelters in recent memory,
for example, liquidating REITs or the step-down preferred
transaction, where the size of those transactions over the
course of a 10-year period were in the multibillions of
dollars.
As a result, you know, a $10 billion estimate seems like it
would be in the ballpark, but again it is very difficult to put
an exact number on----
Mr. Lubick. This whole operation, Mr. Doggett, is
clandestine. They operate under confidentiality arrangements,
whether explicit or implicit, so it is----
Mr. Doggett. If my time permits, I want to explore that
also, but I think the first and most important point is that
the dimensions of this problem--it is a very sizable number,
whether it is $10 billion or $9 billion or $20 billion, we are
talking about billions of dollars in what even Forbes magazine
described as tax schemes never intended by this Congress.
Now I gather by some of the comments that have already been
made in the Committee that there are some who feel that all tax
cuts are created equal and that all tax increases are created
equal. But with $10 billion a year, you could a long way to
meeting the child-care needs through a child-care tax credit to
a working mom. Couldn't you?
In terms of the costs of these proposals?
Mr. Talisman. That is right.
Mr. Doggett. So that for the working mother or the person
that needs long-term care or the person who needs educational
assistance, we would be giving them a tax cut. Some may
ridicule that and say that we ought to treat everybody the
same, but with the money that we would be bringing into the
treasury by addressing these schemes, we would have the
capability to meet some of the real needs that are out there
for tax cuts for working moms or those who have long-term care
needs, or some of the other measures that you have before the
Committee?
Mr. Talisman. The package of raisers on corporate tax
shelters raises, according to our figures, around $7.2 billion.
So, yes, that would----
Mr. Doggett. And that would pay for the child-care tax
credit, would it not?
Mr. Talisman. That is correct. Yes.
Mr. Doggett. And, has the use of contingency fees by some
of these accounting firms become a prevalent practice in these
tax schemes where they earn more if they avoid taxes?
Mr. Talisman. There are a number of devices that are used
to protect the corporate participant, including contingent
fees, rescission agreements, unwind clauses, and, even now, the
sale of insurance.
Mr. Doggett. I look forward to your report on this very
serious problem. Thank you, Mr. Chairman.
Chairman Archer. I would simply suggest to the gentleman
the $7.5 billion has already been consumed by the
administration for its other tax reductions, and so he will
have to look elsewhere for the desirable things that he wants
to do in the Tax Code.
Ms. Dunn.
Ms. Dunn. Thank you, Mr. Chairman. Mr. Lubick, one of the
Treasury Department revenue proposals would change the control
test that is applicable for tax-free incorporations for
distributions and also for reorganizations. The effective date
of the proposal is recommended by the Treasury Department for
transactions occurring on or after the date of enactment of the
proposal.
So, what I would like to ask you, am I correct in assuming
that you would ensure that companies that have filed ruling
requests with the IRS before the effective date of enactment
would be grandfathered from any proposed changes?
Mr. Lubick. We generally defer to the Committee's wisdom on
appropriate transition rules to prevent retroactive unfairness.
And this would be a situation where we would be glad to work
with you and give you our ideas. But we think we are concerned
with establishing the principle first and foremost, which we
think is correct for the future. And to the extent persons
happen to be caught in the web in a way that they have no
opportunity to extricate themselves, I think the Committee has
traditionally given fairness relief, and we certainly concur
that is your province.
Ms. Dunn. You would let----
Mr. Lubick. We concur that it is your appropriate province
to do that.
Ms. Dunn. Good. Thank you.
Chairman Archer. Mr. Coyne.
Mr. Coyne. Thank you, Mr. Chairman. Mr. Secretary, the
administration is proposing making the brownfields expensing
provisions permanent.
Mr. Lubick. Yes, sir.
Mr. Coyne. Regarding the legislation we passed in 1997. I
wonder if you could tell us how the brownfields expensing
provision is working so far and how it is being used?
Mr. Lubick. Well, we think it has worked very well. We
should have some statistics that show a very large impact in
cleaning up and making more livable communities inhabited by
low-income and less fortunate persons.
So far, I know that least 25 sites have been certified and
there has been significant benefit there. And I'm not quite
sure how many are in the process of achieving that status, but
it is--I would judge it as very significant success.
Mr. Coyne. Have you any idea of who is using the
provisions?
Mr. Lubick. Well, the limitation is to census tracts that
have a poverty rate of 20-percent or more, or other census
tracts with a small population under 2,000 where 75 percent of
it is zoned for industrial or commercial use and is contiguous
to census tracts with a 20 percent poverty rate or more, or the
areas designated as Federal empowerment zones or enterprise
zones or there are 76 EPA brownfields pilots that were
announced prior to 1997. So those areas are eligible as well.
They are both urban and rural. So is has widespread application
to those areas where the need for renewal is most important.
Mr. Coyne. Is the administration making any other
recommendations besides making it permanent in the Code during
this budget process? Are there any other recommendations on
that list?
Mr. Lubick. With respect to these areas?
Mr. Coyne. Right.
Mr. Lubick. Yes, we do. We have, in particular, our new
markets credit, which is intended to fund community development
entities that are providing funds for private enterprise to go
into this sort of area to carry on active businesses. And that
in itself should improve the business. We have a proposal for
our Better American Bonds, which is a tax credit modeled on the
QZAB, the Qualified Zone Academy Bonds, the bonds that were
previously adopted by this Committee to provide bonds to
finance environmental improvement, which does not normally
generate revenue to pay off the bonds. So this tax credit will
help communities issue those sort of bonds.
We have some extension of enterprise and empowerment zones.
So there are a number of other things in the budget that are
addressing needs in these areas, including the extension of the
work-opportunity credit and the welfare-to-work credits to help
residents of those districts.
Mr. Coyne. OK. Thank you. The administration's budget
request includes a proposal to reduce the deduction for
interest on borrowing unrelated to life insurance, and I wonder
if you could discuss the rationale for that proposed change?
Mr. Talisman. In 1996, Congress passed legislation to
restrict direct borrowing against life insurance policies. And
then in 1997, Congress further restricted the use of COLI,
corporate-owned life insurance, products with respect to
nonemployees, where you are borrowing against life insurance
contracts, for example, on homeowners, and so forth. This
proposal extends that principle, which is the tax arbitrage
that results from use of tax-exempt interest when combined with
inside buildup of life insurance.
Where the borrowing against the life insurance is not
directly traceable to the life insurance contract, but is in
effect, leveraging the life insurance contract. So that it
would again prorate your interest deduction and disallow an
interest deduction consistent with the changes that were made
in 1996 and 1997.
Mr. Coyne. So are you generally characterizing that as a
tax shelter?
Mr. Talisman. We are characterizing that as a tax shelter.
Yes, we are, because it provides arbitrage benefits that can be
used to shelter other income.
Mr. Coyne. In the past, hasn't it been used for very
legitimate reasons?
Mr. Talisman. Well, when you say was it used for legitimate
reasons, the tax benefits can be dedicated to very legitimate
reasons. For example, retirement benefits, and so forth.
However, the arbitrage is not condoned by the Code and in
fact it would be inconsistent with what Congress has done in
1996 and 1997.
Mr. Coyne. Thank you.
Chairman Archer. Mr. Weller.
Mr. Weller. Thank you, Mr. Chairman. Mr. Secretary, good to
see you again.
Mr. Lubick. You too, Mr. Weller.
Mr. Weller. And I have enjoyed listening to the statistics
going back and forth on the tax burden, and I will share one
too, I guess. It is my understanding that about the average
family's income today, at least the average family in Illinois,
goes to government at the State and local level. And of that,
my understanding is, probably what is the highest tax burden on
Illinois families in the history of our country. What is it
almost 21 percent of our gross domestic product today goes to
the Federal Government alone?
So that is my statistic I would like to toss out about how
high taxes are, and the tax burden on Americans.
Mr. Lubick. May I differ with that statistic?
Mr. Weller. Well, perhaps when you respond to my question
here. You know, when I was back home over the last weekend, you
know, you always run into folks and actually read the fine
print, and they ask questions of me. They say, you know, in the
President's budget, why in the President's budget in a time of
surplus, when we have all this extra money, do we need $176
billion in tax increases? And why in this time of surplus does
the President propose spending $250 billion in Social Security
trust funds for other purposes?
And I am pretty pleased with the decision by our leadership
to put a stop that type of practice that the President wants to
continue.
I also note in your budget that you continue to advocate
targeted tax cuts, and some might describe a targeted tax cut
as targeted so very few benefit and they get very little. And
the issue of brownfields tax incentives was mentioned just a
few moments ago, and I am, of course, a strong advocate of
that, I often wonder, don't middle-class communities--I think
middle-class communities--the need environmental cleanup as
well. I can think of towns like New Lenox and Morris and
LaSalle-Peru that can use that environmental tax incentive
which is targeted so much that they are denied that opportunity
to clean up the environment.
What I want to focus on here, particularly, is in your
budget, you are asking essentially for some blanket authority
to address what you call tax avoidance schemes. And I think I
am one of those who believes that when Congress writes a law,
your job is to follow the law and, of course, collect those
taxes. That is our intent.
But last year, when the Ways and Means Committee and the
Congress passed what I feel is one of our greatest
accomplishments, and that is the IRS reform, we were
addressing, as part of IRS reform, an area where we felt that
IRS was doing something we did not want the IRS and the
Department of Treasury to do. And that is the issue of meal
taxes in the hospitality industry.
And in the IRS reform bill there was section 5002, which
gave a protection to the working moms, the cocktail waitresses,
the coat-check people, the people who provide hospitality at
various employers, including almost 4,000 employees of the
south suburbs that I represent.
It is interesting, these individuals make an average of
about $16,000 a year in the hospitality industry because of the
nature of their job and demands of their job, they are called
upon to be around all the time. They may have to wear certain
types of uniforms. And so they are provided meals, maybe a hot
dog or something by their employer to make it convenient for
them.
And for some reason, you insist on taxing them on that hot
dog. Now, the IRS reform legislation made it very clear the
intent of this Congress was--is that we do not want you to tax
that working mom, probably raising some kids--she is probably a
single mother who is a waitress or cocktail waitress or working
in the checkout, or that busboy, for example.
But it is my understanding that you are continuing to come
back and insisting on taxing that employee of the hospitality
industry. As I point out, 4,000 people in the district I
represent. I just don't understand why you are ignoring the
intent of Congress and legislation that the President signed.
I was wondering if you can respond to that and explain why
you are so insistent on taxing the hot dog and the meal that is
provided to these working moms in the hospitality industry?
Mr. Lubick. We do have an overall problem, Mr. Weller,
which is that if we have a general standard that meals
furnished by an employer to an employee are outside of the tax
base, that compensation will immediately respond, so that every
worker in the country will be getting a little-bit reduced
salary and some meals, which will be--so, the general principle
is difficult. Now there are exceptions where they have been
longstanding exceptions in the Internal Revenue Code.
Mr. Weller. Mr. Secretary, just quickly reclaiming my time,
the intent of Congress--we put a safe harbor in the law in
section 5002 of the IRS reform legislation, which your
President and my President signed into law. We made it very
clear that you should not be taxing the cocktail waitress, the
working mom who is given a hotdog as part of--to help her be
able to be at work. Now that was the intent of Congress, and
yet you continue to come back and insist on taxing this
cocktail waitress and this busboy and those in the hospitality
industry.
And I just don't understand why you ignore the intent of
Congress, when we made it very clear that we want you to put a
stop to taxing these individuals.
Chairman Archer. The gentleman's time has expired.
Mr. Neal.
Mr. Neal. Thank you, Mr. Chairman. Thank you, Mr. Lubick
for your usual sturdy performance here. I appreciate your
presence. The alternative minimum tax. The administration
proposes to extend tax relief from the alternative minimum tax
for tax relief for individuals for nonrefundable credits for 2
additional years, for this year and for next year. I am going
to reintroduce in the next few days my bill from the last
Congress to provide relief on a permanent basis.
As you know, Mr. Chairman, you were helpful last year on
this issue. We discussed it. What is the administration's long-
term position on this issue?
Mr. Lubick. Well, as a long-term matter, Mr. Neal, it is, I
think, abundantly clear that these credits, like so many other
things that are under the individual tax, were never intended
to be the sort of tax preference that the tax should apply to.
Unfortunately, under the revenue scoring constraints that we
operate under, those things which, I think virtually everybody
agrees, ought to be changed have not been capable of being
addressed on a permanent basis.
The problem is going to get continually worse, and we would
hope that a way could be found to deal with this situation on a
permanent basis. Not only the credits, but State and local
taxes, personal exemptions, perhaps even the 15 percent can be
considered a preference under the alternative minimum tax. That
certainly was not the intent when the alternative minimum tax
was first conceived. It was excessive use of tax preferences,
and the problem awaits the will of people to devote the funds
to that before the problem gets completely out of hand.
Mr. Neal. Well, given revenue forecasts for the foreseeable
future, does that provide us with an avenue for relief or
potential for relief?
Mr. Lubick. Well, I would hope so. There was a reference to
the surplus. Of course, at the present time, the unified
surplus depends upon the Social Security surplus. It depends
upon using the funds that were dedicated to the Social Security
Trust Fund for other purposes. If you didn't count Social
Security, we would not be in surplus either this year or next
year.
But, yes, I think Chairman Archer has been talking about
this for some time, and I think quite correctly. And as such
time--this is one of the big-ticket items of general relief
that I think ultimately is appropriate.
Mr. Neal. Thank you, Mr. Lubick, and I hope that we will
have a chance with the Chairman and Members of the Committee to
pursue this issue because I think we all acknowledge that we
are reaching a critical juncture, and as time moves along, I
think we cannot continue to repair this on a 1- or 2-year
basis. We have to speak about a more permanent solution.
The second question I have is, since Mr. Weller mentioned
the issue of tax avoidance, Mrs. Kennelly, as you know, last
year, produced a fairly extensive bill that dealt with this
whole question of hedge funds. And the administration's
proposal seems to be a bit more narrow than the one that Mrs.
Kennelly offered, which I intend to work on again this year,
and about which I have been seeking information and advice.
Could you give us an explanation about the effective date
and how you intend to treat this issue in coming months?
Mr. Talisman?
Mr. Talisman. I think, Mr. Neal, when you said it was more
narrow, I think you may mean that we limited it to partnerships
as opposed to other pass-through entities. Again, we narrowly
tailored our proposal to focus on total return swaps on
partnership interest because that was the way we understood the
transactions were being done. We realize that it may be
possible, theoretically possible, to achieve conversion and
deferral using total return swaps on other pass-through
structures, such as REITs and PFICs, passive foreign investment
companies. We are currently looking at that issue.
We understand that PFICs are actually already addressed by
the law, but we are also looking at that issue as well. We
would certainly like to work with you and your staff in
addressing this issue.
Mr. Neal. My intention is to proceed with a version of the
Kennelly bill, and I hope that we will be able to find some
common ground as this moves along. I do think this general area
has the potential for serious problems down the road.
Thanks, Mr. Chairman.
Chairman Archer. I thank the gentleman for his line of
inquiry. I have been disturbed for a long time about the
alternative minimum tax. Clearly now the problem is exacerbated
by the new child credit and the Hope scholarship credit. Even
if you eliminate those items from the alternative minimum tax,
the tax still hits the personal exemption. Currently, many
people are not entitled to take a personal exemption without
paying a tax on it. The personal exemption has been an
inherent, fundamental part of the income tax law.
Yet this pernicious alternative minimum tax comes back in
when you have to reformulate all your income. You have done
your regular tax return, but then you have to compute and add
back in your personal exemption and pay a tax on it.
Mr. Lubick, why can't we just abolish the personal
alternative minimum tax? Why have it in the Code?
Mr. Lubick. There are a few items, but a very few items,
that probably may be justified to be under it. Most of the
other preferences that were there originally, have been taken
care of.
Chairman Archer. Should the personal exemption be under it?
Mr. Lubick. It certainly shouldn't be, nor should the
standard deduction, nor should the deduction for State and
local taxes, nor should the deduction for medical expenses.
Chairman Archer. Well, you have named all of them. Let's
just get rid of it. What else is left?
Mr. Lubick. Well, there are a few minor things like stock
options----
Chairman Archer. Yes, but they don't amount to a hill of
beans. I would like for my friend from Massachusetts to join
with me to abolish the personal alternative minimum tax. We are
facing a situation where a married couple, earning $59,000,
taking the standard deduction only, will be under the minimum
tax in the next century.
I mean, this is ridiculous. The gentleman set me off on
this. This is a cause celebre for me. I apologize to the other
Members of the Committee for taking the time.
Mr. McInnis.
Mr. McInnis. Thank you, Mr. Chairman. To the Secretary, you
know, in regards to the Chairman's comments, wouldn't you agree
that the alternative minimum tax is outside the boundaries it
was originally intended to address.
Mr. Lubick. I think I stated it in my answer to Mr. Neal
that certainly is our opinion in the Treasury Department and
the question is that it becomes expensive and then you have to
find some pay-for under the existing rules, and the problem is
that because there is an exemption under the alternative
minimum tax that was adopted originally that was not indexed,
the exemption took most people out of it.
Now the value of that exemption compared to a person's
income has been depreciating on an annual basis, and so each
year that you delay in doing this, it becomes more expensive to
do it.
So it is a problem that I think, on the merits, we can
achieve virtual unanimity.
Mr. McInnis. I guess a couple of other points I should ask.
First of all, for my colleagues, well, the contingency fee
issue that was discussed with some accountants. I went to law
school, and I should also point out that trial lawyers collect
contingency fees handling tax matters as well. So it is not
exclusive to a set of hardworking accountants.
Mr. Talisman. The proposal would not impose any
restrictions on----
Mr. McInnis. I understand that. I am just clarifying a
comment, so we know the trial lawyers are in this pool of money
as well.
I guess, when we talk about these shelters, the legitimacy
of those no longer become a concern if we were to reform the
Tax Code and put in a consumption tax.
It would seem to me that the ultimate goal is fundamental
reform of the system and then we can eliminate all of the
questions of this issue.
But let me go on and ask, I'm a little unclear, Mr.
Secretary, tell me again how you draw the determination between
tax shelters that are outside the original intent and are
misapplying the intent of the law versus directives to the
Treasury Department to find revenue raisers? And do you have--
the second question is, do you have incorporated in these tax
shelters, shelters that still live within the boundaries of
their original intentions but are a susceptible target for
revenue-raising?
Mr. Lubick. The are expressly taken out. Where Congress
intended a provision to operate like a tax shelter, for
example, the low-income housing credit, they are expressly
excluded. We are dealing with the unintended shelters.
Mr. McInnis. So there are no shelters in there that are
acting within their boundaries but placed in there to find
revenue.
Mr. Lubick. If the result achieved is that which Congress
was trying to get at, as is true of many special preferences
which have the effect of sheltering other income, this
provision explicitly does not deal with those. It imposes no
restrictions. It couldn't. It couldn't. They are permitted. If
they are permitted under the law--anything that is permitted
under the law is not a tax shelter by our definition.
Mr. McInnis. OK. And to determine that, I assume you look
at legislative history. What are the combination of factors you
use to apply to a specific tax shelter where it is somewhat
gray as to whether the law allows it or not?
I mean, if the law didn't allow it, you could go back and
audit and recover the funds. But here there is an area where
you are saying, well, maybe they are within the letter of the
law but they are not within the intent of the law.
Mr. Talisman. The definition of tax shelter has two
components. One is that the pretax profit is insignificant
relative to the aftertax benefit. That is an articulation that
actually is in the judicial doctrines, including the Shelton
case and the recent ACM case. That clearly contemplated by the
Code to which Mr. Lubick was referring to is already in the
definition of corporate tax shelter for purposes of section
6662. So that articulation is already in the regulations, the
section 6662 that items that are clearly contemplated by the
Code do not constitute a tax shelter.
So that has been a definitional rule that has been in
existence for many years.
Mr. McInnis. Thank you, Mr. Chairman.
Chairman Archer. Mr. Tanner.
Mr. Tanner. Thank you, Mr. Chairman, and my question was
really touched on by Mr. McInnis and also to some degree Mr.
Doggett. You said in response to a question by Mr. Doggett you
have a report out about the abuse of the system as it relates
to these--when could we expect that?
Mr. Lubick. Mr. Talisman is the guy who is in charge of it,
so I think I will let him answer the question so I don't go
under the gun.
Mr. Talisman. We are hopeful to have it out within, I would
say, a month. We are working very hard on it, but we want to
make sure that it is as complete as possible.
Mr. Tanner. And in that report, you will, I suppose, define
for us further what you consider----
Mr. Talisman. And we will also, I hope, take into account
many of the recommendations that we will see based on the
testimony today so that we can comment on those as well.
Mr. Lubick. We have been talking with practitioners, with
companies, and we continue to have our doors open to people to
help us make sure we don't make any mistakes.
Mr. Tanner. Well, I am sure you understand there is concern
that definition and so on as it relates to achieving a solution
to the problems we are talking about here in that, frankly, a
minimization of one's tax liability is a completely legitimate
business purpose.
Mr. Lubick. That is legitimate. Right.
Mr. Tanner. And I think what Mr. McInnis was talking about,
we are all concerned about, the fairness of the Code and so
forth. And to get at these schemes of course is something that
we are all interested in. But there are certain, may we say,
provisions of the Tax Code that are not black and white, and
those instances, we would hate to see--because we will get the
complaints--we would hate to see the service take a position
with regard to, for example, good-faith exception, the
substantial authority, those words, you have some proposal
there is----
Mr. Lubick. We believe in the definition of tax shelter
that we have underdefined rather than overreached. We have
tried to make sure we don't go too far. And we believe we are
exactly within the Code as it is enacted or has been
interpreted by courts for a long time.
Mr. Tanner. This will be addressed in your report?
Mr. Lubick. Right.
Mr. Tanner. Good. We will look forward to it. Thank you.
Chairman Archer. Mrs. Johnson.
Mrs. Johnson of Connecticut. Thank you. And welcome, Mr.
Lubick. I do find it quite remarkable that you are proposing
$82 billion in tax increases when we have a surplus because
taxes do even all come out of workers' pockets. You can call
them corporate, but in the end they are paid by you and me and
the next guy, either through product prices, lost wages, and so
on.
I took a lot of heat last year, and this Committee took a
lot of heat, for proposing $80 billion in tax cuts. And here
you are, with a surplus, coming to us with $82 billion over 5
years in tax increases. So I just wonder why you thought it was
necessary--and I would appreciate it if you would keep it
short, because I do have specific questions as well--but why,
when there is a surplus and when the surplus going out into
other years is trillions, why?
Mr. Lubick. Well, Mrs. Johnson, the package that we have
talked about of initiatives and revenue-raisers is balanced. So
we are dealing with some user fees in the aviation industry,
which again is really not a tax but a question of those
benefiting from the services----
Mrs. Johnson of Connecticut. The $82 billion, though, was
only taxes, not user fees.
Mr. Lubick. Pardon me?
Mrs. Johnson of Connecticut. The $82 billion was only
taxes, not user fees. You are right, it is more money if you
include both taxes and user fees.
Mr. Lubick. No. I think what we are trying to do is recover
from the users of the system the cost----
Mrs. Johnson of Connecticut. Right. But that is not in my
$82 billion figure, as I understand it.
Mr. Lubick. And I think the other item involves the excise
tax on tobacco, which is in the budget, but I think----
Mrs. Johnson of Connecticut. Are you really saying though
when you say balanced, that our budget is balanced, that you
proposed $82 billion in tax increases plus user-fee increases
in order to fund the new spending in the budget?
Yes. The answer is simply yes. I mean, let's not belabor
this. We all know that to stay within the caps you would have
had to free spending and cut $17 billion. And to work within
the balanced budget you had to pay for new spending and so we
have $82 billion in proposals to increase taxes to fund new
spending. It is simple.
I don't want to belabor it, I just want it clear.
Mr. Lubick. But I think you are not taking into account the
proposal involving USA Accounts, which is a tax reduction of--
--
Mrs. Johnson of Connecticut. Sure. And that is one of the
new programs out there, and they all cost money, whether they
cost money to the Tax Code or whether they cost money through
appropriated dollars. But the fact is what you are doing is
raising the money to pay for new programs. And one of them
happens a very interesting and in some circumstances, a very
desirable approach for savings.
Mr. Lubick. It is a tax reduction. It seems to me it is a
tax reduction.
Mrs. Johnson of Connecticut. Sure. It is. But the fact is
you are raising taxes to fund it. So I just think we ought to
be honest about this. To stay within the budget caps and within
the budget deal, all the new spending that the President is
talking about, whether it is long-term care assistance, whether
it is education funding, whether it is construction grants,
whatever it is, it is funded by this pot of $82 billion in tax
increases and the additional fees. And the reason you have to
do that is because you know and I know that to stay within the
balanced budget he would have had to free spending and cut $17
billion in outlays.
So I just want that on the record. But I also want to say
then--ask you, why have you chosen, first of all, when clearly
if you are serious about your spending purposes, why have you
chosen to fund them in part with 30 proposals that have been
rejected by this Committee on a bipartisan basis, I think 2
years in a row but certainly the last time. And then,
specifically, now how can you justify focusing and undoing
something this Committee did, and it happened to be my
amendment, just the last year, and then you do it in such a way
that there is a kind of retroactive whiplash?
And I am referring to the change that you are making in the
S corporations, the change in the S corporation law that we put
in there explicitly to allow S corporations to develop ESOPs,
employee stock ownership plans. And you specifically undo what
we just did last year.
Mr. Lubick. I think, Mrs. Johnson, there has been a lot of
writing since that was adopted. And I think we have adhered to
the objective that was sought at the time, which was to make
sure that an ESOP, which is an S corporation shareholder, is
not subject to double taxation. And the problem is that by
exempting the ESOP from being taxed on its current share of
subchapter S income, you are creating one gigantic tax shelter,
which has been written about by the commentators as a
tremendous opportunity.
Instead, what we have proposed to do, is to do what is the
situation with respect every other S corporation shareholder.
After the tax is paid currently that there is no tax at the
corporate level, but there is a tax at one level currently with
respect to all S-income.
Mrs. Johnson of Connecticut. I will be happy to work with
you on this because I don't believe that is what you are doing,
and I think what you are doing is so extremely complicated that
no one in their right mind would try to go into this negative
carry-forward business.
But as far as I am concerned, I doubt that you as a
government person have ever been in a company that is doing
open-book management. But it is way beyond continuous
improvement. It is such a level of involvement in management
decisionmaking on a weekly basis and creates the most
absolutely incredible level of efficiency and effectiveness and
teamwork that it absolutely blows your socks off.
And why those employees who are literally part of managing
day-in and day-out, can't have an ESOP I cannot imagine.
And why, from Washington, we should get into double
taxation and all this stuff. But I will be happy to look at the
literature, but I am not going to sit quietly by while you
reverse progress we made last year that is really in harmony
with the most dynamic things happening in our entrepreneurial
society.
My red light has been on. So, thank you.
Chairman Archer. The gentlelady's time has long since
expired. [Laughter.]
Mrs. Thurman.
Mrs. Thurman. However, Mr. Lubick, I want to echo Mrs.
Johnson's words because that is where my questions were going
to go to as well.
Mr. Lubick. We will be glad to discuss with both of you the
reasons why I think we can demonstrate that this maintains the
incentive for the ESOP and maintains the incentive for it to be
part of S, but at the same time produces a very equitable
result which was intended from the beginning, when the S
corporations were adopted in about 1958.
Mrs. Thurman. However, when we talk about the form of a
loophole, this has only been in the law for 15 months, which is
what Mrs. Johnson said. I guess one of the questions I would
like answered is, can you cite some of those abuses and/or
could you give us some ideas of what maybe IRS has done in the
enforcement of this so that we would not go into changing what
was the incentive.
I think it was specifically put into law as an incentive
for these corporations to work into employee-owned, which is
very important to them.
The second thing that I might remind you is that there was
a similar situation to this in the Senate last year, very
similar to this proposal, if not exactly this proposal. And one
that this whole Congress, Democrat, Republican, Independent,
has made very clear. And we talked about it when we did the tax
reform; it is complexity. This becomes very complex for these
folks. It was actually reviewed by the Senate last year, and
they threw out any of this change just because of the
complexity of what could potentially happen on that.
I think the third issue is the retroactivity. We got enough
grief in 1993 on retroactivity, and now we are looking at doing
something again on this ESOP issue.
So I think we have some very serious questions.
I will say to you that I was pleased with the decision that
you have made to listen to the testimony that is going to be
given in this panel as we go through today. I think you are
going to find out why some people find this very objectionable,
why this has worked particularly in this area, some people that
are actually in and doing these kinds of ESOPs and why this is
so important.
So I really hope that you do live up to that and take into
consideration what they say because I think they can add a lot
of light to this issue.
Other than that, there are obviously several things in this
budget that I really do like. Sometimes, as Mrs. Johnson said,
we probably rejected many of these, but I think the priorities
that have been set forth in the budget are the right ones for
folks, whether it is the long-term care or child care,
whatever. And I just hope there is a way that we can achieve
these goals without being totally disruptive in this country.
Mr. Lubick. Thank you.
Chairman Archer. Mr. Collins.
Mr. Collins. No questions.
Chairman Archer. Mr. Lubick, Mr. Talisman, thank you for
your endurance. We appreciate your testimony, and you are free
to stay as long as you want and listen to the other witnesses.
Thank you.
Mr. Talisman. Thank you, Mr. Chairman.
Mr. Lubick. We have a large group here of supporters, as
you can see. At Treasury rates, we can afford to tie up the
whole shop for an afternoon, but they are going to observe very
carefully. Thank you.
[The prepared statement and attachment of Mr. English
follows:]
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Chairman Archer. Our next panel is Stefan Tucker, William
Sinclaire, David Lifson, and Michael Olson. If you would come
to the witness table, please.
[Pause for witnesses to come forward.]
The Chair encourages guests to leave the room quietly so
that we may continue. We have a long list of witnesses yet to
appear this afternoon.
Gentlemen, as usual, I would admonish you to attempt to
keep your verbal testimony to within 5 minutes, and, without
objection, your entire written statements will be printed in
the record.
Mr. Tucker, will you lead off and will you identify
yourself for the record and whom you represent and then
proceed.
STATEMENT OF STEFAN F. TUCKER, CHAIR, SECTION OF TAXATION,
AMERICAN BAR ASSOCIATION
Mr. Tucker. Thank you, Mr. Chair. My name is Stefan F.
Tucker, I am the chair of the section of taxation of the
American Bar Association. I am appearing here today on behalf
of the section of taxation and, with respect to one item,
appearing here on behalf of the American Bar Association
itself. We very much appreciate the opportunity to appear
before you today. The section of taxation has a membership of
20,000 tax lawyers, and, with a broad-based and diverse group
of tax lawyers, we are, in fact, the national representative of
the legal profession with regard to tax matters.
First, I would like to point out that the tax section has
been a firm advocate, day-in and day-out, of simplification.
And we think that this tax bill does not represent
simplification. We have already sent the letter dated February
26, Mr. Chairman, of which you were sent a copy, noting to the
administration that we are very disappointed in the breadth of
the proposal.
When I sit here with 70 pages of proposals, that clearly
does not meet anybody's goal of simplification and lack of
complexity. We think careful scrutiny has to be given to any of
these proposals, and we think that, from our perspective,
complexity really fosters noncompliance, whereas simplification
enhances understanding and compliance.
And we are willing to continue to take that position.
We agree with you on one item, very clearly. And that is
the alternative minimum tax is just something that ought to be
eliminated on the personal basis. We think now is the time,
when we are facing budget surpluses, for Congress to stand up
and say this really counts, and we recognize there may be a
cost, but you are going to have 9 million taxpayers who
unexpectedly are going to go into the AMT over the next decade.
We are seeing it on personal exemptions; we are seeing it on
State and local income taxes; we are seeing it on the standard
deduction; we are seeing it on a number of items that nobody
ever thought about.
Now is the time to do it. If we let this continue to go on,
it's is going to get worse; it is never going to get better.
And the scoring is going to get continually worse. It will
never get better.
And yet it is an item that will lead to the destruction, we
believe, of the income tax system at some point.
We also believe strongly----
Chairman Archer. Mr. Tucker, then perhaps we should leave
it in place. [Laughter.]
Mr. Tucker. We may have different views on that as tax
lawyers.
We also think that the phase-out concept is an item whose
time has come and gone. And it is just another way of saying
that we don't want to raise tax rates, so we are going to
impact people with the phase-out of itemized deductions, or the
phase-out of personal exemptions. We think it is about time to
face reality.
It is probably strange for tax professionals, tax lawyers,
to say ``let's stop the undersided approach and just go
straight up,'' but we think we ought to.
We are really here, most importantly, to talk about
corporate tax shelters. And when I use the term ``corporate tax
shelter,'' please understand it is not just focused on
corporations. It focuses equally as much on limited liability
companies, partnerships, business trusts, and trusts. It is a
very widespread situation.
And I will tell you that we at the tax section strongly
share the concerns of the Treasury Department that the tax
shelter problem is a real problem. From our perspective, we
would urge that you do not heed those who say that there are no
problems. Do not heed those that say that corporations pay
enough taxes.
It has been noted already, up here, that the less the
corporation pays, the more the individual pays. If we are going
to reduce tax rates, let's reduce them at the individual level
and let the corporations pay their fair share.
The problems are real. The problems are there. They are not
self-correcting. It's a secretive and insidious methodology,
and let's not ignore the Trojan horse--it's already in the
gate. The promoters are sneaking out at night. Put them out in
full daylight and let people see what it is. Let's look and see
whether the emperor really has any clothes in these corporate
tax shelters.
And our focus is disclosure, disclosure, disclosure. Put it
out and let people look at it, and then determine whether or
not it truly works.
We think that, on the tax shelters, there are four
features: there is a discrepancy between book and tax
treatment; there is little economic risk to the corporation;
too often there is a ``tax indifferent party'' involved; and
there is a broad-based marketing by the promoter, by counsel,
and apparently sometimes by the staff of the taxpayer itself.
And we think that penalties ought to be imposed on those
levels.
And if someone comes up in front of you and says there are
no problems, we would urge that what you do is say: Are you the
purchaser of a product? Are you the marketer of a product? Are
you or your clients the marketers of products? If they are, ask
them to give you three or four, and then look at those, and
then see if they fit within these criteria that we have.
Last, because our time is already short, I would urge you
to look at the proposed income tax----
Chairman Archer. Because I interrupted, you may feel free
to go on for another minute or so.
Mr. Tucker. Thank you, sir. I really appreciate it.
What we would like to do, if I can, is point out that there
are solutions. We really believe, first and foremost, that
there ought to be additional reporting for tax shelters, and we
would note that the taxpayer ought to be attaching to the
return detailed explanations. The taxpayer ought to be giving
descriptions of due diligence. Why is there such a difference
between the due diligence done in a public offering and the due
diligence that is done in a corporate tax shelter?
Why are there simplistic assumptions being made that nobody
has to back up? What is needed is security and real
enforcement. One is SEC enforcement on the public offering, and
two is the penalties imposed upon the people: damages,
liability for not doing the job right.
You don't want to just do this at the corporate level. You
want to look at the promoter. And you want to look at the
advisers. If everybody has risk, it is going to make a
difference.
We think you should broaden the substantial understatement
penalty to cover outside advisers, promoters, and tax-
indifferent parties. And if those tax-indifferent parties are
exempt organizations, and they are being used to inure to the
benefit of private parties, maybe they are violating the rules
that apply to exempt organizations.
We think you ought to focus on a real definition of large
tax shelters. There is a 1997 tax provision that still hasn't
had its definition yet. It was noted before, we are still
awaiting it from Treasury. It's difficult, to come up with a
definition. It ought to be done.
And Congress ought to say that there are existing
enforcement tools at the audit level that can be supported with
funding to look at this.
Last, on the taxation of investment income of trade
associations, on behalf of the ABA itself, we know that a
majority of the Members of the Ways and Means Committee have
stated they do not believe that this is something that should
be done.
We think that it is a big problem. It ought not to be done;
there ought not to be a tax on investment income. You impose a
tax here, you simply put the dollars into another source. It is
going to be a wash. It is not anything that ought to be done at
this point.
Thank you, sir.
[The prepared statement follows:]
Statement of Stefan F. Tucker, Chair, Section of Taxation, American Bar
Association
Mr. Chairman and Members of the Committee:
My name is Stefan F. Tucker. I appear before you today in
my capacity as Chair of the American Bar Association Section of
Taxation. This testimony is presented on behalf of the Section
of Taxation. Accordingly, except as otherwise indicated, it has
not been approved by the House of Delegates or the Board of
Governors of the American Bar Association and, accordingly,
should not be construed as representing the position of the
Association.
As you know, the ABA Tax Section is comprised of
approximately 20,000 tax lawyers. As the largest and broadest-
based professional organization of tax lawyers in the country,
we serve as the national representative of the legal profession
with regard to the tax system. We advise individuals, trusts
and estates, small businesses, exempt organizations and major
national and multi-national corporations. We serve as attorneys
in law firms, as in-house counsel, and as advisors in other,
multidisciplinary practices. Many of the Section's members have
served on the staffs of the Congressional tax-writing
Committees, in the Treasury Department and the Internal Revenue
Service, and the Tax Division of the Department of Justice.
Virtually every former Assistant Secretary of the Treasury for
Tax Policy, Commissioner of Internal Revenue, Chief Counsel of
the Internal Revenue Service and Chief of Staff of the Joint
Committee on Taxation is a member of the Section.
The Section appreciates the opportunity to appear before
the Committee today to discuss certain proposals contained in
President Clinton's budget for Fiscal Year 2000. Our testimony
today will not include comments on each and every proposal in
the President's budget. We do anticipate, however, that
additional individual comments on various proposals will be
submitted in the near future. In addition, individual members
of the Tax Section would be pleased to provide assistance and
comments to members of the Ways and Means Committee and to
staff on any proposals you might identify.
Our general focus today will be the overall need for
simplification of the tax code and the corresponding need to
avoid additional complexity. In addition, we would like to
comment on the various tax shelter proposals contained in the
budget, as well as the proposal to tax the investment income of
trade associations.
SIMPLIFICATION AND COMPLEXITY
The ABA and its Tax Section have long been forceful
advocates for simplification of the Internal Revenue Code. In
resolutions proposed by the Tax Section and passed by the full
ABA in 1976 and 1985, we are on record urging tax law
simplicity, a broad tax base and lower tax rates. We have
reiterated this position in testimony before the House Ways and
Means and Senate Finance Committees on numerous occasions.
Over the past two decades, the Code has become more and
more complex, as Congress and various administrations have
sought to address complicated issues, target various tax
incentives and raise revenue without explicit rate increases.
As the complexity of the Code has increased, so has the
complexity of the regulations that the IRS and Treasury have
issued interpreting the Code. Moreover, the sheer volume of tax
law changes has made learning and understanding these new
provisions even more difficult for taxpayers, tax practitioners
and Service personnel alike.
Although, until recently, many of these changes have not
affected the average taxpayer, the volume of changes has
created the impression of instability, in that the Code is
becoming perhaps too complicated for everyone. This takes a
tremendous toll on taxpayer confidence, evidence of which can
be found in the broad public support for the IRS restructuring
legislation passed last year. This Committee often hears how
our tax system relies heavily on the willingness of the average
taxpayer voluntarily to comply with his or her tax obligations.
Members of the Tax Section can attest to the widespread
disaffection among taxpayers with the current Code. Their
willingness, and their ability, to keep up with the pace and
complexity of changes, is at a point beyond which it should not
be pushed.
It now appears that many in Congress are interested in
enacting tax reductions this year. Press accounts indicate that
various options are being discussed. The Tax Section does not
take a position with respect to the wisdom of tax reduction
generally or any particular proposals. We do urge, however,
that the members of this Committee keep simplification and
avoidance of complexity uppermost in their minds as any tax
reduction packages are fashioned. Tax relief can be delivered
in ways that avoid new, complicated rules and that steer clear
of phase-outs that act as hidden marginal rate increases. While
such broad-based reductions may not have the cache' of new,
more targeted provisions, they will avoid the layering of new
complexity over old. To paraphrase Hippocrates, if Congress
chooses to reduce taxes, we urge you to do no harm.
To this end, on behalf of the Tax Section, I recently sent
to Secretary Rubin a letter expressing our disappointment that
the President's budget proposes to add a multitude of new tax
credits to the Federal income tax system. Our point in that
letter was that, although each credit taken in isolation could
be viewed as meritorious, that kind of micro-balancing
inevitably leads to the type of tax system that is, in total,
overly complex and undeserving of public respect. Particularly
in light of the various, complicated provisions added by the
1997 tax act, Congress and the Administration must focus on the
cumulative impact of all new provisions sought to be added.
Only then can they resist the accretion of income tax benefits
and penalties that are unrelated to the administrable
measurement of annual taxable income and ability to pay.
My letter to Secretary Rubin also urged that particularly
close scrutiny be given to any proposals that include income
phaseouts. These phaseouts have gained popularity in the last
two decades, and are responsible for a significant amount of
the complexity imposed on individual taxpayers. As noted
previously, phaseouts create the effect of a marginal rate
increase as a taxpayer's income moves through the phaseout
range, and the effects of multiple phaseouts on the same
taxpayer can create capricious results. Phaseouts also play a
significant role in the creation of marriage tax ``penalties,''
and add to the difficulty in addressing that set of issues. We
urge you to resist their continued use in the enactment of
additional tax incentives.
We do not claim to have all the answers. The Tax Section
will continue, diligently, to point out opportunities to
achieve simplification whenever possible, including several
ideas that we will discuss later in this testimony. However, it
is also necessary that we point out that simplification
requires hard choices and a willingness to embrace proposals
that are often dull and without passionate political
constituencies. Simplification may not garner political capital
or headlines, but it is crucial. Complexity fosters non-
compliance; simplification enhances understanding and
compliance.
To date, simplification has not achieved the commitment
that we believe is required. Too often, other objectives have
tended to crowd simplification out as a priority. We urge the
Ways and Means Committee to adjust this balance. Without a
commitment on the part of the members of this Committee to
eliminate old and avoid new complexity, the trend will not be
reversed. Members of the Ways and Means Committee must endorse
simplification as a bedrock principle, and that principle must
be communicated to all involved in the tax-writing process.
Time must be taken, and effort must be made, to ensure that
this goal remains paramount.
To that end, the Congress adopted as part of the IRS
restructuring bill a procedure to analyze the complexity of
proposals with widespread applicability to individuals or small
business. By means of this complexity analysis, the Joint
Committee on Taxation will call attention to provisions that
could result in substantial increases in complexity, and will
suggest ways in which the goals of those proposals can be
achieved in simpler ways. We strongly support this increased
focus on complexity and urge the members of this Committee to
pay heed to the JCT analyses. Only by raising awareness of
problems with proposals before they become law will Congress
make substantial inroads into the problem.
We would now like to address certain specific areas in
which the Tax Section considers the need for simplification
immediate.
A. Alternative Minimum Tax
As this Committee is well aware, there is an inherent
problem with the individual alternative minimum tax which, if
not fixed, will result in approximately 9 million additional
taxpayers becoming AMT taxpayers within the next decade. Many
have referred to this problem as a ticking time bomb. Arguably,
most of these taxpayers are not of the type envisioned as being
subject to the AMT when it was revised in 1986. Moreover, many
of these individuals will not even be aware they are subject to
the AMT until completing their returns or, worse, receiving
deficiency notices from the IRS.
The problem stems generally from the effects of inflation.
Married couples with alternative minimum taxable income under
$45,000 ($22,500 for individuals) are generally exempt from the
AMT. These thresholds were effective for tax years beginning
after December 31, 1992, but were not indexed for inflation. As
time passes, inflation (even minimal inflation, as compounded)
will erode these thresholds in terms of real dollars. As a
result, more and more taxpayers will be pulled into the AMT.
The problem is exacerbated by the fact that the AMT does not
permit individuals to claim state taxes as a deduction against
the AMT. As the income levels of these individuals increase
(with inflation or otherwise), and their state tax liabilities
rise correspondingly, they face the increased chance that they
will be pulled into the AMT merely because they claimed state
taxes as an itemized deduction for regular tax purposes.
This looming problem was compounded by the enactment of
various new credits, as incentives, in the 1997 tax act. The
provisions, such as the child tax credit under IRC Sec. 24 and
the Hope Scholarship and Lifetime Learning credits under IRC
Sec. 25A, do not apply for purposes of the AMT. Congress has
recognized this problem by enacting a one-year moratorium (for
1998) that allows application of these incentive credits for
both the regular tax and the AMT.
We urge this Committee in the strongest possible terms to
solve the problems with the AMT once and for all. There is
universal acknowledgement that the effects I have described are
unintended and unjustified. It is also acknowledged that the
revenue cost associated with a permanent solution will only
increase over time and may eventually become prohibitive. It
would be a travesty if a permanent solution to the AMT became
caught on the merry-go-round of expiring provisions. A
permanent solution should not be deferred merely because it
competes with other, more popular proposals for tax reduction.
B. Phaseout of Itemized Deductions and Personal Exemptions
At the urging of the Tax Section, the American Bar
Association at its February Mid-Year meeting adopted a
recommendation that the Congress repeal the phaseout for
itemized deductions (the so-called Pease provision) and the
phaseout for personal exemptions (the PEP provision). We
recommend that the revenue that would be lost by repeal be made
up with explicit rate increases. This would address any revenue
neutrality concern as well as any concern with respect to the
distributional effects of repeal.
It may be difficult for members of Congress to appreciate
the level of cynicism engendered by these two phaseouts.
Countless times, taxpayers who might not otherwise be troubled
by the amount of tax they are paying have reacted in anger when
confronted with the fact that they have lost--either wholly or
partially--their itemized deductions and personal exemptions.
They are no more comforted when told that these phaseouts
should really be viewed as substituting for an explicit rate
increase. Almost without exception, they react by asking why
Congress refuses to impose the additional rate rather than
trying to pull the wool over their eyes.
We have no answer to that question. We take pride in the
fact that a private sector organization such as the ABA is
willing to recommend a simplification proposal funded by a
marginal rate increase on the same taxpayers benefiting from
the simplification. We urge this Committee to give serious
consideration to the ABA's recommendation.
C. Streamlining of Penalty and Interest Provisions
The 1998 IRS Restructuring Act instructs both the Joint
Committee on Taxation and the Treasury Department to conduct
separate studies of the penalty and interest provisions of the
Code and to make recommendations for their reform.
The Tax Section believes that reform of the penalty and
interest provisions is appropriate at this time and look
forward to working with the JCT and Treasury. There are many
cases in which the application of penalty and interest
provisions take on greater significance to taxpayers than the
original tax liability itself. The Tax Section is concerned
that these provisions often catch individuals unaware, and that
the system lacks adequate flexibility to achieve equitable
results. In light of the significant changes being made by the
IRS, the completion of this study and eventual enactment of the
recommendations will be welcome.
The Tax Section has submitted preliminary comments to the
staff of the Joint Committee on Taxation that we hope will be
useful in developing alternatives. We expect to submit final
comments and recommendations to both the Joint Committee and
Treasury in the late spring.
D. International Simplification
We are also pleased that various members of the Ways and
Means Committee and of the Senate Finance Committee are
discussing significant simplifying changes in the international
tax area. In particular, we commend Messrs. Houghton and Levin
of this Committee for their leadership on this issue.
Provisions of the tax code relating to international
taxation are among the most complex in existence. While we
recognize that taxation of individuals and corporations earning
income in multiple countries necessarily involves numerous
complications, we firmly believe that significant simplifying
changes can be made to existing provisions without losing sight
of the various principles guiding those provisions. We urge
this Committee to devote significant effort to these
simplification proposals, and we look forward to working with
you on that effort.
PROVISIONS RELATING TO CORPORATE TAX SHELTERS
The Administration's budget includes no fewer than 16
provisions dealing in one way or another with the issue of
aggressive corporate tax shelters. The purpose of our statement
today is not to comment on the specifics of the
Administration's proposals. We understand that the Treasury
shortly will issue an amplification of its proposals. We are
fully prepared to provide detailed comments on the proposals
following issuance of the amplification. In the meantime, we
wish to offer our own comments on the corporate tax shelter
problem and suggest a course of action.
The sheer number of proposals included in the Budget
obviously reflects the Treasury Department's concern about the
corporate tax shelter phenomenon. While we believe the
Committee should carefully consider the number of proposals
included in the Budget, their possible overlap, and their
potential impact on normal business transactions, the Tax
Section strongly shares the Treasury's concerns with very
aggressive positions being taken by taxpayers and their
advisors in connection with certain transactions and the fact
that these transactions frequently are being mass marketed. We
also share the concern expressed by Chairman Archer regarding
practices that abuse the tax code by making unintended end runs
around it, and we compliment the Chairman for articulating his
concern publicly and, thus, bringing additional attention to
this problem.
A. The Problem
We have witnessed with growing alarm the aggressive use by
large corporate taxpayers* of tax ``products'' that have little
or no purpose other than reduction of Federal income taxes. We
are particularly concerned about this phenomenon because it
appears that the lynchpin of these transactions is the opinion
of the professional tax advisor. The opinion provides a level
of assurance to the purchaser of the tax plan that it will have
a good chance of achieving its intended purpose. Even if the
taxpayer ultimately loses, the existence of a favorable opinion
is generally thought to insulate the taxpayer from penalties
for attempting to understate its tax liability. While some
might dispute this as a legal conclusion, recent cases tend to
support the absence of risk for penalties where favorable tax
opinions have been given.
Because of our concern that opinions of tax professionals
are playing such a key role in the increased use of corporate
tax shelters, the Tax Section has established a task force to
consider amendments to the American Bar Association's rules for
standards of practice of our members. We undertook a similar
project in the early 1980's when so-called ``retail'' tax
shelters proliferated. That effort resulted in the promulgation
of ABA Formal Ethics Opinion 346 and in the adoption of a
similar standard in Treasury's Circular 230, which contains the
ethical standards that tax professionals must comply with under
threat of losing the right to practice before Treasury and IRS.
We expect that our task force will recommend changes in these
disciplinary rules to address the current tax shelter
phenomenon.
Likewise, we are concerned about the blatant, yet
secretive, marketing of these corporate tax shelters. As
discussed below, unless penalties that cannot be seen as mere
minor costs of doing business by the promoters are imposed upon
the promoters, and strongly and diligently enforced, no end is
or will be in sight.
The tax shelter products that concern us generally have the
following features. First, there is a discrepancy between the
book treatment of the transaction and its treatment for Federal
income tax purposes (stated simply, the creation of a
significant tax loss with no similar loss for financial
accounting purposes). Second, there is little economic risk to
the corporation from entering into the transaction other than
transaction costs. Third, one party to the transaction is
frequently what the Treasury refers to as ``tax indifferent''
(that is, a foreign taxpayer not subject to U.S. tax, a U.S.
organization exempt from Federal income tax, or a taxable U.S.
corporation that has large net operating loss carryovers).
Finally, and most telling, it is generally assumed by the
promoter, by counsel and apparently by the taxpayer itself
that, if the ``product'' comes to the attention of Treasury or
Congressional staffs, it will be blocked, but almost invariably
prospectively, by administrative action or by legislation.
The aggressive tax shelters that concern us do not overuse
tax benefits consciously granted by Congress (such as
accelerated depreciation or credits) nor are they tax-favored
methods of accomplishing a business acquisition or financing.
They are transactions that the parties themselves would
generally concede have little support in sound tax or economic
policy, but are, the parties assert, transactions not clearly
prohibited by existing law. Not surprisingly, explicit or
implicit confidentiality is also a common requisite of today's
tax shelter products.
The modern tax shelter transaction usually feeds off a
glitch or mistake in the tax law, often one that is accessed by
finding, or even creating, a purported business purpose for
entering into the transaction. Tax shelter products that
capitalize on mistakes in the Code are not as troublesome to us
as those that depend upon the existence of questionable facts
to support the success of the product. Mistakes in the Code
will eventually be discovered and corrected by the IRS,
Treasury or the tax-writing Committees of Congress. When
mistakes are discovered and corrected by legislation, it is the
prerogative of Congress to determine whether the situation
warrants retroactive application of the correction.
Far more troublesome is the practice of reducing taxes by
misusing sound provisions of the Code. Exploitation of rules
that generally work correctly by applying them in contexts for
which they were never intended, supported by questionable
factual conclusions, is the hallmark of the most aggressive tax
shelters today. Discovery on audit is the tax system's
principal defense, but, in a self-assessment system, the audit
tool cannot be expected to uncover every sophisticated tax
avoidance device. The law should provide clear incentives for
taxpayers to comply with the rules and, in all events, properly
to disclose the substance of complex transactions.
Thus, our concern is centered on the transaction that
depends upon a dubious factual setting for success. Foremost
among these is the conclusion or assertion that there is a
real, non-tax business purpose or motive for entering into the
transaction. There are others. In some cases, it will be
essential for the opinion-giver to conclude that the
transaction in question is not a step in a series of
transactions, which, if collapsed into a single transaction,
would not achieve the tax benefits sought. A third type of
factual underpinning often essential to the delivery of a
favorable tax opinion is the permanence, or intended long-term
economic viability, of a business arrangement among the parties
(for example, a joint venture, partnership or newly formed
corporation). A venture may be represented to be a long-term
business undertaking among the parties, when in fact it is a
complex, single-purpose, tax-motivated arrangement which was
formed shortly before and will be dissolved shortly after the
tax benefit is realized.
In most of these cases, the tax law is quite clear. Without
the presence of a sufficient business purpose, unless the
transaction is not a step in a series of related events, or
unless the new business venture represents a valid business
arrangement with a sufficient degree of longevity, the tax
benefit claimed is simply not available under existing law.
That bears repeating. Most if not all of the tax shelter
transactions that concern us depend upon avoidance of well-
established principles of law such as the business purpose
doctrine, the step-transaction rule, the substance-over-form
doctrine, or the clear reflection of income standard. Thus, the
role of the opinion giver often disintegrates into the job of
designing or blessing a factual setting to support
applicability of the Code provisions that will arguably produce
the desired benefit. The result is the application of a
provision of the Internal Revenue Code that otherwise has a
logical and sound policy purpose to reach a result that is
nonsensical, in some cases almost ludicrous.
A sad additional fact is that all parties to these
transactions know there is substantial likelihood that the
device employed, including the imaginative assertion of the
proper factual setting, will not be uncovered by IRS agents
even if the corporation is audited, as most large taxpayers
are. The tax law is too complex and the returns of major
taxpayers are too voluminous. Many tax shelter products involve
numerous parties, complex financial arrangements and invoke
very sophisticated provisions of the tax law. It often takes
time and painstaking analysis by well-informed auditors to
ascertain that what is reported as a legitimate business
transaction has little, if any, purpose other than the
avoidance of Federal income taxes. Accordingly, there is a very
reasonable prospect that a product will win the ``audit
lottery.'' This aspect of the problem is compounded by the fact
that present law gives no reward for full disclosure in the
case of corporate tax shelter transactions.
Let me emphasize that the transactions that concern us--and
the tax opinions that support them--are altogether different
than attempts to reduce taxes on a business transaction that
has a true business or economic objective independent of
reduction of Federal income taxes. But drawing distinctions
between tax-dominated transactions and true business
transactions that may involve major tax planning is sometimes
tricky, particularly in the legislative context. For that
reason, we recommend that the Congressional response to the tax
shelter problem be measured and appropriate. It should not
overreach; it should not risk inhibiting legitimate business
transactions. As we all know, taxpayers have the right to
arrange their financial affairs to pay the minimum amount of
tax required under the law. Our desire is that in doing so they
not avoid the intent of the law by benignly neglecting judicial
and administrative principles in which the tax law is quite
properly grounded.
B. Possible Solutions
We recommend that your emphasis be on compelling the full
disclosure of the nature and true economic impact of specified
classes of transactions. No taxpayer, or taxpayer's advisor,
has the right to ignore or obfuscate the essential facts
necessary to support the legal position relied upon to produce
the desired tax benefit. Thus, we recommend that provisions be
added to the Code that would give the parties a clear incentive
to focus on the essential facts relied upon to bring the
transaction within the applicable Code provisions. If that
factual underpinning, and its legal significance, is properly
understood by the taxpayer and its advisors, and is properly
disclosed on the tax return, then the system will work much
better. The facts to which I refer include objective facts that
bear on the subjective inquiry the law requires. The inquiry
would not need to state a conclusion as to the taxpayer's state
of mind, but the objective facts that indicate the taxpayer's
actual intent or purpose should be fully understood by the
parties and clearly disclosed on the tax return.
In order to focus the inquiry on the facts relied upon to
support these tax sensitive transactions, there should be a
realistic possibility that penalties will be levied where the
non-tax economic benefits from a transaction are slight when
compared to the potential tax benefits. We agree with the
Treasury Department that, in these types of transactions,
promoters who market the tax shelter and professionals who
render opinions supporting them should face penalties as well
as the taxpayer. The Treasury Department has, in addition,
suggested that tax-indifferent parties should face a potential
tax if the transaction is ultimately found wanting. Under
proper circumstances, that seems desirable. All essential
parties to a tax-driven transaction should have an incentive to
make certain that the transaction is within the law.
You may hear the argument that changes such as those we are
advocating will cause uncertainty and unreliability in the tax
law. As noted earlier, the Tax Section strongly supports as
much simplicity and clarity as possible throughout the Code.
However, total certainty is impossible where complex
transactions are involved. This is particularly true when the
parties seek to avoid judicial principles developed to deny tax
benefits to overly tax-motivated transactions. Taxpayers and
their advisors know that relative certainty can easily be
achieved in legitimate business transactions by steering a
safer course and staying in the middle of the road. The more
clearly the transaction stays within established judicial and
administrative principles, the more certainty is assured. When
they venture to the outer edge, certainty cannot be assured,
nor should it be; the parties who consciously risk going over
the edge should clearly understand there are severe
consequences for doing so.
In an important way, the protection of common law and
general anti-abuse principles contributes to certainty and
reliability in the tax law. Tax shelter transactions commonly
depend in large part on very literal interpretations of the
words of the Code or regulations. They utilize the clarity in
the way the tax law is written to undermine its purpose. In so
doing, these transactions discourage the writing of clear and
certain tax law in favor of more vaguely stated principles that
cannot be so easily skirted. One of the important results of
anti-abuse principles developed by the courts is the protection
of clearly-stated provisions of law on which taxpayers can rely
with certainty for every day business transactions.
As you can see, we think the best and most effective route
for this Committee to follow in dealing with the corporate tax
shelter problem is increased, meaningful disclosure, with
proper due diligence of, and accountability for, the factual
conclusions relied upon by the taxpayer. This will, perforce,
have to involve an expanded penalty structure as well. If this
is done properly, there may be no need for some of the more
complex and broader changes Treasury has proposed. Consistent
with our comments on simplicity earlier in this statement, we
would encourage the Committee to be mindful of the significant
complexity that could be imposed on thousands of taxpayers who
are not employing tax shelters if the solutions selected to
address this problem are overly broad.
Finally, this Committee and the Congress need to be certain
that the Internal Revenue Service's resources are adequate to
deal with the tax shelter issues. In part, promoters of tax
shelters are successful in marketing their products because
they and large taxpayers have concluded that the IRS is less to
be feared today. They are aware of the problems within the
agency, the Congressional criticism it has received, and its
dwindling resources. Our recommendations are directed primarily
at increased reporting and disclosure for ``large tax
shelters.'' We think such changes, together with expanded
penalties, will increase voluntary compliance. However, the
Internal Revenue Service must have the resources to analyze the
information reported and to pursue noncompliance vigorously, or
the increased reporting will be a paper tiger.
C. Specific Proposals
We would suggest the following changes in the Internal
Revenue Code to accomplish the goals outlined:
1. Additional reporting for ``tax shelters''
A question should be added to the corporate income tax
return requiring the taxpayer to state whether any item on the
return is attributable to an entity, plan, arrangement or
transaction that constitutes a ``large tax shelter'' (as
defined below). If the answer is yes, detailed information
should be required to be furnished with the return, including:
(a) A detailed description of the facts, assumptions of
facts, and factual conclusions relied upon in any opinion or
advice provided by an outside tax advisor with respect to the
treatment of the transaction on the return;
(b) A description of the due diligence performed by outside
advisors to ascertain the accuracy of such facts, assumptions
and factual conclusions;
(c) A statement signed by the corporate officer with
principal knowledge of the facts that such facts, assumptions
or factual conclusions are true and correct as of the date the
return is filed, to the best of such person's knowledge and
belief. If the actual facts varied materially from the facts,
assumptions or factual conclusions relied upon in the outside
advisor's advice or opinion, the statement would need to
describe such variances;
(d) Copies of any written material provided in connection
with the offer of the tax shelter to the taxpayer by a third
party;
(e) A full description of any express or implied agreement
or arrangement with any advisor, or with any offeror, that the
fee payable to such person would be contingent or subject to
possible reimbursement; and
(f) A full description of any express or implied warranty
from any person with respect to the anticipated tax results
from the tax shelter.
2. Broaden the substantial understatement penalty to cover
outside advisors, promoters and ``tax indifferent parties''
If the substantial understatement penalty of existing law
is imposed on the taxpayer, a similar penalty should be imposed
on any outside advisors and promoters who actively participated
in the sale, planning or implementation of the tax shelter. The
same type of penalty should also be imposed on ``tax
indifferent parties,'' unless any such party can establish that
it had no reason to believe the transaction was a tax shelter
with respect to the taxpayer.
3. Definition of ``large tax shelter'' for purposes of the
substantial understatement penalty
The definition of ``tax shelter'' presently contained in
section 6662(d)(2)(C)(iii) should be retained. The term ``large
tax shelter'' would be defined as any tax shelter involving
more than $10 million of tax benefits in which the potential
business or economic benefit is immaterial or insignificant in
relation to the tax benefit that might result to the taxpayer
from entering into the transaction. In addition, if any element
of a tax shelter that could be implemented separately would
itself be a `` large tax shelter'' if it were implemented as a
stand-alone event, the entire transaction would constitute a
``large tax shelter.''
4. Specific new penalties should be provided in the case of tax
shelters that fail to disclose the required information
(whether or not the tax shelter is ultimately sustained or
rejected by the courts)
In a self-assessment system, accurate reporting and
disclosure are essential. Where that does not occur, penalties
are necessary. This is particularly true in the case of large
and complex tax-motivated transactions. There should be a clear
disincentive to playing the audit lottery in these types of
transactions. This could be coupled with a reduction in the
rate of any otherwise applicable penalties for those
corporations that comply with the disclosure requirements set
forth in 1, above. This would provide an incentive (and not
just a disincentive) to make such disclosures.
5. Articulate a clear Congressional policy that existing
enforcement tools should be utilized to stop the proliferation
of large tax shelters
Congress should make clear its view that examination of
large tax shelter transactions by the Internal Revenue Service
should be considered a tax administration priority. This should
include the application of both civil and criminal penalties
when appropriate.
TAXATION OF INVESTMENT INCOME OF TRADE ASSOCIATIONS
One of the proposals included in the President's budget
raises serious concerns for the American Bar Association. We
have been asked by the ABA to convey to this Committee its
grave concerns about this proposal.
The proposal would tax all net investment income of trade
associations, business leagues, chambers of commerce and
professional sports leagues (under IRC Sec. 501(c)(6)) in
excess of $10,000 per year. The tax would be imposed at
generally applicable corporate rates. The tax would not be
imposed to the extent such net income was set aside to be used
for any charitable purpose described in IRC Sec. 170(c)(4).
The principal basis for the Administration's proposal is
the erroneous assumption that the endowments that have been
accumulated by some trade associations represent excessive dues
payments by the members of these organizations. Thus, the
Administration argues, the investment income earned on these
excessive dues payments should be subject to tax just as they
would have been if the dues had been set at the proper level,
and the ``excess'' invested individually by the members of the
association.
The ABA has serious reservations about this analysis. Even
if it is correct to assume that these endowments represent
excessive dues payments received in earlier years, the
investment income earned on the excess (whether earned by the
trade association or by its members) has the practical effect
of reducing dues that become payable in future years.
Therefore, the only significant consequence of permitting these
excess dues to be invested by a tax exempt entity without
taxation is to defer the government's receipt of the tax on
such income from the year of the initial dues payment to the
year in which the excess dues are applied to carry out the
trade association's exempt activities.
We understand the theoretical economic analysis that
underlies this proposal. We would submit, however, that this
theoretical analysis ignores the real world, practical
implications of the proposal. As a large trade association, the
ABA must point out that this proposal will discourage the
accumulation of endowments, severely hamper multi-year
planning, and limit the ability of these organizations to fund
socially desirable programs.
For example, these organizations (like any other) fund
large outlays over time, rather than in the year of the outlay.
Dues of trade associations and other section 501(c)(6)
organizations are set at levels necessary to fund such outlays
by allowing them to accumulate funds for capital expenditures,
etc. A tax on investment income would make planning for such
large expenditures very difficult, and highly impractical. The
organizations would be forced either to collect their dues on a
level basis and incur the tax (thus necessitating higher, fully
deductible dues to make up the difference) or to lower their
dues, not accumulate any savings, and then make special
assessments in the year of the large expenditure in order to
fund the project (with such special assessments also being tax
deductible). There is simply no good reason to put these
organizations to that choice.
There is also no valid policy reason for singling out trade
associations for this treatment, but excluding other mutual-
benefit organizations such as labor unions, agricultural and
horticultural organizations, and civic associations. All these
types of organizations, although exempt from income tax under
different provisions of the tax code, are essentially treated
the same for tax purposes. Given this identity of treatment, it
is not appropriate to single out organizations exempt from tax
under section 501(c)(6) for this new investment tax.
CONCLUSION
Mr. Chairman, thank you for the opportunity to appear
before the Committee today. I will be pleased to respond to any
questions.
Chairman Archer. Thank you, Mr. Tucker. I am constrained to
inquire whether any of those promoters might be lawyers?
Mr. Tucker. We think that there clearly may be some, but we
always remember Pogo, ``We have met the enemy, and sometimes
it's us.''
Chairman Archer. OK. Mr. Sinclaire. If you will identify
yourself for the record, you may proceed.
STATEMENT OF WILLIAM T. SINCLAIRE, SENIOR TAX COUNSEL AND
DIRECTOR OF TAX POLICY, U.S. CHAMBER OF COMMERCE
Mr. Sinclaire. Mr. Chairman, Members of the Committee, I am
Bill Sinclaire and I am with the U.S. Chamber of Commerce. The
U.S. Chamber of Commerce appreciates this opportunity to
express its views on the revenue-raising provisions in the
administration's fiscal year 2000 budget proposal and to make
tax relief recommendations. The U.S. Chamber is the world's
largest business federation, representing more than 3 million
businesses and organizations of every size, sector and region.
The breadth of this membership places the Chamber in a unique
position to speak for the business community.
On February 1, the administration released its budget
proposal for fiscal year 2000. The proposed budget would
increase taxes on businesses by approximately $80 billion over
5 years, and it would keep tax receipts, as a percentage of
Gross Domestic Product, at or above 20 percent. The Chamber
believes the administration's budget proposal is fraught with
revenue raisers that would impinge on or replace sound tax
policy with a short-sighted call for additional tax revenue.
The Federal budget surplus in fiscal year 2000 will be larger
than at any time since 1951, and a strong economy with
substantial payments from the business community have played a
significant role in this budgetary success. It would make
little sense to endorse $80 billion in tax increases when
considering the increase is aimed at those who have greatly
contributed to this foremost accomplishment.
In addition, many of the revenue raisers in the
administration's budget proposal lack a sound policy
foundation. The Chamber recommends that Congress reject
proposals that would increase taxes on the business community
and do nothing to create jobs, increase the competitiveness of
American businesses, or strengthen the U.S. economy. As we
prepare for the economic challenges of the next century, we
must orient our current tax policies in a way that minimizes
their negative impact on taxpayers, overall economic growth,
and the ability of American businesses to compete globally.
Instead of asking for the adoption of proposals that would
add to the Federal tax burden on the business community, the
administration should be leading the way in reducing the
encumbrance in a meaningful manner, especially when the Federal
Government is collecting more taxes than it needs.
Accordingly, the Chamber recommends that there be tax
relief of at least the following:
First, the individual and corporate alternative tax should
be completely repealed.
Second, although recently reduced for individuals, the
capital gains tax should be reduced even further, and relief is
still needed for corporations.
Next, Federal estate and gift tax relief should be
implemented by its immediate repeal or through its phase-out
over several years.
Furthermore, businesses should be able to expense the cost
of their equipment purchases more rapidly. In particular, the
small-business equipment expensing allowance should be
increased.
Moreover, the jobs of many U.S. workers are tied to the
exports and foreign investments of U.S. businesses, and job
growth is becoming increasingly dependent on expanded,
competitive, and strong foreign trade. The Federal Tax Code
restrains U.S. businesses from competing most effectively
abroad, which in turn reduces economic growth in the United
States. In this regard, there should be a permanent extension
to the act of financing income exception to Subpart F, and a
repeal of the limitation on the amount of receipts that defense
product exporters may treat as exempt foreign trade income. In
addition, the Chamber has supported the International Tax
Simplification for American Competitiveness Act of 1998,
including its substantively similar predecessors.
Also, the research and experimentation tax credit needs to
be further expanded and extended permanently so business can
better rely on and utilize the credit.
In addition, the existing Federal tax laws relating to S
corporations need to be updated, simplified, and reformed.
Finally, self-employed individuals can currently deduct
only 60 percent of their health insurance costs. The deduction
should be increased to 100 percent for 1999.
In conclusion, our country's 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
reduced. Our Federal Tax Code wrongly favors consumption over
savings and investment. As we continue to prepare for the
economic challenges of the next century, we must align our tax
policies in a way that encourages more savings, investment,
productivity growth, and economic growth.
Mr. Chairman, Members of the Committee, this concludes my
prepared remarks, and thank you for allowing the U.S. Chamber
to express its views.
[The prepared statement follows:]
Statement of William T. Sinclaire, Senior Tax Counsel and Director of
Tax Policy, U.S. Chamber of Commerce
The U.S. Chamber of Commerce appreciates this opportunity
to express its views on the revenue-raising provisions in the
Administration's Fiscal Year 2000 budget proposal, and to make
tax-relief recommendations. 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 Chamber in a
unique position to speak for the business community.
Revenue Raisers in Administration's Budget Proposal
On February 1, 1999, the Administration released its budget
proposal for Fiscal Year 2000. The proposed budget would
increase taxes on businesses by approximately $80 billion over
five years (according to the Joint Committee on Taxation).
Moreover, by the Administration's own admission, it would keep
tax receipts, as a percentage of gross domestic product, at or
above 20 percent for the foreseeable future.
The Chamber believes the Administration's budget proposal
is fraught with revenue raisers that would impinge on or
replace sound tax policy with a shortsighted call for
additional tax revenue. The federal budget surplus in FY 2000
will be larger than at any time since 1951, and a strong
economy with substantial tax payments from the business
community have played a significant role in this budgetary
success. It would make little sense to endorse $80 billion in
tax increases, when considering the increase is aimed directly
at those who have greatly contributed to this foremost
accomplishment.
In addition, many of the revenue raisers in the
Administration's budget proposal lack a sound policy
foundation. The Chamber recommends that Congress reject
proposals that would increase taxes on the business community
and do nothing to create jobs, increase the competitiveness of
American businesses, or strengthen the U.S. economy. As we
prepare for the economic challenges of the next century, we
must orient our current tax policies in a way that minimizes
their negative impact on taxpayers, overall growth, and the
ability of American businesses to compete globally.
The Administration's budget contains 16 separate proposals
that are explicitly directed at so-called ``corporate tax
shelters.'' These are in addition to many others that would
amend specific federal tax code provisions that the
Administration believes create unwarranted tax avoidance
opportunities. The corporate tax shelter proposals are
undefined in scope, overlap in coverage, violate principles of
income measurement and would place virtually unlimited power in
the hands of the Internal Revenue Service. If enacted, they
would introduce unacceptable uncertainty regarding the tax
consequences of even the most basic business transactions. This
is not a situation with which the business community should be
subjected.
Included in, and in addition to the 16 corporate tax
shelter provisions, the Administration's budget proposal
contains numerous provisions that would raise revenue. By way
of example, and not limitation, these objectionable provisions
include the following:
Replace Export Source-Rule With Activity-Based Rule--Under
current law, if inventory is purchased or manufactured in the
U.S. and sold abroad, 50 percent of the income is treated as
earned by production activities (U.S.-source income) and 50
percent by sales activities (foreign-source income). This law
is beneficial to U.S. manufacturing companies that export
overseas because it increases their ability to utilize foreign
tax credits and alleviate double taxation. The Administration
proposes that the allocation between production and sales
activities be based on actual economic activity. This proposal,
however, could increase U.S. taxes on export companies and,
therefore, encourage them to produce their goods overseas,
rather than in the United States.
Capitalize Acquisition Costs--Insurance companies would be
required to capitalize modified percentages of their net
premiums for certain insurance contracts in order to more
accurately reflect the ratio of actual policy acquisition
expenses to net premiums and the typical useful lives of the
contracts. This provision would increase the tax liabilities of
insurance companies, which in turn would be passed on to its
customers.
Require Monthly Deposits Of Unemployment Taxes--Beginning
in 2005, employers would be required to deposit their federal
and state unemployment taxes monthly, instead of quarterly, if
an employer's federal unemployment tax liability in the prior
year was $1,100 or more. This provision, which would not bring
in any additional revenue to the government, would impose an
undue administrative burden on businesses, especially smaller
businesses.
Tax Net Investment Income Of Trade Associations--Trade
associations, chambers of commerce, non-profit business leagues
and professional sports leagues that have annual net investment
income exceeding $10,000 would be subject to the unrelated
business income tax on their excess net investment income. This
provision, which does not apply to labor unions and other tax-
exempt entities, would groundlessly tax properly invested funds
that would later be used to further the tax-exempt purposes of
non-profit entities.
Increase The Proration Percentage--Property and casualty
insurance companies would have to increase the proration
percentage on their funding of loss reserves by income that
may, in whole or part, be exempt from tax. With the property
and casualty industry investing 21 percent of their financial
assets in, and holding about 14 percent of all tax-exempt debt,
there could be a reduction in demand for tax-exempt debt and a
rise in the interest rates of tax exempt obligations.
Repeal Lower-Of-Cost-Or-Market Inventory Accounting
Method--Taxpayers would no longer be able to value their
inventories by applying the lower-of-cost-or-market accounting
method or by writing down the cost of goods that are unsalable
at normal prices or unusable in their usual way because of
damage, imperfection or other similar causes. This provision
would increase taxes on those businesses that use the ``first-
in-first-out'' method or cause them to switch to the ``last-in-
last-out'' method for both tax and financial statement
purposes.
Repeal The Installment Method For Accrual Basis Taxpayers--
The installment method of accounting (which allows a taxpayer
to defer recognition of income on the sale of certain property
until payments are received) would no longer be available for
accrual basis taxpayers. This provision would cause taxpayers
to either pay tax on gains which have not yet been received or
convert to the cash basis.
Modify The Corporate-Owned Life Insurance Rules--The
Administration would repeal the exception under the corporate-
owned life insurance rules proration rules for contracts
insuring employees, officers or directors (other than 20
percent owners) of a business. 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 their key employees.
Deny Tax Benefits Resulting From Non-Economic
Transactions--Proposals would increase the substantial
understatement penalty for corporate taxpayers from 20 percent
to 40 percent for items attributable to a corporate tax
shelter, deny certain tax benefits obtained in a corporate tax
shelter, deny deductions for certain tax advice, impose an
excise tax on fees received in connection to corporate tax
shelters, and impose an excise tax on certain tax benefit
protection arrangements. These proposals unfairly target
legitimate tax saving devices and related expenses and should
be dismissed.
Deny Deductions For Punitive Damages--No deduction would be
allowed for punitive damages paid or incurred by a taxpayer,
whether upon judgment or in settlement of a claim. In addition,
where the punitive damages are paid by an insurance company,
the taxpayer would be required to include in gross income the
amount of damages paid on its behalf. This provision would deny
businesses the ability to deduct legitimate business expenses
relating to legal claims.
Repeal Tax-Free Conversions Of Large C-Corporations To S-
Corporations--Under current law, the conversion of a C-
corporation to an S-corporation is generally tax-free. The
``built-in'' gains of a corporation's assets are not taxed if
the assets are not sold within 10 years of conversion. The
Administration proposes to treat the conversion of a ``large''
C-corporation (those with a value exceeding $5 million) into an
S-corporation as a taxable event to both the corporation (with
respected to its appreciated assets) and its shareholders (with
respect to their stock). This provision would prevent many C-
corporations that want to avoid double taxation from electing
to be S-corporations.
Eliminate Non-Business Valuation Discounts--Valuation
discounts on the minority interests of family limited
partnerships or limited liability companies would no longer be
allowed for estate and gift tax purposes unless such entities
are active businesses. This provision would make it more
difficult for business owners to develop estate plans that
would keep their businesses intact, and their employees
working, after their deaths.
Require The Recapture Of Policyholder Surplus Accounts--The
Administration would require stock life insurance companies
with policyholder surplus accounts to include in the income the
amount in the account. This proposal is contrary to the intent
of Congress in enacting current law.
Modify Rules For Debt-Financed Portfolio Stock--This
proposal by the Administration would effectively reduce the
dividends-received deduction (the ``DRD'') for any corporation
carrying debt (virtually all corporations) and would
specifically target financial service companies, which tend to
be more debt-financed. The purpose of the DRD is to eliminate,
or at least alleviate, the impact of potential multiple layers
of corporate taxation. However, this proposal would exacerbate
the multiple taxation of corporate income, penalize investment,
and mark a retreat from efforts to develop a more fair,
rational, and simple tax system.
Deny The DRD For Certain Preferred Stock--This is another
proposal that would deny the DRD for certain types of preferred
stock which the Administration believes are more like debt than
equity. Although concerned that dividend payment from such
preferred stock more closely resemble interest payment than
debt, the proposal does not include a provision to allow
issuers to take interest expense deductions on such payments.
Accordingly, the instruments would be denied both equity and
debt tax benefits.
Reinstate Superfund Excise Taxes And The Environmental Tax
On Corporate Income--Excise taxes which were levied on various
petroleum products, chemicals and imported substances and
dedicated to the Superfund Trust Fund would be reinstated
through September 30, 2009. The corporate environmental income
tax (which was also dedicated to the Superfund Trust Fund)
would be reinstated through December 31, 2009. These taxes
expired on December 31, 1995. These Superfund taxes should be
thoroughly examined, evaluated and made part of a comprehensive
plan to reform the Superfund program before they are
reinstated.
Defer Interest Deduction And Original Issue Discount On
Certain Convertible Debt--The Administration has proposed to
defer deductions for interest accrued on convertible debt
instruments with original issue discount (``OID'') until the
interest is paid in cash. However, these hybrid instruments and
convertible OID bond instruments have allowed many U.S.
companies to raise billions of dollars of investment capital.
This proposal is contrary to sound tax policy that matches the
accrual of interest income by holders of OID instruments with
the ability of issuers to deduct accrued interest. Re-
characterizing these instruments as equity for tax purposes is
fundamentally incorrect and would put American companies at a
distinct disadvantage to their foreign competitors, which are
not bound by such restrictions.
Increase Taxes On Tobacco Sales--The Administration plans
to propose tobacco legislation that would raise revenues of
$34.5 billion over the next five years. Regardless of the
Administration's altruistic motives to reduce teenage smoking,
levying such a huge tax increase on a single industry would set
a dangerous precedent for future tax increases on other
industries.
Convert Airport And Airway Excise Taxes To Cost-Based User
Fees--Excise taxes which are currently levied on domestic and
international air passenger transportation and domestic air
freight transportation and deposited in the Airport and Airway
Trust Fund would be reduced as new cost-based user fees for air
traffic services are phased in beginning in 2000. The excise
taxes would be reduced as necessary to ensure that the amount
collected each year from the user fees and excise taxes is, in
the aggregate, equal to the total budget resources requested
for the Federal Aviation Administration in the succeeding year.
A $5.3 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.
Business Tax Relief is Needed
Instead of asking for the adoption of proposals that would
add to the federal tax burden on the business community, the
Administration should be leading the way in reducing the
encumbrance in a meaningful manner especially when the federal
government is collecting more taxes than it needs. Accordingly,
the Chamber recommends that there be tax relief in at least the
following areas:
Alternative Minimum Tax--Both the individual and corporate
alternative minimum tax (``AMT'') negatively affect American
businesses, particularly those that invest heavily in capital
assets. The Taxpayer Relief Act of 1997 (the ``1997 Act'')
exempts ``small business corporations'' from the corporate AMT,
however, unincorporated businesses are still subject to the
individual AMT, and larger corporations remain subject to the
corporate AMT.
While the Chamber supports the full repeal of both the
individual and corporate AMT, to the extent complete repeal is
not feasible, significant reforms should be enacted. Such
reforms include providing a ``small business'' exemption for
individual taxpayers; eliminating the depreciation adjustment;
increasing the individual AMT exemption amounts; allowing
taxpayers to offset their current year AMT liabilities with
accumulated minimum tax credits; and making the AMT system less
complicated and easier to comply with.
Capital Gains Tax--Lower capital gains tax rates for both
individuals and corporations would help maintain our growing
economy by promoting capital investment and mobility. Although
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 should be reduced
even further. In addition, capital gains tax relief is still
needed for corporations, whose capital gains continue to be
taxed at regular corporate income tax rates (to a maximum of 35
percent).
Estate and Gift Tax--The federal estate and gift tax is an
inefficient, distortive tax that discourages saving, investment
and job growth, unfairly penalizes small businesses, and
accounts for little more than one percent of total federal
revenues. It can deplete the estates of those who have saved
their entire lives and force successful small businesses to
liquidate or lay off workers. With a maximum rate of 55
percent, the tax is confiscatory, and its compliance, planning
and collection costs are extremely high in relationship to the
tax collected (according to the Joint Economic Committee).
The Chamber supports legislation introduced by
Representative Cox (R-CA) and Senator Kyl (R-AZ), the Family
Heritage Preservation Act (H.R. 86; S. 56), which would
immediately repeal the estate and gift tax, as well as
legislation introduced by Representatives Dunn (R-WA) and
Tanner (D-TN) and Senator Campbell (R-CO), the Estate and Gift
Tax Rate Reduction Act of 1999 (H.R. 8; S. 38), which would
phase-out the tax over 11 years by annually reducing each rate
of tax by five percentage points.
Equipment Expensing--In order to spur additional investment
in income-producing assets, businesses should be able to fully
expense the cost of their equipment purchases in the year of
purchase. In particular, the small business equipment expensing
allowance--which is $19,000 for 1999 and scheduled to increase
to $25,000 by 2003--should be increased or immediately
accelerated to the $25,000 amount.
Foreign Tax Rules--The jobs of many U.S. workers are tied
to the exports and foreign investments of U.S. businesses and
job growth is becoming increasingly dependent on expanded,
competitive, and strong foreign trade. The current federal tax
code restrains U.S. businesses from competing most effectively
abroad--which in turn reduces economic growth in the U.S. While
the 1997 Act contained 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 economy.
The Chamber supported the International Tax Simplification
for American Competitiveness Act of 1998 (H.R. 4173; S 2231),
introduced by Representatives Houghton and Levin, and Senators
Hatch and Baucus in the 105th Congress, and its substantively
similar predecessors in the 105th and prior Congresses. The
Chamber also supports legislation (H.R. 681), introduced by
Representatives McCrery (R-LA) and Neal (D-MA), which would
permanently extend the active financing income exception to
Subpart F, and the Defense Jobs and Trade Promotion Act of 1999
(H.R. 796), introduced by Representative S. Johnson (R-TX),
which would repeal the limitation on the amount of receipts
that defense product exporters may treat as exempt foreign
trade income.
Independent Contractor/Worker Classification--The
reclassification by the Internal Revenue Service of workers
from independent contractors to employees can be devastating to
business owners, as it can subject them to large amounts of
back federal and state taxes, penalties and interest. Existing
classification rules must be simplified and clarified so
disputes with the IRS are minimized. The Chamber has supported
legislation that would provide more objective ``safe harbors''
for determining the status of a worker.
Research and Experimentation Tax Credit--The research and
experimentation (``R&E'') tax credit encourages companies to
invest additional resources into the research, development and
experimentation of products and services that benefit society
as a whole. While the 1998 Omnibus Budget Bill extended this
credit through June 30, 1999, it needs to be extended
permanently, and further expanded, so businesses can better
rely on and utilize the credit. The Chamber supports
legislation (H.R. 835) introduced by Representatives Johnson
(R-CT) and Matsui (D-CA) which expands and permanently extends
the R&E tax credit.
S-Corporation Reform--The existing federal tax laws
relating to S-corporations need to be updated, simplified and
reformed so small businesses can access more funds and better
compete in today's economy. While various relief provisions
were enacted in 1996, other reforms still need to be
implemented, including the allowance of ``plain vanilla''
stock, elimination of ``excess passive investment income'' as a
termination event, and modification of how certain fringe
benefits are taxed to S corporation shareholders. The Chamber
supports legislation introduced by Representative Shaw (R-FL),
the Subchapter S Revision Act of 1999 (H.R. 689), which
contains these and other measures.
Self-Employed Health Insurance Deduction--Self-employed
individuals can only deduct a portion of their health insurance
costs each year (60 percent in 1999, 2000, 2001, 70 percent in
2002, and 100 percent in 2003 and thereafter). The Chamber
believes that the self-employed should be able to fully deduct
their health insurance expenses in the year incurred.
Conclusion
Our country's 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 reduced. Our federal tax
code wrongly favors consumption over savings and investment. As
we continue to prepare for the economic challenges of the next
century, we must orient our tax policies in a way that
encourages more savings, investment, productivity growth, and
economic growth.
The revenue-raising provisions contained in the
Administration's Fiscal Year 2000 budget proposal would further
increase taxes on businesses and reduce savings and investment.
The U.S. Chamber urges that these provisions be rejected, and
not included in any legislation.
Chairman Archer. Thank you, Mr. Sinclaire.
Mr. Lifson, if you will identify yourself for the record,
you may proceed.
STATEMENT OF DAVID A. LIFSON, CHAIR, TAX EXECUTIVE COMMITTEE,
AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS
Mr. Lifson. My name is David Lifson. Thank you, Mr.
Chairman. I am the chair of the Tax Executive Committee of the
American Institute of CPAs. We are pleased to present our
comments on selected revenue proposals in the President's
fiscal year 2000 budget.
Our members work daily with the tax provisions that you
enact, and we are committed to helping make our tax system as
simple and as fair as possible. The tax law is exceedingly
difficult, and we help our clients cope with its complexity.
Our involvement with taxpayers assists both the government
and our clients by assuring that taxpayers pay their fair share
of taxes but no more. Where the tax law is complex, we want to
work with you to craft legislation that accomplishes your
policy objectives with the least possible confusion and
uncertainty for taxpayers.
We have several major concerns about the administration's
proposal. In recent years, tax legislation has increasingly
included complex thresholds, ceiling, phase-ins, phase-outs,
effective dates, and sunset dates in your efforts to provide
benefits within the limits of revenue neutrality. The
administration's budget tax proposals would increase complexity
through the numerous proposed targeted credits.
While we have no doubt that these credits are well-
intentioned, cumulatively, they would further weigh down our
tax system. Many average taxpayers do not understand the
benefit to which they are entitled, and while it is still
early, we believe that many taxpayers will miss some of the
benefits that you intended to deliver to them on their 1998 tax
return.
Other taxpayers are disappointed to learn that they do not
qualify for benefits that they have heard about because complex
fine-print phase-outs disqualify them. Taxpayers cannot be
expected to plan, and they have trouble even complying with
this level of complexity.
We have provided you with a detailed recommendation for
standard phase-ins and phase-outs. It would greatly simplify
the tax law, particularly as it applies to middle-income
families. This involves simplifying over 65 different
provisions in the Tax Code in three concise areas.
Another area that needs no complexity introduction, is the
alternative minimum tax. We are concerned that while it is a
good idea to enact the proposed credit, the proposed additional
adjustment in the budget for the next 2 years, to keep the
alternative minimum tax from encroaching on people for whom it
was not intended.
We ultimately encourage you to repeal the AMT. If you
cannot find a way to repeal it, you need to greatly simplify
it. I won't repeat the many wise comments that were made
earlier that many of the elements that were left over in the
AMT no longer serve their purpose.
Another area that we are extremely concerned about is
section 127, Education Exclusion. We think there needs to be
certainty in education benefits, and we don't understand why
that shouldn't be made a permanent change so students could
plan 4-year careers with reasonable certainty about the tax
law.
We also applaud--we have some things we can applaud about
the administration's proposals, especially the portability of
retirement savings and pension plans. This is an area where we
think it is important that citizens be given more
responsibility for their own retirement savings, and is very
consistent with the realities on the concerns of today's very
mobile work force.
The administration has proposed measures to curtail what
are described as tax avoidance transactions. We oppose abuses
of our tax system by improper activities, and believe that
their restriction makes the tax system fairer for all. However,
Congress should carefully examine the Treasury's proposals.
Since we believe that part of abuse curtailment, the
administration is recommending policies that are not properly
focused and would not address the issues.
Further, we know that you have instructed the IRS and
Treasury and Joint Tax Committee to come up with a
rationalization of the penalty and interest system. We think
that is the place for penalty reform to be debated. We think
that if penalties are not clearly understood by the
participants, then they will not act as a deterrent for
behavior that is objectionable to this Congress.
We also oppose the administration's proposed tax on
investment income of trade associations. The recommendation is
not consistent with the general thrust of the tax law, and it
would bring additional taxes and further layers of complexity
to many small and medium-size business organizations.
We thank you for the time to comment on some specific
proposals. We have a lengthy submission with some solutions as
well as raising problems.
Thank you for your time, and we stand at the ready.
[The prepared statement follows:]
Statement of David A. Lifson, Chair, Tax Executive Committee, American
Institute of Certified Public Accountants
Mr. Chairman, and members of this distinguished committee:
My name is David A. Lifson, and I am the chair of the Tax
Executive Committee of the American Institute of Certified
Public Accountants (AICPA). I am pleased to present to you,
today, our comments on selected revenue proposals in the
President's fiscal year 2000 budget. The AICPA is the
professional association of certified public accountants, with
more than 330,000 members, many of whom provide comprehensive
tax services to all types of taxpayers, including businesses
and individuals, in various financial situations. Our members
work daily with the tax provisions you enact, and we are
committed to helping make our tax system as simple and fair as
possible.
The tax law is exceedingly difficult, and we help our
clients cope with this complexity. Our involvement with
taxpayers assists both client and government by assuring that
taxpayers pay their fair share of taxes and no more. Where the
tax law is complex, we want to work with you to craft
legislation that accomplishes your objectives with the least
possible confusion and uncertainty for taxpayers.
We have several major concerns about the Administration's
proposals. In recent years, tax legislation has increasingly
included complex thresholds, ceilings, phase-ins, phase-outs,
effective dates, and sunset dates in an effort to provide
benefits as broadly as possible within the limits of revenue
neutrality. The Administration's budget tax proposals, as
drafted, continue this trend through the numerous proposed
targeted credits. While these credits are well-intentioned,
cumulatively they would further weigh down our tax system with
complexity. Many average taxpayers do not understand the
benefits to which they are entitled, and while it is still
early, we believe that taxpayers will miss some of the benefits
that you intended for them to take on their 1998 returns all
too frequently. Other taxpayers are disappointed to learn that
they do not qualify for benefits that they have heard about
because of complex, fine-print phase-outs. Taxpayers cannot
plan and they have trouble even complying with this complexity.
Our statement below contains a recommendation for standard
phase-ins and phase-outs that will greatly simplify the tax
law, particularly as it applies to middle income families.
Depending on the income levels of phase-ins and phase-outs,
this proposal should not be unduly expensive, and would be a
substantial improvement to our tax system. In the area of tax
simplification, we also encourage you to consider alternatives
to targeted tax credits and cuts, including an increased
standard deduction, increased personal exemption amount,
reduction of the income level at which current rates apply, and
relief from the marriage penalty.
The Administration's proposal extends, for two years,
refundable credits against the individual alternative minimum
tax to offset the application of AMT to middle-income taxpayers
as a result of credits enacted in the Taxpayer Relief Act of
1997. At that time, we brought these problems to your
attention, and while we support the temporary relief the
Administration proposes, we strongly encourage you to repeal
the AMT or at least greatly simplify it. The AMT is a burden on
our tax system, and this burden is increasingly being placed on
middle-income taxpayers. We have included detailed
recommendations for AMT simplification in our statement in the
event you reject the cause for outright repeal.
The Section 127 exclusion for employer-provided educational
assistance needs to have greater stability in our tax law.
While the temporary extension proposed in the budget is
helpful, it does not provide the dependably consistent
incentive that will encourage students to undertake the
substantial personal and financial commitment necessary to
prepare them for the future. Section 127 education benefits
should be made permanent, not just extended.
We applaud the Administration's proposals to improve the
portability of retirement savings and pension plans. This helps
citizens take greater responsibility for their retirement
savings and is consistent with today's mobile workforce.
The Administration has proposed measures to curtail what
are described as ``tax avoidance transactions.'' We oppose
abuses of our tax system by improper activities, and believe
that their restriction makes the tax system fairer for all.
However, Congress should carefully examine Treasury's
proposals, since we believe, as part of abuse curtailment, the
Administration is recommending standards that are not properly
focussed or defined to address the issues. Many have already
observed that the proposed standards are overly broad and
vague. Further, new or enhanced penalties to encourage
compliance in this area should be considered as part of the
penalty study presently being undertaken by the Joint Tax
Committee staff and the Treasury Department, not just as add-
ons to an already patchwork tax penalty structure. We would be
happy to work with Congress and the Treasury in distinguishing
between legitimate tax planning and improper tax activities.
We oppose the Administration's proposal to tax investment
income of trade associations. This recommendation is not
consistent with the general thrust of the tax law in making
these organizations exempt and is not consistent with sound
business practices of trade associations. The proposal would
bring additional taxes and complexity to many small and medium-
sized organizations.
The AICPA has not fully completed its review of the
Administration's budget tax proposals. We have commented on
some specific proposals below and hope to provide additional
comments as soon as our committees complete their work. We
appreciate this opportunity to provide comments and would be
happy to answer any questions. Please contact David Lifson,
Chair of the Tax Executive Committee, or Gerald Padwe, Vice-
President-Taxation of the AICPA, if we can be of assistance.
Thank you for considering our comments.
I. INDIVIDUAL INCOME TAX PROPOSALS GENERALLY
The Administration's revenue proposals contain numerous
provisions affecting individuals, such as: a new long-term care
credit, a new disabled workers tax credit, the child and
dependent care tax credit expansion, the employer-provided
educational assistance exclusion extension, a new energy
efficient new homes credit, the electric vehicles credit
extension, AMT relief extension, a new D.C. homebuyers credit,
optional self-employment contributions computations, a new
severance pay exemption, a new rental income inclusion, etc.
While we are not commenting on the policy need for these
provisions, we note that Congress must consider the general
administrability of these provisions.
We are very concerned about the increasing complexity of
the tax law as a result of targeted individual tax cuts. The
1997 Taxpayer Relief Act contained several targeted individual
tax cuts that were first effective for 1998 individual income
tax returns. As discussed in the Wall Street Journal of
February 17, 1999, these provisions, while providing tax relief
to certain individuals, have greatly increased the complexity
of the preparation of individual income tax returns. This
increased compliance burden is born mostly by lower income
taxpayers who can least afford the cost of hiring a
professional income tax return preparer.
IRS National Taxpayer Advocate W. Val Oveson, in his first
report to Congress, stated that increasing tax law complexity
is imposing significant compliance and administrative burdens
on the IRS and taxpayers. The report also cited the increasing
complexity caused by the targeted individual tax cuts contained
in the 1997 Taxpayer Relief Act.
The Administration's tax proposals contain 28 new targeted
tax cuts. Many of these provisions have limited applicability;
none are available to high-income taxpayers. Unfortunately, the
way these provisions are drafted with different income limits
for each provision, taxpayers need to make many additional tax
calculations just to determine if they are eligible for the tax
benefit. The Administration's tax proposals will add several
additional income limits to the Internal Revenue Code.
Below are a few examples of provisions in the
Administration's tax proposals that have different phase-out
limits:
The long-term care credit and disabled workers tax
credit would be phased out ``by $50 for each $1,000 (or
fraction thereof) by which the taxpayer's modified AGI
exceeds'' $110,000 (married filing a joint return taxpayers),
$75,000 (single/head of household), or $55,000 married filing
separate.
The first-time D.C. homebuyers credit phases out
for individuals with AGI between $70,000 and $90,000 ($110,000
to $130,000 for joint filers).
The severance pay exemption would not apply if the
total severance payments received exceed $75,000.
The expanded child and dependent care credit
proposal would allow taxpayers the 50 percent credit rate if
their AGI is $300,000 or less, then the credit rate would be
reduced by one percentage point for each additional $1,000 of
AGI in excess of $300,000, and taxpayers with AGI over $59,000
would be eligible for a 20 percent credit rate.
The student loan interest deduction (to which the
President's proposal would eliminate the current 60-month
limit) phases out ratably for single taxpayers with AGI between
$40,000 and $55,000 and between $60,000 and $75,000 for married
filing a joint return taxpayers.
This type of law, with so many different phase-out limits,
provides incredible challenges for middle-income taxpayers, in
determining how much of what benefit they are entitled to. We
suggest common phase-out limits among all individual tax
provisions in order to target benefits to one of three uniform
groups and simplify the law. Our phase-out simplification
proposal is attached.
Another problem with these targeted tax cuts is that the
impact of the alternative minimum tax (AMT) on these cuts is
not adequately addressed. This is evidenced by the provision in
the 1998 IRS Restructuring and Return Act and the provision in
the Administration's tax proposals that provide temporary
relief from the AMT for individuals qualifying for some of the
targeted tax credits. We believe that the individual
alternative minimum tax needs to be simplified; our proposal is
attached.
Finally, much of the complexity in the individual income
tax system is the result of recent efforts to provide
meaningful tax relief to medium and low-income taxpayers. In
order to aid simplification, we believe that Congress should
consider alternatives to targeted tax cuts, including the new
ones proposed by the Administration, with provisions such as
the following:
Increased standard deduction.
Increased amount for personal exemptions.
Increasing the taxable income level where the 28
percent tax and the 31 percent tax rate begins.
Marriage penalty relief.
The AICPA would like to further study the complexity caused
by the proliferation of credits with their complex provisions,
and hopes to provide further specific comments as this
legislation progresses.
Phase-Outs Based on Income Level
Present Law.--Numerous sections in the tax law provide for
the phase-out of benefits from certain deductions or credits
over various ranges of income based on various measures of the
taxpayer's income. There is currently no consistency among
these phase-outs in either the measure of income, the range of
income over which the phase-outs apply, or the method of
applying the phase-outs. Furthermore, the ranges for a
particular phase-out often differ depending on filing status,
but even these differences are not consistent. For example, the
traditional IRA deduction phases out over a different range of
income for single filers than it does for married-joint filers;
whereas the $25,000 allowance for passive losses from rental
activities for active participants phases out over the same
range of income for both single and married-joint filers.
Consequently, these phase-outs cause inordinate complexity,
particularly for taxpayers attempting to prepare their tax
returns by hand; and the instructions for applying the phase-
outs are of relatively little help. See the attached Exhibit
for a listing of most current phase-outs, including their
respective income measurements, phase-out ranges (for 1998) and
phase-out methods.
Note that currently many the phase-out ranges for married-
filing-separate (MFS) taxpayers are 50 percent of the range for
married-filing-joint (MFJ), while many of the phase-out ranges
for single and head of household (HOH) taxpayers are 75 percent
of married-joint. That causes a marriage penalty when the
spouses' incomes are relatively equal.
Recommended Change.--True simplification could easily be
accomplished by eliminating phase-outs altogether. However, if
that is considered either unfair (simplicity is often at odds
with equity) or bad tax policy, significant simplification can
be achieved by creating consistency in the measure of income,
the range of phase-out (including as between filing statuses)
and the method of phase-out.
Instead of the approximately 20 different phase-out ranges
(shown in attached Exhibit A), there should only be three--at
levels representing low, middle, and high income taxpayers.
If there are revenue concerns, the ranges and percentages
could be adjusted, as long as the phase-outs for each income
level group (i.e., low, middle, high income) stayed consistent
across all relevant provisions. In addition, marriage penalty
impact should be considered in adjusting phase-out ranges for
revenue needs.
We propose that, in an effort to eliminate the marriage
penalty and simplify the Code, all phase-out ranges for
married-filing-separate (MFS) taxpayers should be the same as
those for single and head of household (HOH) taxpayers, which
would be 50 percent of the range for married-filing-joint (MFJ)
range.
The benefits that are specifically targeted to low-income
taxpayers, such as the earned income credit, elderly credit,
and dependent care credit, would phase-out under the low-income
taxpayer phase-out range. The benefits that are targeted to low
and middle income taxpayers, such as the traditional IRA
deduction and education loan interest expense deduction, would
phase-out under the middle-income taxpayer phase-out range.
Likewise, those benefits that are targeted not to exceed high
income levels, such as the new child credit, the new education
credits and Education IRA, and the new Roth IRA, as well as the
existing law AMT exemption, itemized deductions, personal
exemptions, adoption credit and exclusion, series EE bond
exclusion, and section 469 $25,000 rental exclusion and credit,
would phase-out under the high-income taxpayer phase-out range.
See the chart below.
Proposed Adjusted Gross Income Level Range for Beginning to End of Phase-Out for Each Filing Status
----------------------------------------------------------------------------------------------------------------
Category of Taxpayer Married Filing Joint Single & HOH & MFS
----------------------------------------------------------------------------------------------------------------
LOW-INCOME.............................................. $ 15,000-$ 37,500 $ 7,500-$ 18,750
MIDDLE-INCOME........................................... $ 60,000-$ 75,000 $ 30,000-$ 37,500
HIGH-INCOME............................................. $225,000-$450,000 $ 112,500-$225,000
----------------------------------------------------------------------------------------------------------------
EXHIBIT A--Selected AGI Phase-Out Amounts
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Proposed--Single &
IRC Section Provision Ft nt. Current-Joint Current--Single & HOH Current--Married/Sep. Proposed-Joint HOH & MFS
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
PHASE-OUT LEVELS FOR LOW-INCOME TAXPAYERS
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
21............................... 30 Percent Dependent (3)................. $10,000-$20,000 $10,000-$20,000 No credit............ $15,000-$37,500 $7,500-$18,750
Care Credit.
22............................... Elderly Credit...... (4)................. $10,000-$25,000 $7,500-$17,500 $5,000-$12,500....... $15,000-$37,500 $7,500-$18,750
32............................... EITC (No Child)..... (2,3,4)............. $5,570-$10,030 $10,030 No credit............ $15,000-$37,500 $7,500-$18,750
32............................... EITC (1 Child)...... (2,3,4)............. $12,260-$26,473 $12,260-$26,473 No credit............ $15,000-$37,500 $7,500-$18,750
32............................... EITC (2 or More (2,3,4)............. $12,260-$30,095 $12,260-$30,095 No credit............ $15,000-$37,500 $7,500-$18,750
Children).
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
PHASE-OUT LEVELS FOR MIDDLE-INCOME TAXPAYERS
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
219.............................. IRA Deduction w/ (1,7,9)............. $50,000-$60,000 $30,000-$40,000 No deduction......... $60,000-$75,000 $30,000-$37,500
retirement plan.
221.............................. Education Loan (1,2,6)............. $60,000-$75,000 $40,000-$55,000 No deduction......... $60,000-$75,000 $30,000-$37,500
Interest Exp..
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
PHASE-OUT LEVELS FOR HIGH-INCOME TAXPAYERS
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
24............................... Child Credit........ (1,5,6)............. $110,000- $75,000- $55,000-............. $225,000-$450,000 $112,500-$225,000
25A.............................. Hope Credit & (1,2,6)............. $80,000-$100,000 $40,000-$50,000 No credit............ $225,000-$450,000 $112,500-$225,000
Lifetm. Lrng. Cr..
23 & 137......................... Adoption Credit/ (1,7)............... $75,000-$115,000 $75,000-$115,000 No benefit........... $225,000-$450,000 $112,500-$225,000
Exclusion.
55(d)............................ AMT Exemption....... (1,8)............... $150,000-$330,000 $112,500-$247,500 $75,000-$165,000..... $225,000-$450,000 $112,500-$225,000
68............................... Itemized Deduction (2)................. $124,500- $124,500- $62,250-............. $225,000-$450,000 $112,500-$225,000
level.
135.............................. EE Bond int. (1,2,7)............. $78,350-$108,350 $52,250-$67,250 No exclusion......... $225,000-$450,000 $112,500-$225,000
Exclusion.
151.............................. Personal Exemption.. (2)................. $186,800-$309,300 $124,500-$247,000 $93,400-$154,650..... $225,000-$450,000 $112,500-$225,000
HOH$155,650-$278,150
219(g)(7)........................ IRAw/spouse w/ (1,6,7)............. $150,000-$160,000 Not applicable No deduction......... $225,000-$450,000 $112,500-$225,000
retrmt.plan.
408A............................. Roth IRA Deduction.. (1,6)............... $150,000-$160,000 $95,000-$110,000 No deduction......... $225,000-$450,000 $112,500-$225,000
408A............................. IRA to Roth IRA (1,6,7)............. $100,000 $100,000 No rollover.......... $225,000-$450,000 $112,500-$225,000
Rollover.
469(i)........................... $25,000 Rent Passive (1,7)............... $100,000-$150,000 $100,000-$150,000 $50,000-$75,000...... $225,000-$450,000 $112,500-$225,000
Loss.
469(i)........................... Passive Rehab. (1,7)............... $200,000-$250,000 $200,000-$250,000 $100,000-$125,000.... $225,000-$450,000 $112,500-$225,000
Credit.
530.............................. Education IRA (1,6)............... $150,000-$160,000 $95,000-$110,000 No deduction......... $225,000-$450,000 $112,500-$225,000
Deduction.
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Footnotes: (1) Modifications to AGI apply; (2) Inflation indexed; (3) Earned income limitations; (4) Low income only; (5) Phase-out range depends on number of children; (6) Newly enacted in
1997; (7) Also see section 221(b)(2); (8) Phase-out applies to alternative minimum taxable income rather than AGI; (9) Increases for future years are specifically provided in the statute.
Additionally, instead of the differing methods of phase-
outs (shown in attached Exhibit B), the phase-out methodology
for all phase-outs would be the same, such that the benefit
phases out evenly over the phase-out range. Every phase-out
should be based on adjusted gross income (AGI).
EXHIBIT B--Current Method of Phase-Out
------------------------------------------------------------------------
Current Methodology for
Code Section(s) Tax Provision Phase-outs Application
------------------------------------------------------------------------
21........................... Dependent Care Credit percent reduced
Credit. from 30 percent to 20
percent in AGI range
noted by 1 percent
credit for each $2,000
in income
22........................... Elderly Credit. Credit amount reduced by
excess over AGI range
23 & 137..................... Adoption Credit Benefit reduced by
& Exclusion. excess of modified AGI
over lowest amount
noted divided by 40,000
24........................... Child Credit... Credit reduced by $50
for each $1,000 in
modified AGI over
lowest amount divided
by 10,000 (single) and
20,000 (joint)
25A.......................... Education Credits reduced by
Credits (Hope/ excess of modified AGI
Lifetime over lowest amount
Learning). divided by 10,000
(single) and 20,000
(joint)
32........................... Earned Income Credit determined by
Credit. earned income and AGI
levels
55........................... AMT Exemption.. Exemption reduced by \1/
4\ of AGI in excess of
lowest amount noted
68........................... Itemized Itemized deductions
Deductions. reduced by 3 percent of
excess AGI over amount
noted
135.......................... Series EE Bonds Excess of modified AGI
over lowest amount
divided by 15,000
(single), 30,000
(joint) reduces
excludable amount
151.......................... Personal AGI in excess of lowest
Exemption. amount, divided by
2,500, rounded to
nearest whole number,
multiplied by 2, equals
the percentage
reduction in the
exemption amounts
219.......................... Traditional IRA Individual retirement
w/ Retirement account (IRA)
Plan. limitation ($2,000/
$4,000) reduced by
excess of AGI over
lowest amount noted
divided by $10,000
219(g)(7).................... IRA w/Spouse w/ Deduction for not active
Retiremt. Plan. spouse reduced by
excess of modified AGI
over lowest amount
noted divided by 10,000
221.......................... Education Loan Deduction reduced by
Interest excess of modified AGI
Expense over lowest amount
Deduction. noted divided by 15,000
408A......................... Roth IRA....... Contribution reduced by
excess of modified AGI
over lowest amount
noted divided by 15,000
(single) and 10,000
(joint)
408A......................... IRA Rollover- Rollover not permitted
Roth IRA. if AGI exceeds 100,000
or if MFS
469(i)....................... Passive Loss Benefit reduced by 50
Rental $25,000 percent of AGI over
Rule. lowest amount noted
530.......................... Education IRA Contribution reduced by
Deduction. excess of modified AGI
over lowest amount
noted divided by 15,000
(single) and 10,000
(joint)
------------------------------------------------------------------------
Contribution to Simplification.--The current law phase-outs
complicate tax returns immensely and impose marriage penalties.
The instructions related to these phase-outs are difficult to
understand and the computations often cannot be done by the
average taxpayer by hand. The differences among the various
phase-out income levels are tremendous. Either we should
eliminate phase-outs and accomplish the same goal with a lot
less complexity by adjusting rates, or at least make the phase-
outs applicable at consistent income levels (only three) and
apply them to consistent ranges and use a consistent
methodology. This would ease the compliance burden on many
individuals. If there were only three ranges to know and only
one methodology, it would be easier to recognize when and how a
phase-out applies. Portions of numerous Internal Revenue Code
sections could be eliminated. By making the MFJ phase-out
ranges double the ranges applicable to single individuals, and
by making the MFS ranges the same as single individuals, the
marriage penalty associated with phase-out ranges would be
eliminated.
Alternative Minimum Tax Proposal
Background on AMT.--The budget proposals would extend, for
two years, the availability of refundable credits against the
individual alternative minimum tax. Thus, this issue has now
joined the list of ``extenders'' or ``expiring provisions''
which Congress must address every few years, searching for the
revenues to prevent some tax inequity (as here) or maintain
some tax incentive.
We are clearly pleased to support this proposal, but we
would caution the Congress (as we have in the past) that there
are many more issues with the individual AMT that need to be
addressed. Some of these issues are discussed below.
Complexity of AMT.--The AMT is one of the most complex
parts of the tax system. Each of the adjustments of Internal
Revenue Code (IRC) section 56, and preferences of IRC section
57, requires computation of the income or expense item under
the separate AMT system. The supplementary schedules used to
compute many of the necessary adjustments and preferences must
be maintained for many years to allow the computation of future
AMT as items turn around.
Generally, the fact that AMT cannot always be calculated
directly from information on the tax return makes the
computation extremely difficult for taxpayers preparing their
own returns. This complexity also calls into question the
ability of the Internal Revenue Service (IRS) to audit
compliance with the AMT. The inclusion of adjustments and
preferences from pass-through entities also contributes to the
complexity of the AMT system.
Effects of the Taxpayer Relief Act of 1997 and AMT on
Individual Taxpayers.--If the Administration's budget proposal
on temporary AMT relief expansion is not enacted, several tax
credits included in the Taxpayer Relief Act of 1997 will have a
dramatic impact on the number of individuals who will find
themselves subject to the alternative minimum tax (AMT). For
many, this will come as a real surprise and, in all likelihood,
will cause substantial problems for the IRS, which will have to
redirect significant resources to this area in the future to
ensure compliance, educate taxpayers, and handle taxpayer
questions. We believe the Administration's proposal should be
for permanent AMT relief rather than just temporary two-year
relief.
Most sophisticated taxpayers understand that there is an
alternative tax system, and that they may sometimes wind up in
its clutches; unsophisticated taxpayers, however, may never
have even heard of the AMT, certainly do not understand it, and
do not expect to ever have to worry about it. Unfortunately,
that is changing--and fairly rapidly--since a number of the
more popular items, such as the education and child credits
that were recently enacted, offset only regular tax and not
AMT. Due to these changes, we believe it is most important that
Congress obtain information (from Treasury, the Joint Committee
on Taxation staff, or OMB) not only as to the revenue impact of
the interaction of all these recent tax changes with the AMT,
but also of the likely number of families or individuals that
will be paying AMT as a result of the 1997 tax legislation.
Indexing the AMT Brackets and Exemption.--While the AICPA
has not undertaken detailed studies, we have all seen, during
the past year, anecdotal examples indicating the likelihood
that taxpayers with adjusted gross incomes in the $60,000-
$70,000 range (or below) will be subject to AMT. Aside from the
fairness issues involved--this is not the group that the AMT
has ever been targeted to hit--we see some potentially serious
compliance and administration problems. Many of these taxpayers
have no idea that they may be subject to the AMT (if, indeed,
they are even aware that there is an AMT). Thus, we anticipate
large numbers of taxpayers not filling out a Form 6251 or
paying the AMT who may be required to do so, thus requiring
extra enforcement efforts on the part of the IRS to make these
individuals (most of whom will be filing in absolute good
faith) aware of their added tax obligations. Further, IRS
notices to these taxpayers assessing the proper AMT may well be
perceived as unfair, subjecting the IRS to unfair criticism
that should be directed elsewhere.
Individual AMT Recommendations.--We recognize that there is
no simple solution to the AMT problem given the likely revenue
loss to the government. As a start, however, Congress should
consider:
1. Increasing and/or indexing the AMT brackets and
exemption amounts.
2. Eliminating itemized deductions and personal exemptions
as adjustments to regular taxable income in arriving at
alternative minimum taxable income (AMTI) (e.g., all--or
possibly a percentage of--itemized deductions would be
deductible for AMTI purposes).
3. Eliminating many of the AMT preferences by reducing for
all taxpayers the regular tax benefits of AMT preferences
(e.g., require longer lives for regular tax depreciation).
4. Allowing certain regular tax credits against AMT (e.g.,
low-income tax credit, tuition tax credits)--permanently,
rather than just for the next two years.
5. Providing an exemption from AMT for low and middle-
income taxpayers with regular tax AGI of less than $100,000.
6. Considering AMT impact in all future tax legislation.
Due to the increasing complexity, compliance problems, and
a perceived lack of fairness towards the intended target, an
additional alternative Congress might also want to consider is
eliminating the individual AMT altogether.
Contribution to Simplification of AMT.--The goal of
fairness that is the basis for AMT has created hardship and
complexity for many taxpayers who have not used preferences to
lower their taxes but have been caught up in the system's
attempt to bring fairness. Many of these individuals are not
aware of these rules and complete their return themselves,
causing confusion and errors. The 1997 law and the impact of
inflation on indexed tax brackets and the AMT exemption are
causing more lower income taxpayers to be inadvertently subject
to AMT. Increasing and/or indexing the AMT brackets and
exemption (recommendation 1) would solve this problem.
Under recommendation 2, those individuals who are affected
only by itemized deductions and personal exemption adjustments
would no longer have to compute the AMT. Itemized deductions
are already reduced by the 3 percent AGI adjustment, 2 percent
AGI miscellaneous itemized deduction disallowance, 7.5 percent
AGI medical expense disallowance, $100 and 10 percent AGI
casualty loss disallowance, and the 50 percent disallowance for
meals and entertainment. Similarly, the phase out of exemptions
already affects high-income taxpayers. It is also worth noting
that because state income taxes vary, taxpayers in high income
tax states may incur AMT solely based on the state in which
they live, while other taxpayers with the same adjusted gross
income (AGI), but who live in states with lower or no state
income taxes, would not pay AMT. This results in Federal tax
discrimination against residents of high tax states.
In addition, under recommendation 3, many of the AMT
preferences could be eliminated by reducing for all taxpayers
the regular tax benefits of present law AMT preferences (e.g.,
require longer lives for regular tax depreciation). This would
add substantial simplification to the Code, recordkeeping and
tax returns.
Under recommendation 4, those who are allowed regular tax
credits, such as the low income or tuition tax credits, would
be allowed to decrease their AMT liability by the credits. This
would increase simplicity and create fairness. Compliance would
be improved.
Under recommendation 5, fewer taxpayers will be subject to
AMT and the associated problems. By increasing the AMT
exemption to exclude low and middle income taxpayers, the AMT
will again be aimed at its original target--the high-income
taxpayer.
By eliminating AMT altogether, all the individual AMT
problems would be solved.
Conclusion on AMT.--In conclusion, we see the AMT as
becoming more prevalent and causing considerable disillusion to
many taxpayers whom do not see themselves as wealthy and who
will believe they are being punished unfairly. The AMT will
apply to many taxpayers it was not originally intended to
affect. We believe our proposals offer a wide range of ways to
help address this problem.
I.B.2--Exclusion For Employer-Provided Educational Assistance
Section 127 allows workers to exclude up to $5,250 a year
in employer reimbursements or direct payments for tuition,
fees, and books for certain courses. This exclusion expires on
June 1, 2000. The President's proposal would extend the Section
127 exclusion for eighteen months for both undergraduate and
graduate courses.
We support extension of the Section 127 exclusion and
encourage Congress to consider making it a permanent part of
the tax code. We also support re-inclusion of graduate-level
courses as expenses qualifying for the exclusion. Expanding and
making Section 127 a permanent part of the tax code would
remove the uncertainty and ambiguity that employees and
employers now regularly face.
Evidence indicates that Section 127 has met the broad
policy goals for which it was designed. It has provided
incentive for upward mobility of employees who might not
otherwise choose or be able to afford to return to school to
improve their skills and educational qualifications. It has
reduced complexity in the tax law because it does not require a
distinction between job-related and non-job related educational
assistance. Further, it has also reduced possible inequities
among taxpayers by allowing lower-skilled employees, on a
nondiscriminatory basis, eligibility for the exclusion without
worry about the job-related test.
Complexity could be further reduced by making Section 127
permanent thereby eliminating the periodic rolling forward of
the expiration date and the need for retroactive reinstatement.
This is particularly troublesome to students who are planning a
multi-year education program and cannot plan on consistent
after-tax costs throughout their education. These students are
often on a tight budget and find it difficult to plan for and
implement full-degree programs.
The continued education and increased competence of the
U.S. worker are critical to surpassing the challenges of an
international marketplace.
I.F.13-17--Promote Expanded Retirement Savings, Security, and
Portability
The President's budget contains five provisions to increase
pension portability, the ability to roll over retirement
savings between pension plans. The AICPA supports these
provisions and commends the Administration for addressing a
complex area of the tax law that is becoming increasingly
utilized given our mobile workforce. These provisions would
simplify planning and reduce the pitfalls and penalties that
taxpayers run afoul of in attempting to comply with the current
rules.
Under the budget proposal:
An eligible rollover distribution from a qualified
retirement plan could be rolled over to a qualified retirement
plan, a Code section 403 (b) annuity, or a traditional IRA.
Likewise, an eligible rollover distribution from a Section 403
(b) annuity could be rolled over to another Section 403 (b)
annuity, a qualified retirement plan, or a traditional IRA. The
conduit IRA rules would be modified similarly.
Individuals who have a traditional IRA and whose IRA
contributions have been tax deductible would be allowed to
transfer funds from their traditional IRA into their qualified
defined benefit retirement plan or Section 403(b) annuity,
provided that the retirement plan trustee meets the same
standards as an IRA trustee.
After-tax employee contributions to a qualified retirement
plan could be included in a rollover contribution to a
traditional IRA or another qualified retirement plan, provided
that the plan or IRA provider agrees to track and report the
after-tax portion of the rollover for the individual.
Distributions of the after-tax contributions would continue to
be nontaxable.
Individuals would be permitted to roll over distributions
from a governmental Section 457 plan to a traditional IRA.
State and local employees would be able to use funds from
their Section 403 (b) annuities or government Section 457 plans
to purchase service credits through a direct transfer without
first having to take a taxable distribution of these amounts.
In addition, there are numerous other pension provisions
from previous budget proposals which the AICPA supports. These
provisions would: Make it easier for workers to contribute to
IRAs through payroll deduction at work; provide a three-year
small business tax credit to encourage them to start up
retirement programs; create a new simplified defined benefit
pension plan (The SMART Plan-Secure Money Annuity or Retirement
Trust Plan); provide faster vesting of employer matching
contributions; improve pension disclosure; improve benefits of
non-highly compensated employees under Section 401 (k) safe
harbor plans; simplify the definition of highly compensated
employee; simplify full-funding limitations and Section 415
benefit limits for multi-employer plans, and eliminate partial
termination rules for multi-employer plans. All of these
provisions would assist taxpayers in setting up retirement
plans and improve the overall rate of savings in the U.S.
The AICPA supports these recommendations and believes that
Congress should consider further efforts to encourage
retirement savings and investment, including making personal
financial planning more available to employees through employee
benefits plans.
I.H.7--Simplify the Active Trade or Business Requirement for Tax-Free
Spin-Offs
The AICPA supports the Administration's proposal to improve
the operation of Section 355. This is a longstanding one, well-
known to the corporate tax community. Current law poses trouble
for taxpayers: for the unwary, a trap; for the well-advised,
sometimes a costly (and economically unproductive) detour.
The problem lies in the statute itself, which accommodates
pure holding companies, but not hybrids. In applying the
``active conduct'' test to holding companies, Section
355(b)(2)(A) requires that ``substantially all'' of its assets
consist of stock (and securities) of controlled subsidiaries
that are themselves engaged in the ``active conduct,'' etc. The
``substantially all'' requirement is not defined in either
statute or regulations. The IRS has defined it, in the context
of an advance ruling, as 90% of gross assets. This raises a
very high threshold for holding companies, one that can be met
only by pure (or virtually so) holding companies.
The unwary taxpayer will make a distribution to
shareholders that may wind up as a tax controversy. The well-
advised taxpayer will take a detour. The objective of the
detour is to convert the hybrid holding company into an
operating company. This can usually be accomplished, so long as
the holding company has at least one controlled subsidiary that
meets the ``active conduct'' test. For example, the holding
company can cause the controlled subsidiary to be completely
liquidated, so that the latter's active business is now
operated directly by the holding company. From an economic
perspective, this step is meaningless because it shouldn't
matter whether a business is conducted directly or indirectly.
But the step is a tax cure-all because, unlike a holding
company, an operating company is not subject to a quantitative
test. Rather, the latter is subject to a qualitative test: is
it operating an active business?
There is no apparent reason for the statute's asymmetric
approach to holding companies and operating companies,
respectively. According to IRS advance ruling guidelines, at
least 90% of a holding company's gross assets must be invested
in qualifying assets, i.e., stock in controlled subsidiaries
that are engage in the active conduct,'' etc. On the other
hand, according to the IRS advance ruling guidelines, an
operating company need have as little at 5% of its gross assets
invested in the active business.
The Administration's proposal would address this lack of
symmetry by treating an affiliated group as a single taxpayer.
No longer would a hybrid holding company be forced to relocate
an active business within its corporate family in order to meet
the ``active conduct'' requirement. This amendment is entirely
consistent with the prevailing, single-entity theory of
consolidated returns, and it has our full support.
II.A.1-6--Corporate Tax Shelters
The President's budget contains sixteen proposals
addressing ``corporate tax shelters.'' The first six of these
address the topic generically by imposing new penalties and
sanctions and by establishing new tax rules to govern
transactions generally. This section provides our comments on
the six generic proposals. We expect to comment on some of the
specific transaction rules separately in subsequent submissions
after our technical committees have completed their reviews of
the proposals.
We begin by recognizing that tax laws are usually followed,
but that they can also be abused. Where there are abuses, we
hold no brief for them--whether they fall under the pejorative
rubric of ``tax shelters'' or any other part of our tax system.
Thus, we sympathize with and support efforts to restrict
improper tax activities through appropriate sanctions.
Specifically, we favor the Administration's recommendation
regarding exploitation of the tax system by the use of tax-
indifferent parties.
However, we also support and defend the right of taxpayers
to arrange their affairs to minimize the taxes they must fairly
pay and, with that in mind, we have some serious concerns about
where the President's proposals draw the distinction between
legitimate tax planning and improper tax activities. We see
them as an overbroad grant of power to the Internal Revenue
Service to impose extremely severe sanctions on corporate
taxpayers by applying standards that are far from clear and
that could give examining revenue agents a virtual hunting
license to go after corporate taxpayers (which, by the way
include huge numbers of small and medium-sized businesses, not
just Fortune 100 companies). This would seem to be inconsistent
with the taxpayer rights thrust of last year's IRS
restructuring legislation. In our view, the debate concerning
the sanctions for improper corporate tax behavior must begin
with a clear understanding of the standards that distinguish
abusive transactions from legitimate tax planning. What
standards justify the imposition of extraordinary punishment on
a corporation (or tax adviser) whose tax treatment of a
transaction is successfully challenged by the IRS?
Our primary concern with the Treasury proposals is the
absence of a clear standard defining what is and what is not an
abusive transaction, which would apply to most provisions of
the tax law. The proposals modifying the substantial
understatement penalty for corporate tax shelters and denying
certain tax benefits to persons avoiding income tax as a result
of ``tax avoidance transactions'' set forth a too-vague
definition of abusive uses of the income tax laws that must be
clarified. Anti-abuse legislation should be directed at
transactions that are mere contrivances designed to subvert the
tax law. The Treasury proposals move beyond the scope we think
is appropriate to reach transactions that are described vaguely
as ``the improper elimination or significant reduction of tax
on economic income.'' This criterion, whatever meaning is
ascribed to it, is certain to capture transactions that would
not be considered abusive by most and other transactions that
have been undertaken for legitimate business purposes. We
believe that greater clarity is possible, and would like to
work with the staff to develop a clearer, more objective
standard for identifying abusive transactions that can be used
for most provisions of the tax code. A clearer standard would
provide advantages to tax administrators and taxpayers alike by
promoting consistency in its application. In addition, we would
like to reverse the proliferation of highly subjective terms
such as ``significant,'' ``insignificant,'' ``improper,'' and
``principal'' which are used in the Treasury proposals and
current law. While we doubt that it is possible to eliminate
them all, it would be a laudable goal to minimize their number.
While the crafting of a clear standard is indeed a
difficult task, perhaps we can begin to approach the issue by
trying to agree on what types of transactions should not be
considered abusive. It should be considered a fundamental
principle that Congress intended the income tax laws to apply
to all transactions, without penalty, that either are
undertaken for legitimate business purposes, or which further
specific governmental, economic or social goals that were
contemplated by discrete legislation. Therefore, a transaction
undertaken for reasons germane to the conduct of the business
of the taxpayer, or that is expected to provide a pre-tax
return which is reasonable in relation to the costs incurred,
or that reasonably accords with the purpose for which a
specific tax incentive or benefit was enacted should not be
considered abusive. While our discussion below criticizes the
Treasury standard for abusive conduct, we do not have our own
fully developed definition to propose to you at this time.
However, we have asked a task force of our Tax Executive
Committee to examine this issue and we are hopeful that we can
submit our specific recommendations to you and to Treasury in a
timely fashion. We would be pleased to have the opportunity to
work with you and them to see if it is possible to develop a
standard that could be used for most purposes of the Code.
The budget proposals provide punitive sanctions on ``tax
avoidance transactions,'' and Treasury's explanation of the
proposals defines such transactions to include those where
reasonably expected pre-tax profit is ``insignificant''
relative to reasonably expected tax benefits. It is the
softness and inadequacy of this definition to deal with the
breadth of the transactions swept into the sanctions, combined
with the extreme nature of the weapons given the IRS, which
create our concern that legitimate tax planning will also be
caught up in this maelstrom. How does this concept apply, for
example, to a host of business decisions that do not involve
profit motive, but rather are to defer income or accelerate
deductions? (We do recognize that there is a proposed exception
under which a transaction would not be considered ``tax
avoidance'' if the benefit is ``clearly contemplated'' by the
applicable provision. However, ``clear contemplation'' is
generally in the eye of the beholder, and if that contemplation
is intended to reflect what Congress had in mind when the
provision was passed, we would respectfully suggest that many
provisions in our highly complex tax laws have no ``clear''
congressional contemplation.)
A second major concern (alluded to earlier) is that these
proposals would result in an alarming shift in authority from
Congress to the IRS. These proposals would result in a grant to
the IRS of virtually unbridled discretion in the imposition of
penalties and other sanctions--and this would come only one
year after Congress had concluded there was a need to rein in
an agency that had proved itself overzealous in pursuing
taxpayers. The obscure manner in which the proposals define the
term ``tax avoidance transaction,'' combined with the wide
range of penalties and other sanctions that could be invoked
upon a finding of such a transaction, would provide IRS
auditors with enormous opportunities and incentives to assert
the existence of ``tax avoidance transactions'' almost at will.
Unfortunately, within a few years we would expect aggressive
agents to use this weapon as a means of forcing corporate
taxpayers to capitulate on other items under examination.
Our third concern is that the provisions are so broad they
could negatively affect legitimate tax planning. Without
backing away from our earlier point regarding abuses of the tax
laws, appropriate planning to minimize taxes paid is still a
fundamental taxpayer right that must be defended. ``The legal
right of a taxpayer to decrease the amount of what otherwise
would be his taxes, or altogether avoid them, by means which
the law permits, cannot be doubted...'' (Gregory v. Helvering,
293 U.S. 465, 1935). We think the budget proposals provide so
many powers to the government there is a real likelihood that,
if enacted, they could prevent advisers and taxpayers from
undertaking or considering tax-saving measures that are not
abusive.
We are also concerned that increased and multiple
penalties, based on a loosely defined standard and with no
abatement for reasonable cause, should not apply in a
subjective area where differences of opinion are the norm, not
the exception. We believe that penalties should be enacted to
encourage compliance with the tax laws, not to raise revenue.
The enactment of new penalties must be carefully developed with
consideration for the overall penalty structure and any
overlaps with existing penalties. We also believe that there
should be incentives for taxpayers to disclose tax transactions
that could potentially lack appropriate levels of authority and
that penalties should be abated with proper disclosure and
substantial authority.
In this regard, it should be noted that the Joint Committee
on Taxation and the Treasury Department are undertaking
independent studies of the entire tax penalty structure, at the
request of the Congress. The AICPA has recently submitted
numerous comments about the penalty administration system to
the Joint Committee and Treasury, and we have commented a
number of times in the past few years that, the penalty system
has become more difficult to administer in the past decade. We
favor a review, de novo, of the penalty system, and we would
suggest (as part of that review but also for purposes of the
current hearing) that merely adding new or increased penalties
to the law whenever Congress or the Administration wishes to
curtail taxpayer activity is not the proper answer. The result
is inevitable taxpayer confusion and a higher likelihood that
the penalty system cannot be administered consistently by the
IRS (with resulting inequities among taxpayers).
The Administration has proposed a large variety of
financial sanctions on transactions that are ultimately
determined to permit ``tax avoidance.'' These include a
doubling of the substantial understatement penalty to 40%, an
extension of that penalty at 20% to fully disclosed positions,
the ability of the IRS to disallow any tax benefits derived
from the transaction, disallowance of deductions for fees paid
to promoters or for tax advice about the transaction, and an
excise tax of 25% on the amount of such fees received. In
addition, no ``reasonable cause'' exception will exist to argue
against the penalty part of any deficiency. Since (as we
discuss below) there is little incentive for disclosure in
these proposals, the 40% substantial understatement penalty
plus the 35% corporate tax rate on disallowance of any tax
benefit, will produce a 75% tax cost (in addition to the
economic costs) for entering such a transaction--indeed a
significant deterrent. For the part of the deficiency
attributable to fees or tax advice, an additional 25% excise
tax is imposed, for a 100% tax cost (or ``only'' 80% if there
is full disclosure under the terms of the proposals)--again,
with no ``reasonable cause'' exception.
We would note that these amounts equal or exceed the tax
penalty for civil fraud (75%). Thus, enactment of the
President's proposals would single out these transactions as
equal to or worse than civil tax fraud. We recognize there may
be those who believe that tax avoidance transactions are the
equivalent of civil tax fraud and deserve this level of
sanction. However, we would also note that the due process
requirements for showing civil fraud are vastly higher than for
tax avoidance transactions. For example, the government bears
the burden of proof for showing civil fraud; for assessing
sanctions on a tax avoidance transaction, the burden of proof
is on the taxpayer (it may or may not shift to the government
if the case is litigated, depending on the size of the
corporation and the development of the administrative
proceeding). Further, for tax avoidance transactions, these
proposals would legislate away the ability of a taxpayer to
argue that the position was taken in good faith and there was
reasonable cause for the taxpayer to act as it did.
While respecting the views on the other side, we do not
believe the case has been made that tax avoidance transactions
(under the loose proposed standard discussed above) rise to the
level of civil fraud. We certainly do not understand why the
due process requirements in place for civil fraud are absent
here.
With further respect to the issue of promoters and tax
advisers, the fee disallowance and excise tax recommendations
imply that there are presently inadequate deterrents in the law
for those who advise on ``abusive'' corporate transactions. We
would like to suggest that consideration be given to whether
changes in Circular 230 (the Treasury regulations governing the
right to practice before the IRS) could be a more effective
answer to some of these problems rather than another tax and
added penalties (on the disallowance of adviser fees). We
recognize that Circular 230 would not apply as presently
written to some promoters, but there have been some proposals
in recent months regarding potential changes in Circular 230
that may be appropriate for consideration. In addition,
preparer and promoter penalties under current law could be
reviewed for adequacy.
We do not agree with the proposal that precludes taxpayers
from taking tax positions inconsistent with the form of their
transactions--but not because we believe taxpayers should be
able to casually disavow the form. However, the Joint Committee
on Taxation analysis of this provision raises several issues
that we believe should be addressed. At this point, we are not
convinced that the tax law or system of tax administration
would be improved by this provision. Given the abundance of
existing case law on this issue, it is not clear to us why new
legislation is required at this time.
One final concern: if the Treasury is concerned that the
current disclosure rules may not be effective, we are prepared
to address the question of when and what form of disclosure
should be required in order to identify the types of
transactions with which the Administration is concerned.
However, we question the lack of incentives for disclosure both
under current law and the President's proposals. The
Administration's disclosure proposals come on top of
registration requirements that were enacted only a year ago (on
which we are still awaiting regulations). For those affected by
the previous registration requirements, this proposal would be
overkill (requiring disclosure for registration purposes with
the IRS as the transaction begins to be marketed, and
additional disclosure to the IRS within 30 days of closing a
transaction). We believe that provisions that do not aid the
tax administrator but add tremendous burdens to preparers and
taxpayers should be eliminated. We stand ready to work with you
and the IRS on this issue.
Today, we can do no more than offer our first impressions
of these proposals. Our analysis and study has just begun as
these proposals and the areas of law which they affect are
necessarily complex. However, we are prepared to devote the
effort necessary to complete a full, careful and timely review
in this area, to offer you our best recommendations and to work
with you and your staffs to develop improvements in the law
that can and should be made to deal with identified problem
areas.
II.B.2--Require Current Accrual of Market Discount by Accrual Method
Taxpayers
The administration's proposal would require accrual method
taxpayers to include market discount in income as it accrues.
The accrual would be limited to the greater of the original
yield to maturity or the applicable federal rate, plus 5%.
Under current law, a taxpayer is only required to include
market discount in income when cash payments are received.
Alternatively, a taxpayer may elect to currently include market
discount in income. The AICPA does not support the
administration's proposal regarding market discount for the
reasons enumerated below.
Market discount may, in many circumstances, be economically
equivalent to original issue discount (``OID''). In many
situations, however, market discount may arise solely because
of a decline in the credit-worthiness of the borrower and the
resulting discount is not related to the time value of money.
For this reason, the current market discount regime protects
taxpayers from including in taxable income market discount that
may very well never be collected. The Administration's proposal
that market discount be accrued in an amount up to the greater
of the original yield to maturity or the applicable federal
rate, plus 5%, would, in many instances, require a taxpayer to
accrue income that may very well never be collected.
The IRS and Treasury, to date, have not issued
comprehensive guidance on how taxpayers should accrue interest,
market discount and original issue discount on debt obligations
where there is substantial uncertainty that the income will be
collected. Accordingly, the mandatory accrual of market
discount should not be required until guidance on non-accrual
of discount is released.
The Administration is proposing to require the current
accrual of market discount. A similar requirement exists for
original issue discount. However, while substantial guidance
has been issued in the form of Treasury Regulations and other
published guidance with regard to OID, no such guidance has
been issued under the market discount provisions. As a result,
taxpayers have been struggling with complex market discount
provisions contained in the code since 1984 but with no
guidance on how to apply the provisions. The AICPA believes
that, substantive guidance should be issued to instruct a
taxpayer exactly how to apply these provisions. Substantive
guidance is needed to address the accrual of market discount in
several areas, including, but not limited to, (1) obligations
subject to prepayment; (2) obligations that become demand
obligations after the original issue date; and (3) obligations
purchased at significant discounts because of a decline in the
credit rating of the issuer. Until such guidance is issued, the
AICPA does not believe it is prudent to require the current
accrual of market discount.
This proposal, if enacted, would expand complex tax rules
applicable to sophisticated financial transactions to a broad
universe of taxpayers. As it is, taxpayers are faced with a
myriad of questions when determining how market discount is
deemed to accrue. Thus, it is unrealistic to expand a complex
regime to a broader universe of taxpayers without first issuing
guidance with respect to the original provisions. For example,
it is common for a taxpayer to hold a market discount
obligation with OID. In this circumstance, most taxpayers will
have to perform three computations to determine income with
respect to these obligations, one for financial accounting
purposes, one for tax purposes with respect to the OID and one
for tax purposes regarding market discount. Even taxpayers
``familiar with the complexities of reporting income under an
accrual method'' would find this burdensome.
Any perceived abuse by the administration that taxpayers
are able to achieve a deferral by not recognizing market
discount currently is unfounded as well. Many taxpayers (such
as financial institutions) that hold market discount
obligations use debt to purchase and carry such obligations.
Generally, such taxpayers cannot deduct interest expense
incurred to purchase and carry the market discount obligations
thereby eliminating, much if not all, of the benefit resulting
from the deferral of market discount.
II.D.4--Repeal of Tax-Free C-to-S Conversions
The AICPA continues to strongly oppose the Administration's
proposal to treat the conversion of a so-called ``large''
(greater than $5 million in value) C corporation to an S
corporation as a taxable liquidation. The Administration's
proposal also in effect would impose a new ``merger tax'' on
certain acquisitions of C corporations by S corporations. We
continue to believe that the proposal is short-sighted, would
be harmful to small business, and is grossly inconsistent with
Congressional efforts to reform Subchapter S to make it more
attractive and more workable. We are pleased that the Congress
has consistently rejected this included in the Administration's
previous budget recommendations.
This proposal would repeal the section 1374 built-in gains
tax for corporations whose stock is valued at more than $5
million when they convert to S corporation status. In place of
the section 1374 built-in gains tax, which would tax built-in
gains if and when built-in gain property is disposed of during
the ten-year period after conversion, the proposal would
require such converting corporations to recognize immediately
all the built-in gain in their assets at the time of
conversion. The proposal would be effective for conversions for
taxable years beginning on or after January 1, 2000.
The AICPA strongly opposes this proposal. We believe this
proposal constitutes a major change in corporate tax law, and
one that would be contrary to sound tax policy. As stated
above, we believe that any significant change affecting
Subchapter S should only be undertaken pursuant to a
comprehensive review and not be the subject of piecemeal
changes designed primarily to attain revenue goals.
Current section 1374 is designed to preserve a double-level
tax on appreciation in assets that accrued in a corporation
before it elected S corporation status. To accomplish this,
section 1374 subjects S corporations to a corporate-level tax
on asset dispositions during the ten years following
conversion. Section 1374's primary purpose is to prevent a C
corporation from avoiding the 1986 Tax Reform Act's repeal of
the General Utilities doctrine, by converting to S corporation
status prior to a sale of its business. Since its enactment,
section 1374 has been refined several times in order to
strengthen its operation, such as the addition of a suspense
account mechanism to prevent built-in gains from escaping tax
due to the taxable income limitation. The experiences of our
members indicate section 1374 is effective in achieving its
purpose. We see no reason to abandon this mechanism.
The proposal also is counter to well-established policy
regarding the tax treatment of the conversion of C corporations
to S corporation status. For example, in 1988, Section 106(f)
of S. 2238 and Section 10206 of H.R. 3545, the then-pending
Technical Corrections Bill, would have modified the computation
of the built-in gains tax by removing the taxable income
limitation. This provision was ultimately rejected under
``wherewithal to pay'' principles. At that time, the AICPA's
position was articulated in the following passage from a letter
from then Chairman of the AICPA Tax Division, Herbert J.
Lerner, to the Honorable Dan Rostenkowski; this statement
continues to reflect the position of the AICPA:
Perhaps of even greater long-term concern is that this
technical correction seems to be yet another manifestation of a
fundamental change in tax philosophy. Several staff members
from the tax writing committees have told us that they believe
that any conversion from C to S status should be taxed as
though the corporation had been liquidated and a new
corporation formed. We believe that this is not sound tax
policy and that it would be contrary to the underlying purpose
of Subchapter S which has been widely used by small businesses
for some 25-30 years. ... This liquidation philosophy is a
major change in tax policy and should be debated as such,
should be subject to public hearings and should not be allowed
to creep into the law through incremental changes.
It is noted that a similar attempt to repeal the taxable
income limitation for elections made after March 30, 1988 was
rejected by Congress in 1992 (Section 2 of H.R. 5626). A
legislative proposal to effectively treat the conversion as a
liquidation was also rejected by Congress in 1982.
The AICPA believes that the proposal under consideration
would effectively repeal the availability of Subchapter S for
so-called ``large'' corporations (i.e., corporations valued at
over $5 million). As noted, the proposal would require such
corporations to be taxed immediately on all unrealized gain in
their assets, including goodwill, and to pay a tax on this
gain. For large corporations with significant unrealized value,
the cost of conversion would be exceedingly expensive and,
therefore, Subchapter S status would in effect be rendered
completely inaccessible to them. As a result, the proposal
would generally leave Subchapter S status available only to
those large corporations with either little or no built-in gain
or sufficient net operating loss carryovers to offset the gain.
We do not believe that restricting the benefits of Subchapter S
to this latter class of C corporations represents sound tax
policy.
A further objection we have to the proposal is the use of
the $5 million fair market value threshold for determining the
applicability of the tax. Basing the applicability of the
provision, which could have devastating tax consequences, on
such a subjective benchmark is simply untenable. If a
corporation wished to convert to S corporation status, how
could it conclusively determine whether or not the immediate
taxation of built-in gains would apply? Even if the corporation
incurred the cost of obtaining an appraisal, how would the
corporation be sure the valuation would not later be challenged
by the Internal Revenue Service? As a pure business matter,
many corporations simply would not be willing to accept any
significant level of uncertainty regarding this potentially
devastating tax on paper gains. Adding such a burdensome and
uncertain provision to the tax law clearly would be contrary to
sound tax policy.
In summary, the AICPA feels strongly that the proposal to
repeal section 1374 for large corporations and impose an
immediate tax on all unrealized gain in their assets runs
counter to long-standing tax policy which Congress has adhered
to for many years. Further, although the proposal may serve the
purpose of raising revenue, it would do so to the detriment of
certainty and fairness in the tax law. The proposal would
effectively eliminate new conversions to Subchapter S status
for most corporations valued at more than $5 million; such a
major change in the tax law should not be made without careful
analysis. We, therefore, strongly urge you to remove the
proposal from consideration.
II.E.5--Repeal the Lower of Cost or Market Inventory Accounting Method
This proposal would eliminate the use of the lower of cost
or market method for federal income tax purposes. This proposal
has been made on a number of occasions in the past, and the
AICPA has opposed each such proposal.
We continue to oppose this proposal. This method has been
accepted in the tax law since 1918 and is an integral part of
generally accepted accounting principles (GAAP). LCM conformity
with GAAP does provide some needed simplicity. Further, there
is no reason why this method should suddenly become
impermissible. It is not a one-sided application of mark-to-
market because once a taxpayer lowers the selling price of its
goods below their cost, the taxpayer is not going to realize a
profit on the eventual sale of the goods.
We are disappointed that a widely established and
universally used tax accounting method, which finds its genesis
in generally accepted accounting principles, would--after
having been a part of our tax structure for over 80 years--be
proposed for repeal. The process is particularly unfortunate
because, when all is said and done, the LCM repeal proposal
involves a timing difference only, rather than a truly
substantive change in tax policy. At the end of the day, the
issue becomes whether components of inventory transactions are
recorded on a return this year or next year; there is no issue
as to whether they will ever be recorded at all.
Now, suddenly, Congress is asked to change a basic tax rule
that predates almost all of us. Taxpayers will have to live
with this change for decades or longer. On that basis,
particularly for an issue that involves only timing, it is
particularly distressing to see the change occur under this
process. One would think that 76 years of totally accepted
usage is precedential enough to warrant a more deliberate
process for its removal from the law.
Without wishing to detract from our main point--LCM should
not be repealed--let us note that if Congress determines to
eliminate lower of cost or market, there needs to be a small
business exception in the interest of simplicity. Many small
businesses (particularly those meeting the retail de minimis
exception to the uniform capitalization rules) are currently
able to use their financial statement inventory numbers on
their tax returns. Since the LCM method will still be required
for financial reporting, it will no longer be possible for
these taxpayers to use financial statement inventory on their
returns. Market writedowns will have to be segregated for
proper reporting as a book-tax difference. Thus, especially for
small business, there will be a disproportionate additional
cost of compliance on top of the added tax cost for not being
able to use LCM.
We believe, therefore, it is imperative that there be a
meaningful small business exception if LCM is repealed. The
Administration proposal includes a small business exception
modeled on present Code section 448 (ability to use the cash
basis of accounting), which holds that the provisions are not
applicable to businesses that average less than $5 million
annual gross receipts (not to be confused with gross income,
which can be a substantially lower number) over a three-year
period. Since, however, we are considering an inventory method
change, and inventories generally turn over several times a
year, it could be a very small business indeed which meets a $5
million gross receipts test. Accordingly, we think it essential
that, if a gross receipts exemption is used, it should be at
least at the $10 million level, rather than $5 million. In
fact, the most recent de minimis statutory rule involving
inventories is the so-called ``retail exception'' in the
uniform capitalization rules, and it is at a $10 million gross
receipts level. Alternatively, Congress might consider a $5
million gross income de minimis rule (which would be gross
receipts less cost of sales).
II.H.1--Subject Investment Income of Trade Associations to Tax
The President's budget proposals would impose a corporate-
rate tax on ``net investment income'' of section 501(c)(6)
organizations (trade associations and other business leagues).
Our comments on this proposal are clearly made in our members'
interests as well as for tax policy reasons: the AICPA is a
section 501(c)(6) organization and it does have investment
income which would be subject to this new proposed tax.
Nonetheless, we question the policy basis on which the
proposals are being put forth. It is implied that current law
provides an incentive to fund association operations on a tax-
free basis (through the build up of non-taxed investment
assets) because members receive a deduction for dues payments
but would have been taxed on the earnings attributable to those
payments had the payments not been made to a 501(c)(6)
organization. Thus, according to the Treasury Department
General Explanation of the Administration's Revenue Proposals,
members are ``avoiding tax'' on the earnings from their dues.
While we understand the theoretical basis for this
argument, it just does not comport with business reality. No
business is going to view dues payments to a trade association
as a prudent means of sheltering income from tax, on the
grounds that earnings on the payments are tax free if for the
account of the association but taxable if for the account of
the member. In order to get the benefit of this ``shelter,''
the member has to actually pay over money to the association,
which puts those funds absolutely outside the members'
control--a fairly ludicrous business decision if the thinking
behind the extra or advance payment is the avoidance of income
tax.
We would also note that associations accumulate surplus not
to accelerate deductions or provide tax deferrals, but because
it is prudent business practice. By providing cushions against
membership fall-off in times of economic decline, for example,
an association is able to protect against annual dues
fluctuations. And, as an organization which relies
predominantly on member dues to fund its exempt purposes, the
AICPA is very much aware of member sensitivity to annual
changes in dues. Associations need to provide a stable dues
structure to smooth out member fall-off and increases from year
to year (which, in turn, affects the association's annual
operating budget for its normal activities). Further, prudence
dictates that there be some cushion available for unanticipated
business issues that arise during a year. (We do recognize that
there is a $10,000 exemption from the proposed tax, but that
amount applies equally to associations with 250 members and
250,000 members. Even for taxable entities (corporations), the
Code permits earnings to be accumulated for the ``reasonable
needs of the business'' before a penalty tax is imposed.)
Finally, we note that the Joint Committee on Taxation has
estimated this provision as a $698 million revenue raiser over
five years and a $1.6 billion revenue raiser over ten years. We
do not know the basis of those revenue estimates, but we would
point out that for any association that becomes subject to this
additional tax, it will either have to curtail services to
members or raise member dues to fund the tax. Those dues
increases will result in additional deductible payments by
members, with a concomitant reduction in federal revenues.
II.I.6--Eliminate Non-business Valuation Discounts
The administration's proposal would eliminate valuation
discounts except as they apply to active businesses. This
proposal is built upon the presumption that there is no reason
other than estate tax avoidance for the formation of a family
limited partnership (FLP). We disagree. There are any number of
other reasons why a taxpayer might wish to set up an FLP
including: management of assets in case of incompetency,
increased asset protection, the reduction of family disputes
concerning the management of assets, to prevent the undesired
transfer of a family member's interests due to a failed
marriage, and to provide flexibility in business planning not
available through trusts, corporations or other business
entities.
The beneficiaries of FLPs do not receive control over the
underlying assets and generally have no say as to the
management of those assets. Individuals receiving non-public,
non-tradeable interests in a legally binding arrangement are
not in as good a position as they would have been if they had
received the underlying assets outright. Substantial economic
data indicate that the value of these interests is less than
the value of the underlying assets. Valuation discounts are a
legitimate method of recognizing the restrictions faced by
holders of FLP interests.
The wholesale change to the taxation of these entities is
unreasonable and too broad. It assumes that FLPS are used only
to avoid transfer taxes and disregards the non-tax reasons for
their formation and the fact that these non-tax reasons do
reduce the value of these interests to owners. In addition, the
Internal Revenue Service already has tools to combat abuses in
this area including valuation penalties, disclosure
requirements on gift tax returns, and the ability to examine
the business purpose of FLPs.
II.I.7--Eliminate Gift Tax Exemption for Personal Residence Trusts
The administration's proposal would repeal the personal
residence exception of section 2702(a)(3)(A)(ii). If a
residence is used to fund a GRAT or a GRUT, the trust would be
required to pay out the required annuity or unitrust amount;
otherwise the grantor retained interest would be valued at zero
for gift tax purposes.
The reasons for change include the inconsistency in the
valuation of a gift made to a remainderman in a personal
residence trust and in transactions not exempt from section
2702 and that the use value of a residence is a poor substitute
for an annuity or unitrust interest. Because the grantor
ordinarily remains responsible for the insurance, maintenance
and property taxes on the residence, the administration
contends that the actuarial tables overstate the value of the
grantor's retained interest in the property.
In reply to the proposal, we would note that the present
rules pertaining to personal residence trusts were enacted by
Congress in 1990 as a specific statutory exception to the
general rules of section 2702 to provide a mechanism for
taxpayers to transfer a personal residence to family members
with minimal transfer tax consequences. The proposal ignores
the longstanding protected and preferred status the personal
residence has held throughout the tax code. Examples of this
status include the exemption provided to personal residences at
the time section 2702 was originally enacted, maintenance of
the itemized deduction for real estate taxes and mortgage
interest on personal residences as provided in the Tax Reform
Act of 1986 and the homestead exemption provided in the
bankruptcy statutes. The acquisition and ownership of the
personal residence has long been acknowledged as being central
to the ``realization of the American dream'' and should
continue to be protected and encouraged. In fact, it can be
argued that the personal residence, or at least some portion of
the value thereof, should be excluded from the transfer tax
base altogether.
In addition, we dispute the contention that the use value
of a residence is significantly less than the value of an
annuity or unitrust interest. Commonly, real estate investments
are predicated upon an assumed return (capitalization rate)
ranging from 12%-15%. Even allowing for the payment of
insurance, maintenance and property taxes expenses by the
grantor and considering also that residential real estate
appreciates on average by approximately 2% per year, it can be
argued that the use value of the residence should be 7%-10% of
the value of the property. As such, it can be argued that the
actuarial tables do, in fact, assign an appropriate value to
the grantor's retained interest.
The current law does not permit abusive application of the
personal residence trust technique. Recently finalized
regulations (Reg. Sec. 25.2702-5) prohibit the sale of the
residence back to the grantor thus eliminating use of the
technique as a means to circumvent the rules regarding GRATs
and GRUTs. Furthermore, restrictions on the amount of property
adjoining the residence which may be placed into a personal
residence trust eliminate the technique as a means to transfer
investment real estate on a tax-protected basis.
II.L.2 and 4--Compliance Provisions Relating to Penalties
We take no position the merits of these proposals, but
oppose their enactment before completion of the penalty studies
being conducted independently by the Joint Committee on
Taxation and the Department of the Treasury. As was noted when
Congress last overhauled our penalty system in 1989, a
piecemeal approach to enacting penalties over the years causes
a complex collection of penalties that are not rationally
related to a taxpayer's conduct and not understood by
taxpayers. This does not encourage taxpayers to modify their
behavior in the intended way, and causes taxpayer frustration
when applied.
With penalty studies already underway, we believe these
provisions should be studied and considered as part of overall
penalty reform legislation. Deferring enactment now would help
assure that these penalties were consistent and rational in a
reformed penalty system and could avoid a possible extra round
of penalty changes in these areas. The AICPA has commented to
Treasury on its penalty study and would be happy to work with
Congress to develop a simple, fair and rational penalty system.
II.L.3--Repeal Exemption for Withholding on Certain Gambling Winnings
We disagree with the proposal to require withholding on
bingo and keno winnings in excess of $5,000. Because gambling
winnings are taxable only to the extent that they exceed
gambling losses, this proposal could result in over-withholding
by not taking into account gambling losses, particularly for
smaller ``winners.'' The currently required reporting of these
winnings on Form 1099 should be sufficient to promote and track
compliance in most cases. For the unusual large winner, say
$100,000 or more, withholding would more likely be appropriate.
Chairman Archer. Thank you, Mr. Lifson. We will be looking
carefully at all of your written suggestions and criticisms.
Mr. Olson, if you will identify yourself for the record, you
may proceed.
STATEMENT OF MICHAEL S. OLSON, CERTIFIED ASSOCIATION EXECUTIVE,
PRESIDENT AND CHIEF EXECUTIVE OFFICER, AMERICAN SOCIETY OF
ASSOCIATION EXECUTIVES
Mr. Olson. Thank you, Mr. Chairman, distinguished Members
of the Committee. My name is Michael Olson. I am president and
chief executive officer of the American Society of Association
Executives. ASAE is an individual membership organization made
up of approximately 25,000 association executives and associate
members who are managing over 11,000 of America's trade
associations and professional societies.
And I am here representing that membership today, Mr.
Chairman, opposing the specifics of the budget proposal
submitted by the Clinton administration that would tax the net
investment income of the 501(c)(6) association community to the
extent their net income exceeds $10,000 a year.
It does this by subjecting the income to the unrelated
business income tax, or UBIT. Income that would be subject to
taxation, however, is not as narrow as one might expect from
the administration term investment income. It actually includes
virtually all passive income, including rent, royalties,
capital gains, interest, and dividend revenues.
America's trade, professional, and philanthropic
associations are an integral part of our society in this
country. They allocate one of every four dollars they spend to
member education and training, and public information
activities in their respective communities. These same
associations fuel America's prosperity by pumping billions of
dollars into the economy and creating literally hundreds of
thousands of jobs.
Importantly, associations perform many quasigovernmental
functions. These include the areas of product performance and
safety standards, continuing education, public information,
professional standards, ethics, research, statistics, political
education, and community service.
Without associations, the government and other institutions
would face added and expensive burdens in order to perform
these very essential functions.
The administration has suggested that its proposal would
only affect a small percentage of associations, that it only
applies to lobbying organizations, and that it somehow provides
additional tax benefits to those members who pay dues to these
associations.
Every one of these assertions is misleading and incorrect.
ASAE estimates that this proposal will tax virtually all
associations with annual operating budgets as low as $200,000 a
year, hardly organizations of considerable size. In fact, the
bulk of the organizations affected by this proposal would
include associations at the State and local level, many of whom
perform little if any lobbying functions.
Furthermore, existing law already eliminates any tax
preference, benefit, or subsidy for the lobbying activities of
these organizations. The primary argument the administration
has used to support its proposal is that members of these
(c)(6) organizations somehow have come up with a scheme to
prepay their dues in order to enjoy a tax-free return on the
investment. This argument, quite frankly, is absurd.
There is every incentive for trade and professional
associations to keep their membership dues as low as possible,
and to suggest that members wish to be overcharged in order to
somehow enjoy a tax-free return on investment is both illogical
and unrealistic. Furthermore, there is no way that the
suspected investment strategy could benefit members since
501(c) organizations are prohibited from paying dividends, not
to mention the prohibition against any individual inurement.
In many ways, this proposal attacks the basic tax-exempt
status of associations and runs counter to the demonstrated
commitment of Congress to furthering the purposes of tax-exempt
organizations. The administration has singled out 501(c)(6)
organizations, although there are 25 categories of 501(c)
organizations. And they propose to treat them in the same
manner as social clubs, which are organized for the private
benefit of individual members.
If Congress enacts this proposal, it will alter in a
fundamental way the tax policy that has governed the tax-exempt
community for nearly a century and will set a dangerous
precedent for further changes in tax law for all tax-exempt
organizations.
In closing, Mr. Chairman, I would like to say to you and
the Committee Members how tremendously pleased I and ASAE as an
organization are that 28 Members of this Committee have written
to the Chairman and Ranking Member expressing their opposition
to this specific administration proposal, and we hope you would
make that a part of the record along with our testimony.
Thank you for your courtesy, sir.
[The prepared statement follows:]
Statement of Michael S. Olson, Certified Association Executive,
President and Chief Executive Officer, American Society of Association
Executives
Mr. Chairman, my name is Michael S. Olson, CAE. I recently
became the President and Chief Executive Officer of the
American Society of Association Executives (ASAE). ASAE is an
individual membership society made up of 24,700 association
executives and suppliers. Its members manage more than 11,000
leading trade associations, individual membership societies,
and other voluntary membership organizations across the United
States and in 48 countries around the globe. ASAE also
represents suppliers of products and services to the
association community.
I am here to testify in strong opposition to the budget
proposal submitted to Congress by the Clinton Administration
that would tax the net investment income of Section 501(c)(6)
associations to the extent the income exceeds $10,000 annually.
Income that would be subject to taxation, however, is not as
narrow as would be expected from the characterization in the
proposal of ``investment income'' but includes all ``passive''
income such as rent, royalties, interest, dividends, and
capital gains. This provision, which is estimated by the
Treasury Department to raise approximately $1.4 billion dollars
over five years, would radically change the way revenue of
these tax-exempt organizations is treated under federal tax
law. In addition, if enacted this proposal would jeopardize the
very financial stability of many Section 501(c)(6)
organizations.
America's trade, professional and philanthropic
associations are an integral part of our society. They allocate
one of every four dollars they spend to member education and
training and public information activities, according to a new
study commissioned by the Foundation of the American Society of
Association Executives. ASAE member organizations devote more
than 173 million volunteer hours each year--time valued at more
than $2 billion--to charitable and community service projects.
95 percent of ASAE member organizations offer education
programs for members, making that service the single most
common association function. ASAE member associations are the
primary source of health insurance for more than eight million
Americans, while close to one million people participate in
retirement savings programs offered through associations.
Association members spend more than $1.1 billion annually
complying with association-set standards, which safeguard
consumers and provide other valuable benefits. Those same
associations fuel America's prosperity by pumping billions of
dollars into the economy and creating hundreds of thousands of
good jobs. Were it not for associations, other institutions,
including the government, would face added burdens in the areas
of product performance and safety standards, continuing
education, public information, professional standards, ethics,
research and statistics, political education, and community
service. The work of associations is woven through the fabric
of American society, and the public has come to depend on the
social and economic benefits that associations afford.
The Administration has suggested that their proposal would
only affect a small percentage of associations, that it is
targeted to larger organizations, that the proposal targets
``lobbying organizations,'' and that it somehow provides
additional tax benefits to those who pay dues to associations.
All of these assertions are misleading, ill-informed and
incorrect.
Based on information from ASAE's 1997 Operating Ratio
Report, this proposal will tax most associations with annual
operating budgets as low as $200,000, hardly organizations of
considerable size. In fact, the bulk of the organizations
affected would include associations at the state and local
level, many of whom perform little if any lobbying functions.
Furthermore, existing law, as outlined below, already
eliminates any tax preference, benefit, or subsidy for the
lobbying activities of these organizations, and can even unduly
penalize their lobbying.
The primary argument the Administration has used to support
its proposal is that members of Section 501(c)(6) organizations
prepay their dues in order to enjoy a tax-free return on
investment. This argument, quite frankly, is absurd and is
discussed below in full. There is every incentive for trade and
professional associations to keep dues as low as possible for
obvious reasons, and to suggest that members wish to be
overcharged in order to somehow enjoy a tax-free return on
investment is both illogical and unrealistic. Furthermore,
there is no way that this suspected investment strategy could
benefit members since Section 501(c)(6) organizations are
prohibited from paying dividends.
In many ways, this proposal attacks the basic tax-exempt
status of associations, and runs counter to the demonstrated
commitment of Congress to furthering the purposes of tax-exempt
organizations. These exempt purposes, such as training,
standard-setting, and providing statistical data and community
services, are supported in large part by the income that the
Administration's proposal would tax and thereby diminish. If
Congress enacts this proposal, it will alter in a fundamental
way the tax policy that has governed the tax-exempt community
for nearly a century, and will set a dangerous precedent for
further changes in tax law for all tax-exempt organizations.
I would now like to review more completely the existing tax
law governing this area, and to specifically address some of
the arguments that have been made in support of the
Administration's proposal. I believe that a careful
consideration of the issues involved will make the Committee
conclude that this proposal is both ill-advised and ill-
conceived, and should be rejected.
I. Taxation of Section 501(c)(6) Organizations Under Current Law.
Section 501(c)(6) organizations are referred to in the tax
law as ``business leagues'' and ``chambers of commerce.'' Today
they are typically known as trade associations, individual
membership societies, and other voluntary membership
organizations. These organizations are international, national,
state, and local groups that include not only major industry
trade associations but also small town merchants' associations
or the local Better Business Bureau. Currently, the tax law
provides that Section 501(c)(6) organizations are exempt from
federal taxation on income earned in the performance of their
exempt purposes. Associations engage primarily in education,
communications, self-regulation, research, and public and
governmental information and advocacy. Income received from
members in the form of dues, fees, and contributions is tax-
exempt, as are most other forms of organizational income such
as convention registrations and publication sales. However,
Section 501(c)(6) groups and many other kinds of exempt
organizations are subject to federal corporate income tax on
revenues from business activities unrelated to their exempt
purposes (``;unrelated business income tax'' or ``UBIT''). UBIT
is applicable to income that is earned as a result of a
regularly-carried-on trade or business that is not
substantially related to the organizations' tax-exempt
purposes. Section 501(c)(6) organizations are also subject to
specific taxes on any income they spend on lobbying activities.
The UBIT rules were designed to prevent tax-exempt
organizations from gaining an unfair advantage over competing,
for-profit enterprises in business activities unrelated to
those for which tax-exempt status was granted. Congress
recognized, however, that Section 501(c)(6) tax-exempt
organizations were not competing with for-profit entities or
being unfairly advantaged by the receipt of tax-exempt income
from certain ``passive'' sources: rents, royalties, interest,
dividends, and capital gains. Tax-exempt organizations use this
``passive'' income to further their tax-exempt purposes and to
help maintain modest reserve funds--to save for necessary
capital expenditures, to even out economic swings, and the
like. Indeed, the legislative history regarding UBIT recognizes
that ``passive'' income is a proper source of revenue for
charitable, educational, scientific, and religious
organizations [Section 501(c)(3) organizations], issue advocacy
organizations [Section 501(c)(4) organizations], and labor
unions and agricultural organizations [Section 501(c)(5)
organizations], as well as trade associations, individual
membership societies, and other voluntary membership
organizations [Section 501(c)(6) organizations].
Therefore, Congress drafted the tax code to expressly
provide that UBIT for most tax-exempt organizations does not
extend to ``passive'' income. As a result, exempt organizations
such as associations are not taxed on rents, royalties,
dividends, interest, or gains and losses from the sale of
property. The proposal to tax ``net investment income'' of
Section 501(c)(6) organizations would allow the IRS to impose a
tax on all such previously untaxed sources of ``passive''
income. Contrary to its denomination, the scope of the tax is
clearly much broader than just ``investment income.''
II. Taxation of Section 501(c)(6) Organizations Under the
Administration Budget Proposal: Treating Professional Associations Like
Social Clubs.
Under the Administration's proposal, Section 501(c)(6)
organizations would be taxed on all ``passive'' income in
excess of $10,000. This proposed tax would not be imposed on
exempt income that is set aside to be used exclusively for
charitable and educational purposes. Funds set aside in this
manner by Section 501(c)(6) organizations could be taxed,
however, if those funds are ultimately used for these purposes.
In addition, the proposal would tax gains realized from the
sale of property used in the performance of an exempt function
unless the funds are reinvested in replacement property.
Essentially, the budget proposal would bring Section
501(c)(6) organizations under the same unrelated business
income rules that apply to Section 501(c)(7) social clubs,
Section 501(c)(9) voluntary employees' beneficiary
associations, and Section 501(c)(20) group legal services
plans. These organizations receive less favorable tax treatment
due to Congress' belief that they have fundamentally different,
and less publicly beneficial purposes than other tax-exempt
organizations. The Clinton Administration proposes to equate
trade associations, individual membership societies, and other
such voluntary membership organizations with country clubs,
yacht clubs, and health clubs.
Social clubs, for example, are organized under Section
501(c)(7) for the pleasure and recreation of their individual
members. As case law and legislative history demonstrate,
social clubs were granted tax exemption not to provide an
affirmative tax benefit to the organizations, but to ensure
that their members are not disadvantaged by their decision to
join together to pursue recreational opportunities. Receiving
income from non-members or other outside sources is therefore a
benefit to the individual members not contemplated by this type
of exemption.
With regard to associations exempt under Section 501(c)(6),
however, Congress intended to provide specific tax benefits to
these organizations to encourage their tax-exempt activities
and public purposes. These groups are organized and operated to
promote common business and professional interests, for example
by developing training material, providing volunteer services
to the public, or setting and enforcing safety or ethical
standards. In fact, the tax code prohibits Section 501(c)(6)
organizations from directing their activities at improving the
business conditions of only their individual members. They must
enhance entire ``lines of commerce;'' to do otherwise
jeopardizes the organizations' exempt status. Social clubs have
therefore long been recognized by Congress as completely
different from professional associations, engaged in different
activities that merit a different exempt status.
Social clubs have always been taxed differently from
associations. This reflects their different functions. Social
clubs are organized to provide recreational and social
opportunities to their individual members. Associations are
organized to further the interests of whole industries,
professions, and other fields of endeavor. ``Passive'' income
received by an association is reinvested in tax-exempt
activities of benefit to the public, rather than in
recreational/social activities for a limited number of people.
Applying the tax rules for social clubs to associations imposes
unreasonable and unwarranted penalties on those organizations.
For example, under the Administration's proposal, these
organizations would be taxed on all investment income unless it
is set aside for charitable purposes. Income that is used to
further other legitimate organizational activities of value to
the industry, the profession, and the public would therefore be
taxed. In addition, the proposal would tax these organizations
on all gains received from the sale of property unless those
gains are reinvested in replacement property. This tax on gains
would apply to real estate, equipment, and other tangible
property. It would also apply, however, to such vastly diverse
assets as software, educational material developed to assist an
industry or profession, certification and professional
standards manuals, and other forms of intellectual property
which further exempt purposes.
It is important to note that the Administration's proposal
targets only Section 501(c)(6) organizations. No other
categories of tax-exempt organizations would be taxed in this
proposal. The Administration's proposal inappropriately seeks
to impose the tax scheme designed for Section 501(c)(7) social
and recreational clubs only on Section 501(c)(6) associations.
Congress has recognized that organizations exempt in these
different categories serve different purposes and long ago
fashioned a tax exemption scheme to reflect these differences.
The Administration's proposal runs counter to common sense and
would discourage or prevent Section 501(c)(6) organizations
from providing services, including public services, consistent
with the purposes for which these associations were granted
exemption.
III. Taxation of Association Lobbying Activities.
The Clinton Administration's proposal has been
characterized by the Secretary of the Treasury as a tax on
``lobbying organizations,'' suggesting that associations
somehow now enjoy a favored tax status for their lobbying
activities. This is incorrect. Many associations do not conduct
any lobbying activity. Moreover, the lobbying activities of
associations have no tax preferences, advantages, or subsidies
whatsoever; the funds are fully taxed by virtue of the Omnibus
Budget Reconciliation Act of 1993. That law imposed a tax on
all lobbying activities of trade and professional associations,
either in the form of a flat 35% tax on all funds that the
organization spends on lobbying activities, or as a pass-
through of non-deductibility to individual association members.
Indeed, not only is there no tax benefit or tax exemption
for associations' lobbying activities, either for the members
or for the entities themselves, but the 1993 law provides a tax
penalty on any funds used to lobby. Lobbying tax penalties can
arise in essentially three ways:
1. Proxy Tax. The ``proxy'' tax, an alternative to
informing association members of dues non-deductibility because
of association lobbying, is set at a flat 35% level. This is
the highest level of federal income tax for corporations, paid
only by corporations with net incomes over $18.33 million.
Associations are denied the ``progressivity'' of the income tax
schedule. Therefore, even though no associations ever achieve
nearly that level of income, they must pay the proxy tax as if
they did.
2. Allocation Rule. Under the ``allocation rule,'' all
lobbying expenses are allocated to dues income to determine the
percentage of members' dues that are non-deductible. Most
associations pay for their lobbying expenses using many sources
of income. Increasingly, associations have far more non-dues
income than dues income. The allocation rule, however, requires
association members to pay tax on all association income used
to conduct lobbying activities, regardless of the percentage of
lobbying actually paid for from their dues. Indeed, under the
``allocation rule,'' a business can pay more tax if it joins an
association that lobbies for a particular government policy
than if the business had undertaken the lobbying itself.
3. Estimation Rule. The ``estimation rule'' requires that
associations estimate in advance how much dues income and
lobbying expense they anticipate. The estimation forms the
basis for the notice of dues non-deductibility, which must be
given at the time of dues billing or collection. If reality
turns out to be different from the estimates, the association
or its members are subject to very high penalties. There is no
way to ensure freedom from the penalty for underestimating
short of ceasing to spend money on lobbying the moment the
association reaches its estimate. There is no way to avoid the
penalty for overestimating at all.
Associations are therefore already subject to more than tax
neutrality and absence of exemption or subsidy for lobbying
activities. The Administration's proposal would not make any
provision with respect to lobbying activities of these
associations, although it would certainly generally weaken the
financial resources of associations and reduce their ability to
assist industries, professions, and the public. Indeed, the
Administration's characterization of the proposal as one that
addresses ``lobbying organizations'' is tantamount to an
Administration decision to further weaken and suppress the
ability of tax-exempt organizations to lobby at all.
IV. Taxation of Member Dues.
The Administration's proposal has also been justified by
its proponents as eliminating a double tax advantage claimed to
be enjoyed by dues-paying association members. According to the
Administration, association members already receive an
immediate deduction for dues or similar payments to Section
501(c)(6) organizations. At the same time, members avoid paying
taxes on investment income by having the association invest
dues surplus for them tax-free.
This argument is flawed for a variety of reasons:
The argument implies that members voluntarily pay
higher dues than necessary as an investment strategy. While in
some circumstances members of tax-exempt associations can
deduct their membership dues like any other business expense,
members receive no other tax break for dues payments. As
discussed above, they are in fact denied a deduction for any
amount of dues their association allocates to lobbying
expenses.
The argument implies that associations overcharge
their members for dues, thereby creating a significant surplus
of dues income. In fact, dues payments usually represent only a
portion of an association's income; and dues are virtually
always determined by a board or committee consisting of
members, who would hardly tolerate excessively high dues.
Finally, associations tend to maintain only modest surpluses to
protect against financial crises, expending the rest on
programs and services. Again, associations are member-governed;
members would typically make certain that their associations do
not accumulate a surplus beyond the minimum that is necessary
and prudent for the management of their associations.
The argument assumes that Section 501(c)(6)
organizations somehow pay dividends to their members. Tax-
exempt organizations do not pay dividends or returns in any
form to their members, let alone for payment of dues. Indeed,
an organization's exempt status may be revoked if any portion
of its earnings are directed to individuals.
In other words, the Administration suggests that
association members are voluntarily paying higher than
necessary dues, solely to avoid paying tax on their own
investment income resulting when not all dues revenues are
expended immediately. This is the same as suggesting that
individuals donate to charities in hopes that the charities
will earn investment income on un-spent donations. It is an
argument that defies common sense and completely misunderstands
the structure and operation of tax-exempt organizations.
V. Expenditures Attributed to Investment and Other ``Passive'' Income
Would Generally Qualify As Deductible Expenses If Incurred by Members
of the Association.
The investment income and other ``passive'' income of
associations is used to further the exempt purpose of the
organizations. Most if not all of these expenditures for
association programs and activities, which are made on behalf
of the association's members, would be deductible if carried on
directly by the members. This is because these expenses would
otherwise be regarded as ordinary and necessary business
expenses under Section 162(a) of the tax code or as a
charitable contribution. Therefore, it is inappropriate to
essentially deny this deduction by imposing the UBIT tax on
this income. Under the Administration's proposal, this would in
fact be the indirect result of subjecting the ``passive''
income of Section 501(c)(6) organizations to taxation.
VI. The Administration's Proposed Tax Would Reach All Forms of
``Passive'' Income and Jeopardize Tax-Exempt Programs.
Trade associations, individual membership societies, and
other similar voluntary membership organizations typically
receive only a portion of their income from membership dues,
fees, and similar charges. In many such organizations,
particularly professional societies, there are natural limits
or ``glass ceilings'' on the amounts of dues that can be
charged to members. As a result, these Section 501(c)(6) tax-
exempt organizations have increasingly sought additional
sources of income to enable them to continue their often broad
programs of exempt activities on behalf of businesses,
professions, and the public. One of those additional sources
has been ``passive'' income--rents, royalties, dividends,
interest, and capital gains--that may be earned from a variety
of sources.
Section 501(c)(6) organizations rely heavily on ``passive''
income to support their exempt activities. The proposal would
adversely affect virtually all associations, since most
organizations from time to time receive some amount of rents,
royalties, interest, dividends, or capital gains. These
associations use ``passive'' income to further a host of
beneficial activities which would be threatened by imposition
of the Clinton Administration's ``investment'' tax. For
example, Section 501(c)(6) tax-exempt associations are
responsible for:
Drafting and disseminating educational materials.
Establishing skills development seminars and
programs.
Creating training and safety manuals for various
professions.
Producing books, magazines, newsletters, and other
publications.
Increasing public awareness, knowledge, and
confidence in an industry's or a profession's practices.
Conducting and sponsoring industry research and
surveys.
Compiling statistical data for industries and
professions which is often requested or relied upon by
government.
Providing professionals and businesses with new
technical and scientific information.
Developing and enforcing professional safety and
health standards.
Developing and enforcing ethical standards for
industry practice.
Operating accreditation, certification, and other
credentialing programs.
Organizing and implementing volunteer programs.
The Administration's proposal imposes a broad-based,
pervasive, and detrimental penalty on virtually all
associations of any kind or size. A tax on the ``investment
income'' of Section 501(c)(6) organization does not address any
issue of income used for lobbying activities; all such
activities by these organizations is already free of tax
exemption or subsidy of any kind (indeed, it can be subject to
offsetting ``penalty'' taxation). There is no double or special
tax benefit to those who pay dues to associations. Instead the
Administration's proposal taxes significant sources of funding
that associations use now for highly desirable services to
entire industries, professions, and the public. Treating
Section 501(c)(6) organization in the same manner as social
clubs ignores the special, quasi-public purposes and functions
of associations, and threatens the ability of such
organizations to continue to provide publicly beneficial
services in the future. In summary, this proposal is a
legitimate threat, albeit ill-conceived, to the ongoing
viability of thousands of America's membership organizations,
and should be rejected by this Committee.
Thank you for this opportunity to testify before you today.
I would be happy to supplement this testimony with answers to
any questions you may have.
Chairman Archer. Without objection, so ordered. The chair
appreciates the testimony of all four of you. Specifically, I
would like to ask Mr. Lifson and Mr. Tucker, who I think
represent some of the finest talent, experience, and expertise
in dealing with the Tax Code. I understand that you both are
concerned about the complexity of the tax-relief proposals.
However, I don't want to get into any of those issues for this
question. Relative to the President's budget, which, if any, of
the administration's revenue-raising proposals could you
support and feel was justified by tax policy?
Mr. Tucker. We clearly can support the focus on corporate
tax shelters. We think----
Chairman Archer. That is mentioned in your testimony,
correct?
Mr. Tucker. Right. Sixteen provisions are too many. They
are too complex. We think there needs to be a straight focus on
disclosure, but we can support the focus on that as long as it
does not eliminate legitimate business transactions for which
there is a business purpose.
Chairman Archer. Have you been able to examine in detail
the administration's proposal on tax shelters?
Mr. Tucker. We have, and we are doing it. We have set up a
task force to work specifically with the----
Chairman Archer. But you have not reached a conclusion
about the details of that proposal?
Mr. Tucker. No, sir.
Chairman Archer. All right. Well, we will be happy to have
your input when you do reach that conclusion.
Mr. Tucker. We will be glad to.
Chairman Archer. Which, if any, other revenue-raiser in the
President's budget would either one of you support?
Mr. Lifson. The only area that we feel extreme concern
about is the treatment of tax-indifferent parties, which I
think is part of the 16 specific areas, or the tax-shelter
area. We have no position yet on any of the other revenue-
raisers. We are working on a supplemental submission at this
time.
Chairman Archer. So you are not in a position to either
support or oppose all of the other revenue-raisers?
Mr. Lifson. Correct.
Chairman Archer. How soon do you think you might conclude
your analysis?
Mr. Tucker. We can get back to you within a couple of
weeks. We have no problem going through that in detail.
Chairman Archer. Fine. That would be very helpful. Thank
you.
Mr. Doggett.
Mr. Doggett. Thank you, Mr. Chairman. Let's see, Mr.
Sinclaire, I believe that in your written testimony you
outlined nine different forms of tax cuts that you favor for
business. What would be the cost of those to the Treasury.
Mr. Sinclaire. I do not have a revenue estimate on those
items.
Mr. Doggett. You do not have a----
Mr. Sinclaire. No, I do not.
Mr. Doggett. Is it something you could supply the
Committee?
Mr. Sinclaire. We do not have any basis to develop revenue
estimates. We would rely on revenue estimates that come from
the Joint Committee.
Mr. Doggett. And in addition to those nine specific forms,
did I understand your oral testimony to be that you favor
repealing all taxes on corporate profits?
Mr. Sinclaire. No.
Mr. Doggett. You do not? Your focus is on these nine
specific forms?
Mr. Sinclaire. That is not the complete list. There are
other items where we support tax reform such as extension of
section 127, items of that nature, the WOTC, the welfare-to-
work tax credit. Also, there are other items. This is not an
exclusive list of items.
Mr. Doggett. One gets the impression from the Forbes
article that I referenced earlier and from other sources, that
some corporate officials are actually being harassed into using
these tax shelters by what are referred to as tax-shelter
hustlers. Do you find that to be a problem?
Mr. Sinclaire. The Chamber does not provide tax advice----
Mr. Doggett. The Chamber took a position on these nine
forms of tax cuts. Do you think that it is important to address
this problem of tax hustlers and the whole problem of tax
shelters and tax avoidance?
Mr. Sinclaire. When there is an abusive situation, the
Chamber does not condone that. So in that sense, yes we would
favor that there be some examination and possible changes.
Mr. Doggett. Mr. Tucker, with reference to your testimony,
is this problem of aggressive positions by tax shelter hustlers
a sizable one in this country?
Mr. Tucker. Whenever you have significant tax reduction
that occurs, not because of business purpose or business-
related, but simply because somebody is marketing a product
that combines different provisions of the Code that were not
intended to be utilized together, we think that does create
problems. When you see the corporate taxes are reduced at the
cost of what could otherwise be benefits for individuals or
small business, then we think, yes, that is still a problem.
Mr. Doggett. And I would suppose that it is also a
professional problem, reflecting on those tax practitioners who
are trying to counsel their clients to comply completely with
the tax law if there is somebody down the street suggesting you
can avoid a significant amount of tax?
Mr. Tucker. Yes, sir.
Mr. Doggett. If I understand one of your specific
recommendations, in which I think you do share with the
Treasury that is mentioned in your testimony, you believe that
it is important that there be penalties not only against the
corporations that might have taken advantage of one of these
improper rackets, but more particularly to focus it on the
people that hustled them into it and sold them on one of these
improper schemes.
Mr. Tucker. Yes, sir, as well as the tax-indifferent party
that may be joining into that scheme.
Mr. Doggett. And you offer that on behalf of your section
even though, I suppose, there may be some, certainly some tax
lawyers in the country, and maybe some members of your section,
that could be subject to these penalties.
Mr. Tucker. We believe that this is a very important set of
provisions for the country as a whole. We recognize that any
time something is done prospectively, you may eliminate certain
very beneficial items to certain people, but we think this is
something that is important for the country.
Mr. Doggett. You mentioned prospectively. Is it important
that there be a capacity to apply some of these penalties
retroactively?
Mr. Tucker. We think that we already have a number of
provisions in the Code, that, if we had the funding for the
Revenue Service to go out and do the proper scrutiny analysis
(when you have substance versus form, when you have the step
transaction theory), the business purpose theory--there are
already a number of points that could be utilized.
What we are really looking at is the ability to have them
look at items because disclosure has been given, and we think
that is important, because even those activities that have
happened in the past could be picked up under these preexisting
judicial and legislative actions.
Mr. Doggett. The Forbes article suggested that just one
firm here in the Washington, DC, area had as many as 40 people
out promoting these kinds of schemes. Just in terms of the
dimension of the problem around the country, are there a
significant number of people involved in promoting questionable
tax schemes around the country?
Mr. Tucker. Legend says that there are. I cannot tell you
whether there are, but we hear that there are numbers of
people, but I certainly could not say who they are or what
numbers there are.
Mr. Doggett. Thank you. Look forward to getting your
report.
Mr. Tucker. Thank you, sir.
Mr. Houghton [presiding]. Mr. Weller.
Mr. Weller. Thank you, Mr. Chairman. Appreciate the panel's
testimony here and recognize we have a vote and we are going to
have to break for a few minutes to go vote. I will try and be
quick.
First, Mr. Lifson, your testimony on simplifying the Code,
I welcome that, and your suggestions and ideas. And not only do
you note that once again the administration in their targeted
tax cuts create more marriage-tax penalties with their phase-
outs. Right now, I think, in addition to the joint filers, the
marriage tax penalty, and then if you add in over 60 additional
marriage penalties that are created by various phase-outs, we
really don't need three or four more, which the administration
proposes adding to complicate the Tax Code even more.
And I would also like to mention in your testimony on page
4 that some suggestions that you propose as we look for ways to
simplify the Tax Code and, of course address some of the
unfairness, you suggest marriage-tax penalty relief, increasing
the amount for personal exemptions, increasing the standard
deduction, and also expanding the 15-percent tax bracket. And I
just want you to urge you to take a look at a tax
simplification package that Rep. Dunn and I have offered, which
we believe simplifies the Code as well as addresses the
unfairness in the Tax Code.
And one of the things we do is we expand the 15-percent
bracket. So a family of four making $55,000 is in the 15-
percent tax bracket, rather than the 28-percent tax bracket as
they are today. Eliminate the marriage penalty, eliminate the
death tax, eliminate tax on retirement savings. And so I
welcome your suggestions and I am anxious to look at this
further.
I recognize because of the vote we are going to have to run
here. But I do want to ask a quick question of Mr. Olson.
Mr. Olson. Yes, sir.
Mr. Weller. The administration is part of the $176 billion
tax increase package that the President proposes in his budget,
includes a new tax on associations, which you referenced in
your testimony. A lot of times when people think of
associations they think of Chamber of Commerce, they think of
the Farm Bureau, they think of the National Federation of
Independent Business. Can you give an example of some of the
smaller groups that--and give an example not only of a smaller
organization, but also the impact of this new tax increase that
the administration wants to impose on the money they have in
the bank account, for example, with the tax on the interest
they would have in the money they would set aside from dues and
that. Could you give an example?
Mr. Olson. I might answer your question in reverse order.
The issue of accruing investments and creating a fund balance
for a nonprofit or tax-exempt organization is important to
understand because it is the result of careful stewardship over
many, many years, and in many instances, decades, of volunteer
leadership, where you are in an environment corporately where
nothing can inure to the benefit of one individual. You have
group stewardship of these resources. So these are not fast,
overnight, quick-buck profits that have been accumulated by a
corporation, these are carefully shepherded investment funds
that have grown through prudent management of member resources
over many years.
Examples of some of the smaller groups that have fund
balances that could be impacted extend to groups like Rotary
clubs, Boy Scouts, Young Republicans, the Democratic Women, of
State organizations, local organizations. Anything with a
(c)(6) in its classification under the Internal Revenue Service
code, and there are over 70,000 such organizations, would be
directly impacted by this.
And the average of these 70-some thousand in terms of the
investment revenues as a part of their total budget runs about
5.5 percent. Regardless of the size budget, the percentage is
about the same. And that is a big part of their operation.
Mr. Weller. Mr. Olson, you indicated, you have just made
the statement that the Young Republicans, the Democratic
Women's Club--I guess I'm running out of time because of this--
you know, one point I would like to make is that, you know,
Secretary Lubick said somehow the individual members will
benefit by the new tax on their organization. And I hope that
you can submit some testimony for the record----
Mr. Olson. We have for the record. It's in our lengthy
preparation. Yes, sir, it is there in detail.
Mr. Weller. Thank you.
Mr. Olson. Thank you for asking.
Mr. Houghton. Gentlemen, I am sorry. We have to vote. We
will have to leave. And then as soon as we have our vote, maybe
votes, we will take a look at our next panel, Mr. Kies,
Weinberger, Wamberg, and Hernandez. Thank you very much for
coming. Sorry we have to push it.
[Recess.]
Chairman Archer [presiding.] The Committee will come to
order. Our next panel, which is our second-to-last panel, is
before us now, and welcome. Mr. Kies, if you will identify
yourself--I know you are relatively unknown [laughter] in this
room--you may proceed.
STATEMENT OF KENNETH J. KIES, MANAGING PARTNER, WASHINGTON
NATIONAL TAX SERVICES, PRICEWATERHOUSECOOPERS LLP
Mr. Kies. Thank you, Mr. Chairman. My name is Ken Kies. I
am a managing partner at PricewaterhouseCoopers, Washington
National Tax Services office. The firm has more than 6,500 tax
professionals in the United States and Canada, and works
closely with thousands of corporate clients worldwide,
including most of the Fortune 500.
I'm here to comment on the administration's corporate tax
shelter proposals, specifically the first six proposals in the
Treasury's list under that section. My comments summarize the
key points of a 50-page analysis we have prepared on these
proposals and which has been made available to the Committee
today.
Our analysis reflects the collective experience of many of
the firm's corporate clients. In our view, these proposals are
overreaching, unnecessary, and at odds with sound tax-policy
principles. In my brief time today, I am going to give you
several reasons why these proposals should be rejected.
First, despite statements made by the administration and
inferences left by the recent Forbes article on tax shelters,
there is no revenue data or other evidence that would suggest
that corporate tax planning is eroding the corporate income tax
base. To the contrary, as CBO data show, corporate income tax
payments as a percentage of GDP over the past 4 years are at
their highest level since 1980, and are projected to remain
there for the next 10 years.
Second, Treasury and IRS already have more than adequate
tools to address perceived abuses. These include numerous tax
penalties, common-law doctrines, like the economic substance
and business purpose doctrine, and more than 70 antiabuse
provisions in the Code today. Treasury also has the ability to
move quickly to respond to perceived abuses by issuing
administrative notices.
Third, Treasury and IRS have not used the tools they
already have. Congress in 1997 enacted legislation broadening
the definition of a tax shelter, subject to stiff penalties. At
that time, Commerce expressly stated that this change would
discourage taxpayers from entering into questionable
transactions.
As of today, Treasury, still has not issued regulations
necessary to activate the 1997 changes. Without having used the
tools that Congress specifically granted in 1997, the
administration is now asking for a new set of tools it believes
are more appropriate.
Fourth, the proposals presented by Treasury are dangerously
vague. They turn on a subjective and, I believe,
unadministerable definition of a tax-avoidance transaction.
This definition could be used by the IRS agents to increase
taxes on a broad range of legitimate business transactions.
The IRS would have the authority simply to deny tax
benefits even for transactions that clearly comply with
substantive tax law.
I believe these proposals, if enacted, would represent the
broadest grant of discretion ever given by a Congress to agents
of the IRS. Ironically, this would come a year after Congress
took action to rein in the power of IRS agents.
Fifth, corporate tax executives have told us that these
proposals would make their jobs nearly impossible. There could
be no certainty as to the tax treatment of complex business
transactions, which are often undertaken across borders and are
subject to a patchwork of laws imposed by U.S., foreign, State,
and local taxing jurisdictions. And let's not forget that these
corporate tax executives are the individuals who are in charge
of collecting more than one-half of the total tax revenue that
fund our government, not only through corporate income tax
payments, but also through individual income tax and payroll
tax withholding and the collection of the bulk of the existing
excise taxes.
Sixth, corporate tax executives are conservative by nature.
In addition to being bound by professional and company-imposed
ethical standards, they have a fiduciary duty to avoid monetary
penalties that could reduce their company's profitability.
Moreover, most corporations are extremely sensitive about
preserving and enhancing their corporate image, thus corporate
tax executives are careful not to recommend a transaction to
their management that later might be reported unfavorably in
the national press.
Because of the extreme complexity of tax rules, corporate
tax executives need assistance from their professional advisers
and other to help determine tax-efficient and prudent ways to
implement business objectives.
Seventh, I believe these proposals would represent a
dramatic shift in the balance between the Congress and
executive branch in terms of tax policymaking. For many years,
Congress and the executive branch have had differing views on
the merits of proposed changes to tax law. As an example, the
current administration in its past three submissions on the
budget, has advanced more than 40 revenue-raising proposals
that have been opposed by the Congress, in many cases on a
bipartisan basis. This is a healthy tension, one that more
often than not yields correct tax policy decisions. The
administration's proposals effectively would ask Congress to
allow the executive branch in the form of the individual IRS
agent to dictate much of tax policymaking.
To conclude, Treasury and the IRS already have more than
ample tools to address situations involving abusive tax
planning. Some tools that you have provided have gathered dust
for 2 years. At this time, I believe there is no demonstrated
need to expand on these tools, particularly in such a way that
would give IRS agents nearly limitless authority to recast the
tax treatment of legitimate business transactions.
I would be happy to answer any questions that you or the
Members of the Committee have, Mr. Chairman. Thank you.
[The prepared statement and attachments follow. Appendices
to the statement are being retained in the Committee files.]
Statement of Kenneth J. Kies, Managing Partner, Washington National Tax
Services, PricewaterhouseCoopers LLP
I. Introduction
PricewaterhouseCoopers appreciates the opportunity to
submit this written testimony to the Committee on Ways and
Means on the revenue-raising proposals included in the
Administration's FY 2000 budget submission.
PricewaterhouseCoopers, the world's largest professional
services organization, provides a full range of business
advisory services to corporations and other clients, including
audit, accounting, and tax consulting. The firm, which has more
than 6,500 tax professionals in the United States and Canada,
works closely with thousands of corporate clients worldwide,
including most of the companies comprising the Fortune 500.
These comments reflect the collective experiences of many of
our corporate clients.
Our testimony focuses on broad new measures proposed by the
Administration relating to ``corporate tax shelters.''
Specifically, these include proposals that would (1) modify the
substantial understatement penalty for corporate tax shelters;
(2) deny certain tax benefits to persons avoiding income tax as
a result of ``tax-avoidance transactions''; (3) deny deductions
for certain tax advice and impose an excise tax on certain fees
received with respect to ``tax-avoidance transactions'' (4)
impose an excise tax on certain rescission provisions and
provisions guaranteeing tax benefits; (5) preclude taxpayers
from taking tax positions inconsistent with the form of their
transactions; and (6) tax income from corporate tax shelters
involving ``tax-indifferent parties.'' \1\
---------------------------------------------------------------------------
\1\ General Explanation of the Administration's Revenue Proposals,
Department of the Treasury, February 1999, pp. 95-105.
---------------------------------------------------------------------------
In our view, these proposals are overreaching, unnecessary,
and at odds with sound tax policy principles. They introduce a
broad and amorphous definition of a ``corporate tax shelter''
that could be used by Internal Revenue Service (Service)
revenue agents to challenge many legitimate transactions
undertaken by companies operating in the ordinary course of
business in good-faith compliance with the tax laws. If enacted
by Congress, these proposals would represent one of the
broadest grants of authority ever given to the Treasury
Department in the promulgation of regulations and, even more
troubling, to Service agents in their audits of corporate
taxpayers.
A. Initial observations.
1. Revenue data shows no erosion of the corporate tax base.
Before turning to our specific concerns with the
Administration's proposals, it is worthwhile to consider
several important points. First, these proposals have arisen in
response to a perception at the Treasury Department that tax-
planning activities are eroding the corporate tax base.\2\ The
facts suggest otherwise. Corporate income tax payments reached
$189 billion in 1998 and are projected by the Congressional
Budget Office (CBO) to grow to $267 billion in the next 10
years.\3\ Projections by the CBO and the Office of Management
and Budget (OMB) show that these corporate revenues will remain
relatively stable as a share of the overall economy in the
coming years. There is no data in the projections of CBO or OMB
to suggest that corporate tax activity will cause corporate tax
revenues to decline in the future.
---------------------------------------------------------------------------
\2\ Budget of the United States Government: Fiscal Year 2000,
Analytical Perspectives, p. 71.
\3\ The Economic and Budget Outlook: Fiscal Years 2000-2009,
Congressional Budget Office, January 1999, p. 53.
---------------------------------------------------------------------------
Moreover, corporate income tax receipts as a percentage of
taxable corporate profits stood at 32.4 percent in 1998 and are
projected to remain relatively constant over the next 10 years
(32.5 percent in 2008).\4\ This is approximately the effective
tax rate that would result by subjecting all corporate taxable
income to the graduated corporate tax rate schedule, which
taxes income at rates starting at 15 percent and increasing to
the top statutory rate of 35 percent.\5\ The CBO measure of the
corporate tax base is based, with minor modifications, on the
economic profits measured by the national income and product
accounts rather than income reported for tax purposes. As a
result, there is nothing in this forecast to suggest that the
corporate tax base is under assault from an imagined new
``market'' in corporate tax shelters.
---------------------------------------------------------------------------
\4\ Ibid.
\5\ Approximately 80 percent of corporate income is earned by
corporations subject to the 35-percent top statutory rate. The largest
7,500 corporations account for approximately 80 percent of all the
corporate income tax collected.
---------------------------------------------------------------------------
In fact, during the past four years corporate income tax
payments as a percentage of gross domestic product have reached
their highest levels since 1980.\6\
---------------------------------------------------------------------------
\6\ The Economic and Budget Outlook: Fiscal Years 2000-2009, supra
n.4., at 131.
2. The proposals are inconsistent with the Congressional view
that the scope of Treasury Department authority should be
---------------------------------------------------------------------------
limited.
The Administration's proposals run counter to the spirit of
recent Congressional actions. In last year's landmark Internal
Revenue Service Restructuring and Reform Act,\7\ Congress
enacted significant new limitations on the authority of Service
agents in audit situations. Now, a mere eight months later, the
Administration is asking Congress to empower agents with broad
authority to ``deny tax benefits'' where they see fit.
---------------------------------------------------------------------------
\7\ Internal Revenue Service Restructuring and Reform Act of 1998,
P.L. 105-208.
---------------------------------------------------------------------------
In last year's Administration budget (for FY 1999),
Treasury asked for expansive authority to ``set forth the
appropriate tax results'' and ``deny tax benefits'' in hybrid
transactions \8\ and in situations involving foreign losses.\9\
Congress dismissed these proposals. The FY 2000 budget
proposals now ask for authority of the same type but
significantly broader than the authorization that Congress
rejected just last year. The Treasury's new proposals thus can
be seen as an attempted end run around earlier failed
initiatives--this time accompanied by the shibboleth of
``stopping tax shelters.''
---------------------------------------------------------------------------
\8\ General Explanation of the Administration's Revenue Proposals,
Department of the Treasury, February 1998, p. 144.
\9\ Id. at 143.
3. Congress in the past has taken actions to stop perceived tax
---------------------------------------------------------------------------
shelter abuses when necessary.
Congress has been alert to perceived tax shelter issues and
has taken a series of actions in the past. In fact, Congress in
1997 enacted legislation \10\ broadening the definition of a
``tax shelter'' subject to stiff penalties under the Internal
Revenue Code and requiring that such arrangements be reported
in writing to the Service.\11\ The Joint Committee on
Taxation's ``Blue Book'' explanation discusses the intent
underlying these changes:\12\
---------------------------------------------------------------------------
\10\ Taxpayer Relief Act of 1997, P.L. 105-34.
\11\ Under the 1997 legislation, the statutory definition of a tax
shelter was modified to eliminate the requirement that the tax shelter
have as ``the principal purpose'' the avoidance or evasion of Federal
income tax; the new law requires only that the tax shelter have as ``a
significant purpose'' the avoidance or evasion of tax. See discussion
in Part IV below of current penalties and registration requirements
applicable to tax shelters.
\12\ Joint Committee on Taxation, General Explanation of Tax
Legislation Enacted in 1997 (JCS-23-97), December 17, 1997, p. 222.
The Congress concluded that the provision will improve
compliance with the tax laws by giving the Treasury Department
earlier notification than it generally receives under present
law of transactions that may not comport with the tax laws. In
addition, the provision will improve compliance by discouraging
---------------------------------------------------------------------------
taxpayers from entering into questionable transactions.
Nineteen months later, the Treasury Department has yet to
implement the new tax shelter reporting rules. To provide fair
notice to taxpayers, Congress made the effective date of these
provisions contingent upon Treasury's issuing guidance on the
new requirements. But as of this date, no such guidance has
been issued. It is totally inappropriate from the standpoint of
sound tax policy that Treasury at this time would request
expanded authority to address the issue of tax shelters when it
has eschewed recent authority explicitly granted by the
Congress on the identical issue.\13\
---------------------------------------------------------------------------
\13\ It should be noted that this unfinished regulation project is
but one of many interpretive projects that the Treasury Department has
not completed; the collective effect of this unfinished work is
considerable uncertainty for corporate taxpayers attempting to comply
with the tax law in good faith. This issue will be discussed further in
these comments, and an illustrative list of unfinished regulation
projects relevant to corporate taxpayers is set forth in Appendix F.
---------------------------------------------------------------------------
Moreover, the Administration's penalty proposals come at
the same time that Treasury and the Joint Committee on
Taxation, as required by the 1998 Internal Revenue Service
Restructuring and Reform Act, are conducting studies reviewing
whether the existing penalty provisions are ``effective
deterrents to undesired behavior.'' \14\ These studies, which
are required to be completed by this summer, are to make any
legislative and administrative recommendations deemed
appropriate. The Treasury proposals, if enacted, would preempt
the careful penalty review process that was designed by the
Congress last year.
---------------------------------------------------------------------------
\14\ P.L. 105-208, sec. 3801.
---------------------------------------------------------------------------
Meanwhile, Congress and Treasury successfully have worked
together to identify specific situations where the tax laws are
being applied inappropriately and to enact quickly substantive
tax-law changes in response. Recent examples include
legislation enacted or introduced relating to liquidations of
REITs or RICs \15\ and transfers of assets subject to
liabilities under section 357(c).\16\ The Administration's FY
2000 budget proposes a series of specific changes in a number
of other areas. Whether or not the tax policy rationales given
by Treasury for these targeted proposals are persuasive, the
appropriate manner in which to curb avoidance potential is for
Congress to deliberate upon specific legislative proposals, and
not to grant broad and unfettered authority to Treasury and
Service revenue agents.
---------------------------------------------------------------------------
\15\ P.L 105-277, sec. 3001 (provision aimed at attempts to read
statutory provisions as permitting income deducted by a liquidating
REIT or RIC and paid to its parent corporation to be entirely tax free
during the period of liquidation).
\16\ A provision addressing the tax treatment of certain transfers
of assets subject to liabilities described in section 357(c) passed the
House February 8, 1999, as part of H.R. 435; an identical provision was
approved by the Senate Finance Committee January 22, 1999, as part of
S. 262. The provisions would apply to transfers on or after October 19,
1998, the date on which House Ways and Means Committee Chairman Bill
Archer introduced legislation on this topic. That legislation was
developed by Chairman Archer in coordination with the Treasury
Department in response to concerns that some taxpayers were structuring
transactions ``to take advantage of the uncertainty'' under the tax
law.
---------------------------------------------------------------------------
Finally, it should be mentioned that the broad grant of
authority in the Treasury Department tax shelter proposals is
totally unnecessary. On several occasions in recent years,
Treasury has determined that administrative actions were
necessary to stop certain perceived avoidance transactions.\17\
While we may not agree that Treasury's action was appropriate
in each instance that such action was taken, it is clear that
no further grant of authority is necessary or warranted from
the Congress on these matters.
---------------------------------------------------------------------------
\17\ Treasury Department activities to stop perceived avoidance
transactions will be discussed in further detail in these comments. An
illustrative list of prior Treasury Department administrative actions
to stop perceived avoidance is set forth in Appendix C.
---------------------------------------------------------------------------
B. Outline of comments.
These comments set forth a number of key considerations
that should be weighed by Congress in evaluating the
Administration's corporate tax shelter proposals:
First, we discuss each of the Administration's
corporate tax shelter proposals, offering a brief critique and
analysis on tax policy grounds.
Second, we explore the potential detrimental
impact of the Administration's proposals on an illustrative
series of legitimate business transactions.
Third, we analyze the existing tools that are
available to the Treasury Department and the Internal Revenue
Service--and Congress--to address tax shelters and other
perceived abuses under the tax system. This discussion includes
an explanation of current-law penalty and disclosure rules;
specific anti-abuse rules; common-law doctrines (e.g.,
``economic substance'' and ``substance over form'') that may be
invoked; and opportunities to address abuses through
legislative action.
Fourth, we discuss the vital role played by
corporations in administering U.S. tax laws--while dealing with
their complexity--and the important responsibilities of
corporate tax directors to their shareholders. These roles and
responsibilities are often overlooked during consideration of
U.S. corporate income tax policy.
Finally, we discuss the role played by accounting
firms in advising corporations on tax issues.
II. ANALYSIS OF ADMINISTRATION S CORPORATE TAX SHELTER PROPOSALS
A. Modify substantial understatement penalty for corporate tax
shelters.
1. Treasury proposal.
The proposal generally would increase the penalty
applicable to a substantial understatement by a corporate
taxpayer from 20 percent to 40 percent for any item
attributable to a ``corporate tax shelter,'' effective for
transactions occurring on or after the date of first committee
action. In addition, the present-law reasonable cause exception
from the penalty would be repealed for any item attributable to
a corporate tax shelter.
A ``corporate tax shelter'' would be defined as any entity,
plan, or arrangement (to be determined based on all facts and
circumstances) in which a direct or indirect corporate
participant attempts to obtain a tax benefit in a tax avoidance
transaction. A ``tax benefit'' would be defined to include a
reduction, exclusion, avoidance, or deferral of tax, or an
increase in a refund, but would not include a tax benefit
``clearly contemplated by the applicable provision (taking into
account the Congressional purpose for such provision and the
interaction of such provision with other provisions of the
Code).''
A ``tax avoidance transaction'' would be defined as any
transaction in which the reasonably expected pre-tax profit
(determined on a present-value basis, after taking into account
foreign taxes as expenses and transaction costs) of the
transaction is insignificant relative to the reasonably
expected net tax benefits (i.e., tax benefits in excess of the
tax liability arising from the transaction, determined on a
present-value basis) of such transaction. In addition, a tax
avoidance transaction would be defined to cover certain
transactions involving the improper elimination or significant
reduction of tax on economic income.
2. Analysis.
This proposal is overbroad, unnecessary, and totally
inconsistent with the goals of rationalizing penalty
administration and reducing taxpayer burdens.
First, the proposal creates the entirely new and vague
concept of a ``tax avoidance transaction.'' The first prong of
the definition of a tax avoidance transaction is styled as an
objective test requiring a determination of whether the present
value of the reasonably expected pre-tax profit from the
transaction is insignificant relative to the present value of
the reasonably expected tax benefits from the transaction.
However, the inclusion of so many subjective concepts in this
equation precludes its being an objective test. As an initial
matter, what constitutes the ``transaction'' for purposes of
this test? Next, what are the parameters for ``reasonable
expectation'' in terms of both pre-tax economic profit and tax
benefits? Further, where is the line drawn regarding the
significance of the reasonably expected pre-tax economic profit
relative to the reasonably expected net tax benefits?
Not only is this prong of the test extremely vague, the
uncertainty is compounded by the second prong of the definition
of tax avoidance transaction. Under this alternative
formulation, certain transactions involving the improper
elimination or significant reduction of tax on economic income
would be considered to be tax avoidance transactions even if
they did not satisfy the profit/tax benefit test described
above. The inclusion of this second prong renders the
definition entirely subjective, with virtually no limit on the
Service's discretion to deem a transaction to be a tax
avoidance transaction.
Second, elimination of the reasonable cause exception would
result in situations where a revenue agent is compelled to
impose a 40-percent penalty even though the agent determines
that (1) there is substantial authority supporting the return
position taken by the taxpayer, and (2) the taxpayer reasonably
believed (based, for example, on the opinion or advice of a
qualified tax professional) that its tax treatment of the item
was more likely than not the proper treatment. If, in that
situation, a revenue agent concluded it would be appropriate to
``waive'' the penalty, the agent could do so only by
determining that the transaction in question was not a
corporate tax shelter, i.e., that the increased penalty was not
applicable. Over time, one clearly unintended consequence of
forcing revenue agents to make such choices might be a skewed
definition of the term ``tax shelter.''
The automatic nature of the proposed increased penalty
would alter substantially the dynamics of the current process
by which the vast majority of disputes between the Service and
corporate taxpayers are resolved administratively. Today, even
where a corporation and the Service agree that there is a
substantial understatement of tax attributable to a tax shelter
item, the determination as to whether the substantial
understatement penalty should be waived for reasonable cause
continues to focus on the merits of the transaction and the
reasonableness of the taxpayer's beliefs regarding those
merits. If, however, the reasonable cause exception no longer
were available, the parties necessarily would have to focus on
whether the transaction in question was a ``tax avoidance
transaction'' and other definitional issues unrelated to the
underlying merits of the transaction.
Stripping revenue agents of their discretion to waive
penalties for reasonable cause would make it more difficult for
the Service to achieve its objective of resolving cases at the
lowest possible level. Unnecessary litigation also would
result. In many cases, the size of the penalty and the absence
of flexibility regarding its application could compel the
taxpayer to refuse to concede or compromise its position on the
merits of the issue, since only by prevailing on the merits
could the taxpayer avoid the penalty. Moreover, the mere
availability of such an onerous penalty may cause some revenue
agents to threaten its assertion as a means of exacting
unrelated (and perhaps unwarranted) concessions from the
taxpayer. Clearly, the use of the increased substantial
understatement penalty as a ``bargaining chip'' is not
appropriate or warranted for the proper determination of tax
liability of a corporation and the efficient administration of
the examination process.
Increasing the penalty on substantial understatements that
result from corporate tax shelters to 40 percent also would be
inconsistent with the Service's published policy regarding
penalties. Policy Statement P-1-18 states that ``[p]enalties
support the Service's mission only if penalties enhance
voluntary compliance.'' Similarly, Internal Revenue Manual
(20)122 provides that ``[t]he fundamental reason for having
penalties is to support and encourage voluntary compliance.''
Thus, the Service's principal purpose in asserting penalties is
not to punish, but rather to ensure and enhance voluntary
compliance. The imposition of a 40-percent substantial
understatement penalty in situations where under current law
reasonable cause would be found to exist would punish taxpayers
that in fact are in compliance with the tax laws.
Creating new penalties--especially ones whose applicability
depends on whether a particular transaction meets an inexact
definition--would put too many revenue agents in a position of
having to interpret statutes, rules, and regulations unrelated
to the substance of the issue or transaction in question. Based
on our experience, it is likely that many agents would find it
easier and less risky to assert the new penalty rather than
expose themselves to being second-guessed by others at the
Service as to whether the penalty was applicable. Accordingly,
pressures on revenue agents may cause the new penalty to be
asserted initially in far too many circumstances than are
warranted.
Further, the Service historically has had significant
difficulty administering civil tax penalties fairly and
consistently among regions, service centers, district offices,
and functions. Those difficulties resulted in the
Commissioner's establishing a task force in 1987 to study civil
tax penalties, the issuance of a report by that task force in
February 1989, a legislative overhaul of the Code's penalty
provisions in 1989,\18\ and the creation and issuance of the
Consolidated Penalty Handbook as part of the Internal Revenue
Manual.
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\18\ The ``Improved Penalty Administration and Compliance Tax Act''
was enacted as part of the Omnibus Budget Reconciliation Act of 1989.
(P.L. 101-239, secs. 7701-7743)
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It is evident that Congress believes there is room for
significant further improvement and clarity in the
administration of penalties. As discussed above, the Internal
Revenue Service Restructuring and Reform Act of 1998 requires
the Joint Committee on Taxation and the Treasury Department to
conduct separate studies regarding whether the current civil
tax penalties operate fairly, are effective deterrents to
undesired behavior, and are designed in a manner that promotes
efficient and effective administration.\19\ The Joint Committee
and Treasury will make whatever legislative and administrative
recommendations they deem appropriate to simplify penalty
administration and reduce taxpayer burden. With these important
studies in process at this time, this legislative proposal to
increase the substantial understatement is ill-conceived and
unwarranted.
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\19\ See n.14, supra.
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B. Deny certain tax benefits to persons avoiding income tax as a result
of tax-avoidance transactions.
1. Treasury proposal.
The proposal would expand the current-law rules in section
269 to authorize Treasury to disallow a deduction, credit,
exclusion, or other allowance obtained in a ``tax avoidance
transaction'' (as defined above). The proposal would be
effective for transactions entered into on or after the date of
first committee action.
2. Analysis.
In crafting this proposal, Treasury has disregarded the
off-quoted observation of Judge Learned Hand that taxpayers are
entitled to arrange their business affairs so as to minimize
taxation and are not required to choose the transaction that
results in the greatest amount of tax.\20\ Under the Treasury
proposal, even though a taxpayer's transaction has economic
substance and legitimate business purpose, the Service would be
empowered to deny the tax savings to the taxpayer if another
route of achieving the same end result would have resulted in
the remittance of more tax.
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\20\ Judge Hand wrote: ``Over and over again courts have said that
there is nothing sinister in so arranging one's affairs as to keep
taxes as low as possible. Everybody does so, rich or poor; and all do
right, for nobody owes any public duty to pay more than the law
demands: taxes are enforced extractions, not voluntary contributions''
(Comm'r v. Newman, 159 F.2d 848, 850-51 (2d Cir.1947) (dissenting
opinion)).
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Essentially, this proposal would grant unfettered authority
to the Service to determine independently whether a taxpayer is
engaging in a transaction defined as a ``tax avoidance
transaction,'' and, based on that determination, to disallow
any deduction, credit, exclusion, or other allowance obtained
by the taxpayer. A tax avoidance transaction would be defined
to include a transaction involving the ``improper elimination''
or ``significant reduction'' of tax on economic income. In
other words, if the Service believed for any reason that the
taxpayer had structured a transaction that yields too much in
tax savings, it would have the power to strike it down. This
power could be invoked without regard to the legitimacy of the
taxpayer's business purposes for entering into the transaction
or the economic substance underlying the transaction. In other
words, if the transaction is too tax efficient, then it simply
would not be permitted by the Service.
The Administration states that this proposed enormous
expansion of the current section 269 rules must be adopted
because the current-law restrictions only apply to the
acquisition of control or the acquisition of carryover basis
property in a corporate transaction. It is important to place
the current rules in context. The statutory rule has been in
the tax law since 1943. Congress at that time was concerned
that corporations were trafficking in net operating losses and
excess profits credits.\21\ The statute is focused on
acquisitions of corporate control and nontaxable corporate
reorganizations that produce tax advantages following the
combination that were not independently available to the
parties prior to the combination.
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\21\ See H.Rpt. No. 871, 78th Cong., 1st Sess. 49 (1943).
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The original objective for enactment of section 269--to
police the transfer of tax benefits in corporate combinations--
has been virtually superseded by other statutes and
regulations. For example, sections 382, 383, and 384 provide
detailed limitations on the use of NOLs, built-in deductions,
and tax credits following certain corporate combinations. The
consolidated return regulations under section 1502 contain
numerous limitations on the use of net operating losses, built-
in deductions, and tax credits following the addition of a new
member to a consolidated group. Further, section 1561 places
limits on surtax exemptions in the case of certain controlled
corporate groups.
Nevertheless, even though section 269 has been superseded
in certain respects by subsequent specific legislation and
thereby rarely is applied, taxpayers considering prudent
planning transactions must take into account section 269 in
many different corporate contexts because of the broad reach of
its provisions. This statute results in burdensome and time-
consuming administrative issues for taxpayers and revenue
agents alike, with few changes in positions ultimately required
and little revenue generated in return. The issue of whether
the taxpayer has obtained a particular benefit it would not
otherwise enjoy often is a difficult determination, and
determining the taxpayer's principal purpose is a subjective
exercise. This results in a lack of uniformity in the statute's
application.
The Administration now proposes to expand significantly an
outdated and significantly superseded statute. The proposal
would cover transactions that significantly reduce tax on what
the Service views as ``economic income.'' Such potentially
broad application would create uncertainty for corporate
taxpayers following prudent tax planning to implement business
objectives in a variety of transactions.
Another significant expansion of section 269 contemplated
in the Treasury proposal is to cover any ``exclusion'' obtained
in conjunction with any broadly defined ``tax avoidance
transaction.'' Currently, section 269 refers only to a
``deduction, credit or other allowance'' secured by the
taxpayer in an inappropriate manner. Under current law, courts
have refused to apply section 269 in instances where the
secured benefit is an exclusion from income.\22\ To address the
allocation of income from one taxpayer to another, Congress has
legislated other provisions, such as the allocation rules of
section 482 under which Treasury has promulgated comprehensive
regulations. No tax policy rationale exists for the expansion
of current section 269 to cover these situations.
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\22\ Modern Home Fire and Casualty Insur. Co. v. Comm'r, 54 TC 839
(1970).
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C. Denial of deductions for certain tax advice; excise tax on certain
fees received with respect to corporate tax shelters.
1. Treasury proposal.
The Treasury proposal would deny a deduction to a
corporation for fees paid or incurred in connection with the
purchase and implementation of corporate tax shelters and the
rendering of tax advice related to corporate tax shelters. The
proposal also would impose a 25-percent excise tax on fees
received in connection with the purchase and implementation of
corporate tax shelters (including fees related to the
underwriting or other fees) and the rendering of tax advice
related to corporate tax shelters. These proposals would be
effective for fees paid or incurred, and fees received, on or
after the date of first committee action.
2. Analysis.
The imprecise definition of a corporate tax shelter
transaction contained in this and related Treasury proposals
would make it difficult for taxpayers and professional tax
advisers to determine the circumstances under which this
provision would be applicable. The substantive burdens of
interpreting and complying with the statute and the
administrative problems that taxpayers and the Service would
face in attempting to apply this provision cannot be
overstated.
Further aggravating the complexity and burdens that are
imbedded in this proposal is the fact that the ultimate
determination that a particular transaction was a corporate tax
shelter may not be made until several years after the fees are
paid. In that situation, issues arise as to when the excise tax
is due, whether the applicable statute of limitations has
expired, and whether and upon what date interest would be owed
on the liability.
More fundamentally, the creation of the proposed excise tax
subjects tax advisers to an entirely new and burdensome tax
regime, a regime that again shifts the focus away from the
substantive tax aspects of the transaction to unrelated
definitional and computational issues. It is also unclear who
would administer or enforce this new tax regime. For instance,
if the existence of a tax shelter is determined as a result of
an income tax examination of a corporation, would the revenue
agents conducting that examination have jurisdiction over a
resulting excise tax examination of the taxpayer's tax adviser?
Would the income tax and excise tax examinations be conducted
concurrently? How would conflicts of interest between the
taxpayer and the adviser be identified and handled? These are
only a few of the serious real-world issues that would have to
be resolved to administer an inherently vague and cumbersome
proposal.
Finally, the real possibility exists that the effect of the
proposal may be to deter certain taxpayers from seeking and
obtaining necessary advice and guidance from a qualified tax
professional in many transactions where the broad and vague
scope of the prohibition calls into question the ultimate
deductibility of fees. In many such cases, it is likely that
qualified tax advice would have either convinced the taxpayer
that it would be unwise or improper to enter into the
transaction, or resulted in the restructuring of the
transaction so as to bring it within full compliance with the
letter and spirit of the internal revenue laws.
D. Impose excise tax on certain rescission provisions and provisions
guaranteeing tax benefits.
1. Treasury proposal.
The proposal would impose on the corporate purchaser of a
corporate tax shelter an excise tax of 25 percent on the
maximum payment under a ``tax benefit protection arrangement''
(including a rescission clause and insurance purchased with
respect to a transaction) at the time the arrangement is
entered into. The proposal would apply to arrangements entered
into on or after the date of first committee action.
2. Analysis.
This proposal breaches basic normative rules of tax law by
purporting to tax an expectancy, and by not limiting tax to
income received or realized by a taxpayer.
As a practical matter, the provision fails to consider the
way rescission provisions or guarantees work. Generally, such
an agreement puts the tax adviser at risk for an agreed-upon
percentage of the amount of additional tax for which the
taxpayer ultimately is liable as a result of the transactions
to which the adviser's advice relates. That amount, of course,
cannot be determined unless and until the Service proposes
adjustments to the taxpayer's liability related to the item or
transaction in question, and the taxpayer's correct liability
is either agreed upon or determined by a court. Until such
time, it is unclear how an excise tax determination
appropriately could be made, and assessing tax based upon the
highest potential rescission benefits obtainable by a taxpayer
in the future, whether actually realized or not, contravenes
basic issues of fairness in our normative income tax system.
Further, the creation of the proposed excise tax subjects
corporate taxpayers to an entirely new and burdensome tax
regime, a regime that again shifts the focus away from the
substantive tax aspects of the transaction in question to
unrelated matters regarding the taxpayer's use of a tax adviser
and the details of its relationship with the adviser. As such,
the provision constitutes an unwarranted intrusion into the
manner in which corporate taxpayers conduct their business
affairs. In addition, the provision not only discourages, but
actually stigmatizes, the willingness of qualified tax advisers
to stand behind the quality and accuracy of their professional
services.
E. Preclude taxpayers from taking tax positions inconsistent with the
form of their transactions.
1. Treasury proposal.
The proposal generally would provide that a corporate
taxpayer could not take any position on its return or refund
claim that the income tax treatment of a transaction differs
from that dictated by its form if a ``tax-indifferent party''
has an interest in the transaction. The form of a transaction
would be determined based on all facts and circumstances,
including the treatment given the transaction for regulatory or
foreign law purposes. A ``tax indifferent party'' would be
defined to include foreign persons, Native American tribal
organizations, tax-exempt organizations, and domestic
corporations with expiring loss or credit carryforwards. The
proposal would be effective for transactions entered into on or
after the date of first committee action.
2. Analysis.
The prevalent theme of this proposal is an approach of
``heads I win, tails you lose.''
The Administration's proposal would turn upside down the
most sacred of all tax doctrines: the tax treatment of a
transaction should be based on its substance, and not its form,
when its form does not properly reflect its substance. While
some courts have said that there are restrictions on when a
taxpayer may take a position contrary to the form of its own
transaction, even those courts have not imposed an absolute
prohibition. If the form chosen by the taxpayer has economic
substance, then the taxpayer generally may not assert that the
transaction should be taxed in accordance with a different
form. However, if the taxpayer can show that the form chosen
does not reflect the economic substance of the transaction,
then a court generally will evaluate the merits of the
taxpayer's claim.
In cases where the tax treatment of a transaction is
derived from a written agreement between a taxpayer and a third
party, courts have been more hesitant to entertain a substance-
over-form argument made by the taxpayer. In these cases, the
economic relationship between the taxpayer and other party is
established primarily by the agreement itself, rather than
independent evidence. The most typical case involves an
allocation of the purchase price among various assets after the
taxable acquisition of a business. Courts essentially have
incorporated the ``parol evidence'' rule from applicable State
law into the tax law. In some circuits, this means that the
taxpayer may assert substance over form only with ``strong
proof.'' Other circuits, following the so-called ``Danielson
rule,'' hold that the taxpayer may assert substance over form
only with proof that would render the agreement unenforceable
(e.g., proof of mistake or fraud). Courts have limited the
application of the strong proof rule or the Danielson rule to
cases involving a written agreement between two parties, where
the Service is confronted with potentially conflicting tax
claims and thus a potential whipsaw.
The Treasury proposal essentially is a drastic expansion of
the Danielson rule with an unusual twist. First, the proposed
rule prohibiting taxpayers from asserting substance over form
would not be limited to cases involving an economic
relationship set forth in a written agreement with a third
party; rather, it would apply to any transaction where a
taxpayer has chosen a particular form. Second, the proposal
would apply where there are no potentially conflicting tax
claims, and thus no potential for whipsaw, contrary to the
approach adopted by the courts.
The fact that a taxpayer, under the proposal, could
disclose on its return that it was treating a transaction
differently than the transaction's form does not answer these
criticisms. The meaning of ``form'' would be unclear in many
circumstances. Does ``form'' refer to the label given to the
transaction or instrument, or does it refer to the rights and
liabilities set forth in the documentation? For example, if an
instrument is labeled debt, but has features in the
documentation typically associated with an equity interest, is
the form debt or equity?
Recent attention has been given to Canadian exchangeable
share transactions, in which a U.S. corporation acquires a
Canadian corporation and the Canadian shareholders retain
shares in the Canadian target that are exchangeable for shares
in the U.S. acquiror. These shares appear in form to be shares
in the Canadian target but in substance may have legal and
economic rights equivalent to shares in the U.S. acquiror. One
commentator recently suggested that taxpayers structuring these
transactions and treating these instruments as shares in the
Canadian target are taking positions contrary to the ``form.''
However, this seems to be a classic case where the Service
would be asserting that the form of the transaction (i.e.,
shares in the Canadian target) does not reflect its substance
(i.e., shares in the U.S. acquiror). The issue should not be
what the form of the transaction is but rather what the
substance is.
This proposal would have the unfortunate effect of forcing
the taxpayer and the Service to fight over the characterization
of a transaction's form, when they ought to be debating the
substance of the transaction. The proposal does not subject the
Service to the same rule, i.e., the Service would not be
precluded from asserting substance over form.
F. Tax income from corporate tax shelters involving tax-indifferent
parties.
1. Treasury proposal.
The proposal would impose tax on ``tax-indifferent
parties'' on income allocable to such a party in a corporate
tax shelter, effective for transactions entered into on or
after the date of first committee action.
2. Analysis.
This proposal ignores the fact that many businesses
operating in the global economy are not U.S. taxpayers, and
that in the global economy it is increasingly necessary and
common for U.S. companies to enter into transactions with such
entities. Moreover, the fact that a tax-exempt person earns
income that would be taxable if instead it had been earned by a
taxable entity cannot in and of itself be viewed as
objectionable by the government--if that were the case, the
solution simply would be to repeal all tax exemptions. This
overreaching Treasury proposal cannot be justified on any tax
policy grounds.
Invocation of a rule that would impose tax on otherwise
nontaxable persons should require some greater evidence of tax
abuse than the mere fact that one of the parties is a foreign
person or a tax-exempt entity. The only limit on the
application of this proposed rule would be the basic definition
of a corporate tax shelter, but as discussed elsewhere in this
testimony, that overbroad definition and the nearly unfettered
authority contained in the proposal likely would cover many
routine business arrangements.
Moreover, as it applies to foreign persons in particular,
the provision is overbroad in two significant respects. First,
treating foreign persons as tax-indifferent ignores the fact
that in many circumstances they may be subject to significant
U.S. tax, either because they are subject to the withholding
tax rules, because they are engaged in a U.S. trade or
business, or because their income is taxable to their U.S.
shareholders. To treat all such persons as by definition tax-
indifferent would lead to the application of the tax-
indifferent party tax to persons that are already subject to
U.S. tax. The coordination of normal U.S. taxes with the
special tax-indifferent party tax is not addressed by the
proposals, so it is not clear whether it is intended that a
second U.S. tax would be collected in such cases. If that is
not the intent, then coordination rules would be required,
which could create substantial complexity, particularly when
the liability for the tax-indifferent party tax is imposed on
other parties to the transaction.
Second, limiting the collection of the tax to parties other
than treaty-protected foreign persons does not hide the fact
that the tax-indifferent party tax would constitute a
significant treaty override. Collecting the tax-indifferent
party liability from other parties would function purely as a
collection mechanism, much like a withholding tax, but it is
the income of the foreign person that would be subject to the
tax.\23\ Imposing such a tax on treaty-protected income remains
inconsistent with treaty obligations regardless of the
collection mechanism adopted. Such a treaty override seems
doubly objectionable in a context in which the tax avoidance
about which Treasury is concerned is not that of the treaty-
protected foreigner, but rather that of another taxpayer. Thus,
while Treasury and Congress may conclude that in certain
circumstances a treaty override is required to advance
significant U.S. tax policy goals, this misguided and
unnecessary provision does not justify the serious damage to
treaty relationships that it would engender.
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\23\ Depending on the terms of the relevant contractual
arrangements, the other participants who paid the tax on the income of
the foreign person might well seek to recover that tax from the foreign
person.
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III. POTENTIAL IMPACT OF TREASURY PROPOSALS ON LEGITIMATE BUSINESS
TRANSACTIONS
The overreaching and vague Treasury Department proposals
would have a severely detrimental impact on tax analysis and
planning relating to a large number of legitimate business
transactions. The proposals contemplate that many of the
provisions would apply whenever a corporate tax shelter (as
newly defined) is found to exist, even if the taxpayer's
position is substantively correct under the Code, regulations,
and case law.\24\ By contrast, the current-law tax shelter
penalty provisions come into play only if the taxpayer
initially is found to have understated its tax liability.
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\24\ This follows from the facts that the trigger for applying
several of the proposed sanctions (other than the understatement
penalty) is the mere existence of a corporate tax shelter, and that the
definition of a corporate tax shelter does not appear to exclude any
arrangement based on the substantive correctness of the positions taken
by the taxpayer. Sanctions that could be invoked on this basis include
the denial of tax benefits under section 269, the denial of deductions
for fees paid, the excise tax on fees received, and the excise tax on
tax benefit guarantees. Indeed, it would appear that by permitting the
denial of benefits under section 269 without reference to substantive
correctness, the Treasury proposal then could come full circle and
impose an understatement penalty on the taxpayer even though its
position had been shown to be substantively correct in the first
instance.
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Faced with the regime of draconian sanctions proposed by
Treasury, taxpayers would find it difficult to make business
decisions with any certainty as to the tax consequences, since
even a correct application of existing rules could be
overturned based on a finding that a transaction worked an
``improper deferral'' or a ``significant reduction of tax.''
Our testimony below presents only a few of the examples that
could be cited of normal business transactions that could be
caught in the web woven by the new proposals.
A. International transactions.
1. Debt capitalization of U.S. subsidiary of foreign parent.
Something as basic as the capital structure of a company
can be said to reduce the tax on the company's economic income.
For example, if the foreign parent of a U.S. subsidiary chooses
to capitalize the subsidiary with significant debt, the U.S.
tax liability of the U.S. subsidiary may be reduced
substantially, with no effect on the group's economic income.
Existing law includes provisions under which the Service can
test the legitimacy of the interest deductions claimed by the
subsidiary in that situation, including the ``earnings
stripping'' rules under section 163(j), the anti-conduit rules
under section 7701(l), various treaty-shopping rules, and
common law debt-equity principles. Even if the taxpayer's
interest deduction passed all of those hurdles, the Treasury
proposals could be interpreted to label the corporation's
capital structure as a tax shelter, given the reduction of tax
on economic income.
The taxpayer could avoid the tax shelter designation only
if it could show that the tax benefit of its interest deduction
was ``clearly contemplated'' under the Code. Thus,
notwithstanding all the rules that the tax law has developed to
test interest deductions, the final determination of the
taxpayer's liability would come down to application of a rule
that provides virtually no substantive guidance. When is the
tax benefit of a deduction for interest ``clearly
contemplated'' by the Code? Obviously not always, because the
Code has many specific rules that limit the extent to which a
taxpayer may receive a tax benefit for interest it has paid. If
a transaction satisfies those specific provisions of the Code,
can its tax benefits safely be described as ``clearly
contemplated'' within the meaning of the proposed tax shelter
provisions? Presumably not, because Treasury considers its
proposal to be a significant change to current law, so as to
permit the Service to prevail in circumstances in which it
could not prevail under existing law.
Thus, under the Treasury proposals, taxpayers are left with
the uneasy sense that some interest deductions that satisfy all
current substantive tax provisions must be ``clearly
contemplated,'' and hence are safe from further scrutiny under
this proposal as corporate tax shelters, while other interest
deductions would not so qualify. The taxpayer, however, would
have no idea how to distinguish between them. Moreover,
taxpayers and the Service often would disagree over when a
benefit was ``clearly contemplated.'' In the case of a debt-
capitalized U.S. subsidiary, the Service might well argue that
in its opinion the benefit received (namely, the interest
deduction) exceeds that which was ``clearly contemplated'' by
Congress.
To complicate matters further, the likelihood of a ``not
clearly contemplated'' attack may be greater in the context of
a cross-border transaction. While the current Treasury
explanation of its proposals does not discuss extensively the
use of hybrid entities or instruments,\25\ previous Treasury
proposals suggest that the presence of a cross-border hybrid
likely would affect Treasury's analysis. For example, suppose
that the debt instrument giving rise to the U.S. subsidiary's
interest deduction was viewed as stock by the parent's home
country, so that the payments were viewed as dividends that
received favorable tax treatment in that jurisdiction.\26\
Would the Service argue that the benefit of the subsidiary's
interest deduction is ``clearly contemplated'' only when the
payment is viewed as interest in the hands of both the payor
and the payee? Treasury pronouncements to date provide no clear
answer, having suggested, for example, that inconsistent cross-
border characterizations leading to the recognition of a
foreign tax credit in two jurisdictions simultaneously may be
abusive in Treasury's view, while the simultaneous recognition
of depreciation deductions in two jurisdictions has been viewed
by Treasury as appropriate.\27\
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\25\ There is an oblique reference to hybrid arrangements in
connection with the proposal that would prohibit taxpayers from taking
a position that is inconsistent with the form of their transactions.
\26\ For example, the parent might receive a foreign tax credit for
the underlying U.S. corporate tax paid by the U.S. subsidiary, or the
dividends might be eliminated through a ``participation exemption'' or
similar regime.
\27\ See Notice 98-5 and the Administration's 1998 budget
proposals.
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Accordingly, a foreign parent faced with the need to
determine the capital structure for its U.S. operations would
find it extraordinarily difficult to predict its U.S. tax
treatment with any certainty. Even if a cross-border
transaction complies with all existing rules, and regardless of
whether the transaction tries to achieve any cross-border
arbitrage, a company always would face the possibility of a
Service challenge that would deny the benefit of its deductions
and impose several other sanctions based on interpretations of
the ``corporate tax shelter'' definition. Adding this type of
fundamental uncertainty to the already extreme complexity of
the Code cannot be defended as appropriate tax policy.
2. Foreign tax reduction
As a threshold matter, it is not clear whether the Treasury
proposal is limited to avoidance of U.S. as opposed to foreign
taxes. The proposals are drafted broadly in terms of ``a tax
benefit in a tax avoidance transaction,'' ``a significant
reduction of tax,'' etc. Recent Treasury Department activities
should make it clear that the inquiry is a serious one, since
IRS Notice 98-11 establishes that Treasury may be as concerned
about avoidance of foreign taxes as about U.S. taxes. This
follows from the fact that the Notice would treat otherwise
identical transactions differently, depending on whether the
effect of the transaction was to achieve a reduction of foreign
tax.\28\
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\28\ The Notice proposes rules that would trigger subpart F
inclusions with respect to payments involving hybrid branches only if
such payments had the effect of reducing foreign taxes. The policy
debate concerning the substantive treatment set forth in the statute is
beyond the scope of this testimony--it should suffice for our purposes
here to note that Treasury does seem to object to foreign tax reduction
by U.S. taxpayers.
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The new tax shelter proposals would seem to give Treasury
authority to deny tax benefits in connection with any
arrangements entered into by a U.S.-based multinational in
connection with the debt-capitalization of its foreign
operations, or indeed any transaction or structure that had the
effect of significantly reducing foreign taxes. The uncertainty
would be further compounded by the issue of hybrid status
discussed above--would the Service be more likely to challenge
a foreign tax-reduction structure with hybrid elements? For
example, would a ``hybrid branch'' within the meaning of Notice
98-11 be more susceptible to challenge than a conventional
branch that had the same tax effect (i.e., foreign tax
reduction with no subpart F inclusion)? The question cannot be
answered based on the proposals themselves or any other
Treasury guidance.
Accordingly, enactment of the Treasury proposals would
throw the structuring of international operations of U.S.
companies into complete tax uncertainty--the tax consequences
of many transactions and investments would not be determinable
until long after the fact, since their tax results could not be
determined based on the existing Code, regulations, or case
law. Instead, the taxpayer would have to wait until Service
revenue agents reviewed the transactions and determined whether
they were offended by any particular aspect, regardless of the
extent to which the transaction complied with existing law.
This discretion and the unprecedented complexity and
uncertainty it would cause cannot be justified on any tax
policy principle.
3. Foreign tax credits in high-tax settings.
If the Treasury proposals were enacted, a U.S.-based
multinational could find itself in a remarkable whipsaw.
Efforts to reduce foreign taxes could trigger a response of the
Service based on Notice 98-11 type concerns; on the other hand,
failure to reduce foreign taxes potentially could subject the
taxpayer to scrutiny based on the fact that the resulting
foreign tax credits were deemed disproportionate to its
economic income. This follows from the Treasury proposal
defining a tax shelter to include any arrangement in which pre-
tax profits are insignificant in relation to net tax benefits.
By selectively defining the relevant ``transaction,'' the
Service could determine that any particular activity in a
foreign jurisdiction produced limited net income, and thus that
such income was ``insignificant'' in relation to the foreign
tax credits associated with it. This problem is particularly
acute in the case of financial institutions that may engage in
a portfolio of transactions, some of which could be isolated
and shown to be economic losses. But the problem also could be
faced by any business with multiple product or service lines of
varying profitability.
Further, even in the case of an activity with ``normal''
profits, foreign tax base or timing differences could increase
artificially the apparent foreign tax rate to the point where
the economic profit would appear to be insignificant by
comparison. With tax base and timing differences, a normal
business scenario could produce a foreign tax rate that looks
high enough that the economic profit could be viewed as not
substantial relative to the foreign tax credit benefits.
Moreover, by treating foreign taxes paid as an expense like
any other, the proposals misconceive and distort the role of
the foreign tax credit in the U.S. tax system. By treating
foreign taxes as an expense, Treasury is in effect positing
that the correct standard for identifying an abuse is to ask
whether the taxpayer would carry out a transaction if it did
not receive a foreign tax credit at all--in other words, a
transaction should be viewed as proper only if it makes
economic sense without regard to any foreign tax credits.
This cannot be right in view of the fundamental purpose of
the foreign tax credit. Most foreign business operations
conducted by U.S.-based taxpayers in jurisdictions that impose
significant taxes probably would be untenable in the absence of
a U.S. credit for those foreign taxes. Does the Treasury
proposal mean that all U.S.-owned controlled foreign
corporations in Germany, Japan, Italy, France, and the United
Kingdom, among other countries, represent corporate tax
shelters? The basic goal of the foreign tax credit is to enable
U.S.-based companies to conduct overseas activities without
suffering double taxation, and that function is served by
treating a foreign tax as if it were a U.S. tax (up to the U.S.
rate). Thus, adopting a definition of tax shelter that takes as
its analytical starting point a world in which no foreign taxes
are creditable is inconsistent with the fundamental operation
of U.S. international tax rules as they have operated for
decades.
In sum, the Treasury proposals would make the U.S. tax
results of cross-border transactions largely unknowable.
Transactions that satisfied the requirements of all existing
statutory, regulatory, and judicial standards nevertheless
could be challenged by the Service under standards of utter
vagueness. They could be attacked for paying too little foreign
tax, or for paying too much. They could be targeted for
violating nebulous policy concerns, such as those with respect
to hybrids, that Treasury has not yet managed to articulate
fully.
This fundamental tax uncertainty would deprive U.S.
businesses of the ability to make rational cross-border
business decisions, disrupting international trade and
investment at a time when the growth of a global economy has
made them an increasingly important component of U.S. economic
prosperity. Finally, the Treasury proposals would damage U.S.
international tax policy by abandoning some of its fundamental
precepts, and do broader damage to U.S. tax policy in general
by seeking to replace known legal standards with a regime
governed solely by administrative edict.
B. Corporate transactions.
1. In general.
There is a lengthy list of legitimate merger and
acquisition transactions that could be caught by Treasury's
proposed broad definition of ``tax avoidance transaction.'' For
example, tax-free reorganizations involving small corporations
acquired by large corporations or spin-off transactions
involving unequal amounts of debt allocated between the
separated entities might be treated by the Service as ``tax
avoidance transactions.'' The nearly unfettered ability of the
Service to recharacterize the tax effects of legitimate
corporate transactions would cause considerable uncertainty in
many cases of prudent and appropriate tax structuring of
transactions.
By contrast to the haphazard manner in which the rules for
taxing corporate transactions would develop under the Treasury
proposals, current law consists of statutory, regulatory, and
judicial doctrines that have been refined and developed over
time and that provide guidance and appropriate tax results in
corporate transactional planning.
2. Reasons for concern.
Broad anti-abuse rules like the Treasury proposals can
adversely affect the ability of corporations to engage in
legitimate business transactions by bringing the tax
consequences of ordinary transactions into question. Given the
Service's limited resources, such disputes may not be resolved
satisfactorily through ordinary avenues such as the private
letter ruling process.
The development of the tax law regarding transfers of
property outside the United States provides a relevant example.
Prior to 1984, section 367(a) required transferors of property
to foreign persons to receive permission from the Service, in
the form of a private letter ruling, in order for the transfer
to qualify as a nontaxable transaction. This was to ensure that
the principal purpose of the outbound transfer was not tax
avoidance. By requiring that taxpayers get advance approval
before making an outbound transfer of assets, taxpayers were
precluded from completing a transaction and determining in
later litigation, if necessary, the question of whether tax
avoidance was one of the principal purposes of the transaction.
Under these rules, Treasury was able to prevent taxpayers from
undertaking legitimate business transactions simply by
declining to issue a favorable private letter ruling.
To remedy this inequity, the Tax Reform Act of 1976
established a special declaratory judgment procedure (section
7477) allowing taxpayers to immediately litigate the Service's
section 367 determinations in the Tax Court. Under the
procedure, the taxpayer was able to have the dispute reviewed
by the Tax Court if it was demonstrated that a request had been
made to the Service for a determination and that the Service
either failed to act or acted adversely. After a number of
taxpayer-favorable decisions, Congress replaced this system in
1984, and today taxpayers are not required to obtain a private
letter ruling in advance of a section 367 transaction.
Obviously, requiring taxpayers to obtain prior approval
from Treasury for legitimate business transactions proved to be
an unworkable process. In order for a voluntary tax system to
work in a global economy, taxpayers must be able to implement
their business strategy while providing a review process that
ensures appropriate and consistent tax treatment for all. The
Treasury proposals, by creating general corporate anti-abuse
rules without guidelines or restrictions, would result in
uncertainty for taxpayers engaging in ordinary corporate
transactions and generally would burden taxpayers with the
responsibility of litigating disputes with the Service over the
limits of the anti-abuse rules themselves.
C. Partnership transactions.
As the globalization of the world economy continues, many
companies are turning to partnership joint ventures as a
preferred business form to conduct new business operations.
Such joint ventures provide immediate access to technology,
financing, new markets, and human capital that otherwise might
take years for a company to develop internally. The reach of
Treasury's tax shelter proposals seriously jeopardizes this
legitimate joint-venture activity.
Many joint ventures are speculative in nature. Pre-tax
profits are anticipated but may be longer term, and the
investment's ultimate rate of return is uncertain. It is quite
common for joint ventures to generate economic losses in
formative years; these ``tax benefits'' could be significant
when compared to reasonably expected pre-tax profits at the
outset of the joint venture.
The breadth of the Treasury's proposed definition of a tax
shelter quite likely would impose an in terrorem effect in the
formation of joint ventures with marginal rates of return
because of increased uncertainty created by the potentially
broad reach of the new proposals. The consequence would be a
lack of competitiveness by U.S. companies in the global market.
In certain industries, partnerships are used to spread the
risk of research. These research partnerships, which generate
little in short-term profits, are economically viable because
of the potential intellectual capital created in the long term.
Conceivably, under the Administration's definition of tax
shelters, the Service would be put in the position of second-
guessing the economics of a particular research partnership,
causing the parties to justify anticipated pre-tax profits in
light of failures to generate viable new technology. Fear of
Service challenges to what are otherwise legitimate business
decisions could well dampen the kind of research U.S. companies
undertake.
Oil and gas exploration depends on huge amounts of capital
generated through the formation of partnerships. This industry
can be wildly speculative. If the Treasury tax shelter
proposals were adopted, the Service effectively would sit side-
by-side with the wildcatters in assessing what wells can be
drilled in order to avoid these activities later being defined
as a tax shelter.
Consider, for example, the case of an independent oil and
gas operator that frequently engages in searches for oil on
undeveloped and unexplored land that is not near proven fields.
The taxpayer engages in a particular speculative wildcat oil-
drilling venture at an anticipated cost of $5 million. Based on
the experience of taxpayers engaging in this type of business,
there is a 90-percent chance that the taxpayers will not find a
commercially profitable oil deposit and that the entire $5
million investment will be lost. There is a 10-percent
probability that the venture will produce pre-tax economic
profits in the average probability-weighted amount of $40
million. Under the Treasury proposals, the Service might treat
the venture as a corporate tax shelter on the ground that the
reasonably expected pre-tax profit is insignificant relative to
the reasonably expected net tax benefits.
The real estate industry also relies heavily on partnership
vehicles. In the case of real estate investment trusts (REITs),
lower-tier partnerships routinely are used to acquire new
properties from sellers interested in diversifying their own
investment portfolios. The proposed definition of a tax shelter
would cause reassessments of what properties a REIT can invest
in because, more often than not, a particular real estate deal
will be speculative in nature.
Other industries that use the partnership vehicle to
aggregate capital for investment purposes include venture
capital funds and investment partnerships. Both generate
capital to be invested in other businesses for higher and
sometimes speculative rates of return. An overbroad and vague
tax shelter definition may well alter the types of investments
made at the margin by these industries.
Investment decisions are made all the time by competent
business executives and investors. Unfortunately, Treasury's
misguided tax shelter proposals would call into question many
of their investment decisions. Injecting the Service into what
are otherwise legitimate business decisions would create an
unintended and detrimental drag on our robust economy.
D. Other illustrations.
As discussed above, the Treasury proposals would discourage
taxpayers from undertaking beneficial but unprofitable
activities that, absent legitimate tax incentives, they would
not perform. Such activities particularly are vulnerable to
being tagged as tax shelters because they literally could be
viewed as arrangements in which a ``corporate participant
attempts to obtain a tax benefit in a tax avoidance
transaction.''
As one example of the potential chilling effects of the
Treasury proposals, legislation enacted in 1997 allows
taxpayers to deduct certain costs of cleaning up economically
depressed sites, known as ``brownfields.'' The legislation
sought to encourage taxpayers to clean up sites that otherwise
might prove too costly or uneconomical to clean up. Under the
tax shelter proposal, a taxpayer's attempt to deduct cleanup
costs whose treatment is not clear under the brownfields
statute could be treated as a tax shelter.
The claimed deductions might constitute a ``tax benefit''
under the proposal because certain deductions while potentially
permissible may not be deemed ``clearly contemplated by the
applicable provision'' (emphasis added). Moreover, the
taxpayer's cleanup activities could be considered a ``tax
avoidance transaction'' because the taxpayer's pre-tax profit
from cleaning up a site probably would be insignificant
relative to its reasonably expected tax benefits. Thus, a
taxpayer that cleans up a brownfields site and claims a
deduction for its costs could face a serious risk of being
treated as a tax shelter participant merely because the
treatment of some of those costs is less than clear under the
statute. Treasury may well respond that it does not intend to
impact detrimentally the recently enacted ``brownfields''
statute. The fact remains that the overbroad reach of the
Treasury proposals could call into question the tax effect of
this provision and many other normal business transactions and
activities.
Besides the examples set forth above, numerous ordinary
business transactions could be affected by the Treasury
proposals. These could include certain hedging transactions,
certain sale-leaseback transactions, various corporate
distributions, and certain transactions between joint venture
entities.
IV. ADEQUACY OF EXISTING TOOLS TO ADDRESS ``ABUSE''
A. Current penalties and registration requirements relating to tax
shelters.
The chief tax executive of a corporation has several duties
and responsibilities in the tax analysis, collection, and
enforcement process.\29\ Some are derived from the tax
executive's fiduciary duties to shareholders to preserve and
protect corporate assets, including a duty to protect corporate
assets from unnecessary additions to tax through the imposition
of penalties.
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\29\ A detailed description of the responsibilities and burdens of
a chief tax executive is set forth in Part V of these comments.
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The existing penalty structure in the Code is a burdensome
and complex patchwork of rules that present the chief tax
executive with considerable uncertainty in determining their
application and scope. The corporate tax executive must
consider carefully the possible application of those penalties
prior to implementing any particular course of action.
Three broad types of penalties potentially apply with
respect to tax shelters: (1) the accuracy-related penalty under
section 6662, which is applicable to underpayments of tax
resulting from certain types of conduct, (2) tax shelter-
specific penalties such as those applicable to promoters of
abusive tax shelters and to the failure to register or furnish
information regarding tax shelters, and (3) penalties related
to the preparation or presentation of tax returns, claims, or
other documents reporting the benefits or attributes of tax
shelter items. A list of these penalty provisions is contained
in Appendix A.
1. Accuracy-related penalty.
One of the most significant penalties that a chief tax
executive must consider in analyzing any transaction is the
accuracy-related penalty under section 6662. That penalty is
imposed on any portion of an underpayment attributable to one
or more of the following:
negligence or disregard of rules and regulations;
any substantial understatement of income tax;
any substantial valuation misstatement;
any substantial overstatement of pension
liabilities; or
any substantial estate or gift tax valuation
understatement.
The penalty equals 20 percent of the portion of the
underpayment attributable to the specified conduct. The first
three components of the accuracy-related penalty (i.e., the
negligence/intentional disregard, substantial understatement,
and valuation misstatement components) are the most relevant to
potential tax shelter transactions.
Pursuant to section 6664(c), the accuracy-related penalty
will not be imposed on any portion of an underpayment if the
taxpayer shows there was a reasonable cause for the
underpayment and that the taxpayer acted in good faith with
respect to such portion. The determination of whether a
taxpayer acted with ``reasonable cause and in good faith'' is
made on a case-by-case basis, taking into account all pertinent
facts and circumstances, the most important of which is the
extent of the taxpayer's efforts to assess its proper tax
liability. As a general rule, it is more difficult to establish
the existence of reasonable cause when the underpayment of tax
is attributable to true tax shelter activities.
a. Definition of ``tax shelter'' for purposes of the
accuracy penalty rules.--For purposes of the accuracy-related
penalty imposed by section 6662, the term ``tax shelter'' means
a partnership or other entity (e.g., a trust), an investment
plan or arrangement, or any other plan or arrangement the
purpose of which is to avoid or evade federal income tax.
Congress significantly broadened the scope of these rules in
the Taxpayer Relief Act of 1997, to treat an entity, plan, or
arrangement as a tax shelter if one of its significant purposes
is tax avoidance or evasion.\30\ The Service and Treasury have
not yet issued guidance regarding the definition of the term
``significant purpose.''
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\30\ Section 6662(d)(2)(C)(iii). Prior law defined tax shelter
activity as an entity, plan or arrangement only if it had as its
primary purpose the avoidance or evasion of tax.
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The broadened definition of the term ``tax shelter'' for
accuracy-related penalty purposes under the 1997 Act is a
powerful tool that the Treasury and the Service can utilize to
respond to perceived avoidance situations. The failure,
however, to provide necessary guidance under that statute, in
the form of regulations or otherwise, has made it extremely
difficult for chief tax executive to analyze and evaluate
potential transactions so as to protect against the imposition
of such penalties.
b. Negligence or disregard of rules or regulations.--A 20-
percent accuracy-related penalty is imposed on the amount of
any underpayment that is attributable to negligence or the
disregard of rules or regulations. Negligence includes any
careless, reckless, or intentional disregard of rules or
regulations, any failure to make a reasonable attempt to comply
with the provisions of the law, and any failure to exercise
ordinary and reasonable care in the preparation of a tax
return. In other words, negligence is the lack of due care or
failure to do what a reasonable and ordinarily prudent person
would do under the circumstances. Disregard of rules or
regulations means any careless, reckless, or intentional
disregard of the Code, regulations (final or temporary), or
revenue rulings or notices published in the Internal Revenue
Bulletin.\31\
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\31\ Treas. Reg. section 1.6662-3(b)(2).
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Negligence includes the failure to keep adequate books and
records or to substantiate items properly.\32\ A position with
respect to an item is attributable to negligence if it lacks a
``reasonable basis.''\33\ Negligence is strongly indicated
where, for example, a taxpayer fails to include on an income
tax return an income item shown on an information return, or a
taxpayer fails to make a reasonable attempt to ascertain the
correctness of a deduction, credit, or exclusion on a return
that would seem to a reasonable and prudent person to be ``too
good to be true'' under the circumstances.\34\ This prudence
standard is imposed on a chief tax executive as he or she
analyzes the appropriateness of a particular transaction.
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\32\ Treas. Reg. section 1.6662-3(b)(1).
\33\ Pursuant to Treas. Reg. section 1.6662-3(b)(3), the
``reasonable basis'' standard is a relatively high standard of tax
reporting and is not satisfied by a return position that is merely
arguable or merely a colorable claim. A return position generally
satisfies the standard if it is reasonably based on one or more of the
authorities set forth in Treas. Reg. section 1.6662-4(d)(3)(iii),
taking into account the relevance and persuasiveness of the authorities
and subsequent developments, even though it may not satisfy the
substantial authority standard as defined in Treas. Reg. section
1.6662-4(d)(2).
\34\ Treas. Reg. section 1.6662-3(b).
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c. Substantial understatement of income tax.--In
determining whether it would be prudent to enter into a
particular transaction, the corporate tax executive also must
consider the component of the accuracy-related penalty that is
imposed on the portion of any underpayment that is attributable
to a substantial understatement of income tax. An
``understatement of tax'' is the excess of the amount required
to be shown on the return for the tax year less the amount of
tax actually shown on the return, reduced by any rebates.
An understatement is ``substantial'' if the understatement
exceeds the greater of (1) 10 percent of the tax required to be
shown on the return for the tax year, or (2) $10,000 (in the
case of a corporation other than an S corporation or a personal
holding company).
d. Substantial valuation misstatement.--A 20-percent
accuracy-related penalty also is imposed on the portion of any
underpayment of tax attributable to a substantial valuation
misstatement with respect to the value or adjusted basis of
property reported on any return. In the case of a gross
valuation misstatement, the penalty is increased to 40 percent.
These penalties apply if the aggregate of all portions of the
underpayment attributable to the misstatement exceeds $10,000
for corporations other than S corporations or a personal
holding company.\35\ This aspect of the accuracy-related
penalty regime has received renewed emphasis and review by
corporate tax executives in light of the Tax Court's recent
decision upholding the Service's imposition of the 40-percent
penalty.\36\
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\35\ Section 6662(e)(1) provides that a valuation misstatement is
substantial if: the value or adjusted basis of any property claimed on
any income tax return is 200 percent or more of the correct value or
adjusted basis; or (a) the price for any property or services (or for
the use of property) in connection with any transaction between trades
or businesses owned or controlled, directly or indirectly, by the same
interests (as described in section 482) is 200 percent or more (or 50
percent or less) of the amount determined to be the correct amount of
such price, or (b) in tax years beginning after December 31, 1993, the
net section 482 transfer price adjustment for the tax year exceeds the
lesser of $5,000,000 or 10 percent of the taxpayer's gross receipts.
Pursuant to section 6662(h)(2), a gross valuation misstatement occurs
where: the value or adjusted basis of any property claimed on any
return is 400 percent or more of the amount determined to be the
correct value or adjusted basis; or (a) the price for any property, or
for its use, or for services, claimed on any return in connection with
a transaction between persons described in section 482 is 400 percent
or more (or 25 percent or less) of the amount described in section 482
to be the correct amount of such price, or (b) in tax years beginning
after December 31, 1993, the net section 482 transfer price adjustment
for the tax year exceeds the lesser of $20,000,000 or 20 percent of the
taxpayer's gross receipts.
\36\ DHL Corp. v. Comm'r, T.C. Memo. 198-461, December 30, 1998.
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e. Concluding analysis.--In sum, the accuracy-related
penalty provides a powerful incentive for corporate tax
executives to review closely and analyze both the structure and
the implementation of any proposed business transaction that
results in tax benefits, and to impose prudence on the
decision-making process. This penalty, and the overall penalty
regime, can be made much clearer and more precise so as to
provide corporate tax executives with certainty in analyzing
particular transactions. To this end, the ongoing studies aimed
at reviewing and potentially streamlining the current complex
and burdensome penalty system hold the potential for meaningful
improvements.\37\ At this time, there is no demonstrated
justification for increasing the penalties and adding further
uncertainty to the process as contemplated by the Treasury
proposals.
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\37\ The penalty studies were required by section 3801 of the
Internal Revenue Service Restructuring and Reform Act of 1998.
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2. Penalties imposed on tax shelter promoters.
The Code contains a number of penalties applicable to tax
shelter promoters. These promoter penalties collectively form a
``safety net'' to ensure that tax shelter activities are not
promoted and that misinformation about proper tax rules is not
disseminated by unscrupulous advisors. It is highly unlikely
that a prudent tax executive of a large corporation seriously
would consider entering into the sort of abusive transaction
for which promoter penalties would be applicable. Accordingly,
the penalties are briefly described below to illustrate that
the Code already contains a number of safeguards against
abusive tax planning activities.
a. Penalty for promoting abusive tax shelters.--Under
section 6700(a), a civil penalty--equal to the lesser of $1,000
or 100 percent of the gross income derived (or to be derived)
by the particular promoter from the activity--may be imposed
against persons who promote abusive tax shelters. The term
``promoting'' encompasses organizing such tax shelters,
participating directly or indirectly in their sale, and making
or furnishing (or causing another person to make or furnish)
certain false or frauduent statements \38\ or gross valuation
overstatements \39\ in connection with their organization or
sale. Pursuant to section 7408, the Service also can obtain an
injunction against such promoters to enjoin them from further
promotion activity.
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\38\ A statement with respect to the allowability of any deduction
or credit, the excludability of any income, or the securing of any
other tax benefit by reason of holding an interest in the entity or
participating in the plan or arrangement which the person knows or has
reason to know is false or fraudulent as to any material matter.
Section 6700(a)(2)(A).
\39\ A gross valuation overstatement is a statement as to the value
of property or services that is directly related to the amount of any
income tax deduction or credit, provided that the value exceeds 200
percent of the correct value. Section 6700(a)(2)(B).
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b. Aiding and abetting penalty.--The Service may impose a
penalty under section 6701 of $1,000 ($10,000 with respect to
corporate tax returns and documents) against any person who (1)
aids, assists, or gives advice in the preparation or
presentation (e.g., during a Service examination) of any
portion of a tax return, affidavit, claim, or other document;
(2) knows (or has reason to believe) that the portion of the
return or document will be used in connection with any material
matter arising under the internal revenue laws; and (3) knows
that, if the portion of the tax return or other document is
used, an understatement of another person's tax liability would
result.
In addition, disciplinary action may be taken against any
professional appraiser against whom an aiding and abetting
penalty under section 6701(a) has been imposed with respect to
the preparation or presentation of an appraisal resulting in an
understatement of tax liability.
3. Penalties for failure to furnish information regarding tax
shelters.
a. Penalty for failure to register a tax shelter.--An
organizer of an entity, plan, or arrangement that meets the
definition of a tax shelter under section 6111 who fails to
timely register such shelter, or who files false or incomplete
information with such registration, is subject to a penalty
under section 6707(a). The penalty equals the greater of (1)
$500 or (2) one percent of the amount invested in the shelter.
The penalty for failing to register a ``confidential
corporate tax shelter,'' as defined in section 6111(d) (as
amended by the Taxpayer Relief Act of 1997), is the greater of
(1) $10,000, or (2) 50 percent of the fees paid to all
promoters with respect to offerings prior to the date of the
late registration. The penalty applies to promoters and to
actual participants in any corporate tax shelter who were
required to register the tax shelter but failed to do so. For
participants, the 50-percent penalty is based solely on fees
paid by the participant. The penalty is increased to 75 percent
of applicable fees where the failure to register the tax
shelter is due to intentional disregard on the part of either a
promoter or a participant.\40\
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\40\ Section 6707(a)(3).
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b. Penalty for failure to furnish tax shelter
identification numbers.--Pursuant to section 6707(b)(1), a
person who sells an interest in a tax shelter and fails to
furnish the shelter's identification number to each investor in
the shelter is subject to a monetary penalty unless the failure
is due to reasonable cause. Section 6707(b)(2) provides that an
investor who fails to furnish the shelter's identification
number on a return reporting a tax item related to the tax
shelter also is subject to penalty.
c. Penalty for failure to maintain lists of investors in
potentially abusive tax shelters.--Pursuant to section 6708,
any person who is required to maintain a tax shelter customer
list, as required by section 6112, and who fails to include any
particular investor on the list will be assessed a penalty for
each omission unless it is shown that the failure results from
reasonable cause and not from willful neglect. The maximum
penalty for failure to maintain the list is $100,000 per
calendar year. This penalty is in addition to any other penalty
provided by law.
4. Tax return preparer penalties.
Section 6694(a) provides that if any part of an
understatement of liability with respect to a return or claim
for refund is due to a position that did not have a realistic
possibility of being sustained on its merits \41\ and an income
tax return preparer with respect to that return or claim knew
(or reasonably should have known) of that position, the
preparer is subject to a penalty of $250 with respect to the
return or claim, unless it is shown that there is reasonable
cause for the understatement and that the preparer acted in
good faith. The penalty will not apply if the position (1) was
adequately disclosed and (2) is not frivolous.\42\
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\41\ A position is considered to satisfy the realistic possibility
standard if a reasonable and well-informed analysis by a person
knowledgeable in tax law would lead that person to conclude that the
position has approximately a one-in-three, or greater, likelihood of
being sustained on its merits. Treas. Reg. section 1.6694-2(b)(1). In
determining whether a position has a realistic possibility of being
sustained, the relevant authorities are the same as those considered in
determining whether, for purposes of the accuracy-related penalty,
there is substantial authority for a tax return position. Treas. Reg.
section 1.6694-2(b)(2).
\42\ A frivolous position is one that is patently improper. Treas.
Reg. section 1.6694-2(c)(2).
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If the preparer establishes that an understatement
attributable to an unrealistic position was due to reasonable
cause and that the preparer acted in good faith, the preparer
penalty will not be imposed. This determination depends upon
the facts and circumstances of the particular case, including
the nature of the error, the frequency and materiality of the
error, the preparer's normal office practices, and reliance on
any other preparer's advice.\43\
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\43\ Treas. Reg. section 1.6694-2(d).
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5. Registration requirements.
Section 6111 requires tax shelter organizers \44\ to
register tax shelters with the Service by the day on which the
first offering for sale of interests in the tax shelter
occurs.\45\ Pursuant to section 6111(d), which was added by the
Taxpayer Relief Act of 1997, certain ``confidential
arrangements'' are also treated as tax shelters for purposes of
the registration requirements. Those provisions, however, are
not effective until the Service or Treasury issues guidance
with respect to the 1997 Act amendments to the registration
requirements. To date, no such guidance has been issued. The
Service and Treasury, therefore, have failed to take advantage
of what would appear to be a potent weapon in the Government's
arsenal to curb abusive tax shelter activity.
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\44\ The term ``tax shelter organizer'' is defined as the person
who is principally responsible for organizing a tax shelter (``the
principal organizer''), i.e., any person who discovers, creates,
investigates, or initiates the investment, devises the business or
financial plans for the investment, or carries out those plans through
negotiations or transactions with others. Temp. Treas. Reg. section
301.6111-1T, A-27.
\45\ The temporary regulations provide that certain investments
will not be subject to tax shelter registration even if they
technically meet the definition of a tax shelter. The following
investments are not subject to registration: (1) sales of residences
primarily to persons who are expected to use the residences as their
principal place of residence, and (2) with certain exceptions, sales or
leases of tangible personal property by the manufacturer (or a member
of an affiliated group) of the property primarily to persons who are
expected to use the property in their principal active trade or
business. By Notice, the Service may specify other investments that are
exempt from the registration requirement. Temp. Treas. Reg. section
301.6111-1T, A-24. In addition, the tax shelter registration
requirements are suspended with respect to any tax shelter that is a
``projected income investment.'' Generally, a tax shelter is a
projected income investment if it is not expected to reduce the
cumulative tax liability of any investor for any year during any of the
first five years ending after the date on which the investment is
offered for sale.
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In the context of the tax shelter registration
requirements, section 6111(d)(1) provides that a ``corporate
tax shelter'' includes any entity, plan, arrangement, or
transaction: (1) that has as a significant purpose the
avoidance \46\ of tax or evasion by a corporate participant;
(2) that is offered to any potential participant under
conditions of confidentiality; \47\ and (3) for which the tax
shelter promoters may receive total fees in excess of $100,000.
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\46\ As in the case of the definition of ``tax shelter'' for
accuracy-related penalty purposes, the terms ``significant purpose''
and ``tax avoidance'' are not defined or explained for tax shelter
registration purposes.
\47\ A transaction is offered under conditions of confidentiality
if: (1) a potential participant (or any person acting on its behalf)
has an understanding or agreement with or for the benefit of any
promoter to restrict or limit the potential participant's disclosure of
the tax shelter or any significant tax features of the tax shelter; or
(2) the promoter (a) claims, knows, or has reason to know, (b) knows or
has reason to know that any other person (other than the potential
participant) claims, or (c) causes another person to claim that the
transaction (or any aspect thereof) is proprietary to the promoter or
any party other than the potential participant, or is otherwise
protected from disclosure or use. Section 6111(d)(2).
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Under the rules applicable to confidential corporate tax
shelters, individuals who merely discussed participation in the
shelter may in some circumstances be required to comply with
the registration requirements. A promoter of a corporate tax
shelter is required to register the shelter with the Service
not later than the day on which the tax shelter is first
offered for sale to potential users. As previously discussed,
civil penalties under section 6707 may be imposed for the
failure to timely register a tax shelter. Criminal penalties
are applicable to willful noncompliance with the registration
requirements.\48\
---------------------------------------------------------------------------
\48\ See, e.g., section 7203.
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These registration rules, which Treasury and the Service
have not yet implemented, as well as the collective impact of
the existing complex and disparate penalty regime, render the
Treasury proposals unnecessary and inappropriate.
B. Existing ``common-law'' doctrines.
Pursuant to several ``common-law'' tax doctrines, Treasury
and the Service have the ability to challenge taxpayer
treatment of a transaction that they believe is inconsistent
with statutory rules and the underlying Congressional intent.
For example, these doctrines may be invoked where the Service
believes that (1) the taxpayer has sought to circumvent
statutory requirements by casting the transaction in a form
designed to disguise its substance, (2) the taxpayer
artificially has divided the transaction into separate steps,
(3) the taxpayer has engaged in ``trafficking'' in tax
attributes, or (4) the taxpayer improperly has accelerated
deductions or deferred income recognition.
These broadly applicable doctrines--known as the business
purpose doctrine, the substance over form doctrine, the step
transaction doctrine, and the sham transaction and economic
substance doctrine--provide the Service considerable leeway to
recast transactions based on economic substance, to treat
apparently separate steps as one transaction, and to disregard
transactions that lack business purpose or economic substance.
Recent applications of those doctrines have demonstrated their
effectiveness and cast doubt on Treasury's asserted need for
additional tools.
Since the enactment of the internal revenue laws, the
Service, often with the blessing of the courts, has probed
taxpayers' business motives. Such inquiries have led to the
development of the ``business purpose doctrine,'' which permits
the Service to disregard for federal income tax purposes a
variety of transactions entered into without any economic,
commercial, or legal purpose other than the hoped-for favorable
tax consequences. Although the business purpose doctrine
originated in the context of corporate reorganizations,\49\ it
quickly was extended to other areas.\50\
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\49\ Gregory v. Helvering [35-1 USTC para. 9043], 293 U.S. 465
(1935), which generally is regarded as the origin of the business
purpose doctrine, involved a reorganization motivated by tax avoidance.
\50\ In Commissioner v. Transport Trading & Terminal Corp. [49-2
USTC para. 9337], 176 F.2d 570 (2d Cir. 1949), cert. denied, 338 U.S.
955 (1950), the doctrine was extended to all statutes that describe
commercial transactions.
---------------------------------------------------------------------------
The ``substance over form doctrine'' often is associated
with the business purpose doctrine. Under the substance over
form doctrine, a court may ignore the form of a transaction and
apply the tax law to the transaction's substance if the court
perceives that the substance of a transaction lies within the
intended reach of a statute, but that the form of the
transaction takes the event outside that reach.\51\ Therefore,
while a taxpayer may structure a transaction so that it
satisfies the formal requirements of the tax law, the Service
may deny legal effect to the transaction if its sole purpose is
to evade taxation.\52\
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\51\ The Business Purpose Doctrine: The Effect of Motive on Federal
Income Tax Liability, 49 Fordham L. Rev. 1078, 1080 (1981).
\52\ Stewart v. Commissioner [83-2 USTC para. 9573], 714 F.2d 977,
987 (9th Cir. 1983).
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The courts have long been willing to elevate substance over
form in interpreting a sophisticated code of tax laws where
slight differences in a transaction's design can lead to
divergent tax results. In the tax law arena, the substance over
form doctrine has been used expansively to justify the
Service's recasting of transactions.\53\ For example, the
doctrine has been used to: (1) void reorganizations,\54\ (2)
reject the assignment of income,\55\ (3) recharacterize the
sale or transfer of property between related parties,\56\ (4)
recharacterize sale and leaseback arrangements,\57\ (5)
disallow interest deductions,\58\ and (6) disregard the
separate corporate entity.\59\
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\53\ 49 Fordham L. Rev. at 1080-81 (listing examples and collecting
citations).
\54\ Gregory v. Helvering, supra n. 49.
\55\ Helvering v. Horst [40-2 USTC para. 9787], 311 U.S. 112, 114-
120 (1940) (holding that income, rather than income-producing property,
had been assigned).
\56\ Commissioner v. Court Holding Co. [45-1 USTC para. 9215], 324
U.S. 331, 333-334 (1945).
\57\ Frank Lyon Co. v. U.S. [78-1 USTC para. 9370], 435 U.S. 561
(1978).
\58\ Knetsch v. U.S. [60-2 USTC para. 9785], 364 U.S. 361 (1960).
\59\ Moline Properties, Inc. v. Commissioner [43-1 USTC para.
9464], 319 U.S. 436, 438-439 (1943).
---------------------------------------------------------------------------
The ``step transaction'' doctrine permits the Service to
aggregate formally separate transactions into a single
transaction. Under the doctrine, tax results are determined by
looking at the final result of the various steps of the
transaction. The doctrine particularly ignores the intermediate
steps in a transaction where those steps primarily were taken
for tax purposes.
The ``sham transaction'' doctrine allows the Service to
deny deductions and losses or otherwise recast transactions
that lack any economic results beyond a tax deduction. The sham
transaction doctrine has been expanded to apply even to certain
bona fide transactions, where sufficient economic motivation is
lacking.
The recent decisions in ACM v. Commissioner \60\ and ASA
Investerings v. Commissioner \61\ illustrate the continuing
force of these long-standing judicial doctrines. In ACM, the
Third Circuit, affirming the Tax Court, relied on the sham
transaction and economic substance doctrines to disallow losses
generated by a partnership's purchase and resale of notes. The
Tax Court similarly invoked those doctrines in ASA Investerings
to disallow losses on the purchase and resale of private
placement notes. Both cases involved complex, highly
sophisticated transactions, yet the Service successfully used
common law principles to prevent the taxpayers from realizing
tax benefits from the transactions.
---------------------------------------------------------------------------
\60\ 157 F3d 231 (3d Cir. 1998).
\61\ [98-2 USTC para. 52,845], T.C.M. 1998-305 (1998).
---------------------------------------------------------------------------
1. The business purpose and substance over form doctrines.
The business purpose and substance over form doctrines
continue to serve as powerful tools for the Service to
recharacterize a taxpayer's transactions to combat tax
avoidance.\62\ The business purpose doctrine generally provides
that a transaction will not be respected for tax purposes
unless it serves some purpose other than tax avoidance. The
Supreme Court's decision in Gregory v. Helvering,\63\ generally
is cited as the origin of the business purpose doctrine. In
Gregory, a reorganization complied with all of the formal
statutory requirements, but was disregarded for federal income
tax purposes because no valid economic purpose existed for the
creation and immediate liquidation of a transferee corporation.
The transaction simply was an attempt to convert ordinary
dividend income into capital gains. The Supreme Court's
decision was not based on any tax-avoidance motive of the
taxpayer, but rather on the lack of a business purpose for the
transaction which the statutory scheme contemplated. The court
stated:
---------------------------------------------------------------------------
\62\ See, e.g., ASA Investerings, supra; ACM Partnership, supra.
\63\ Supra n. 49.
The legal right of the taxpayer to decrease the amount of
what otherwise would be his taxes, or altogether avoid them, by
means which the law permits, cannot be doubted. But the
question for determination is whether what was done, apart from
tax motive, was the thing which the statute intended. [293 U.S.
---------------------------------------------------------------------------
at 469]
The Tax Court has noted that the doctrine in Gregory is not
limited to the field of corporate reorganizations, but has a
much wider scope.\64\
---------------------------------------------------------------------------
\64\ Braddock Land Co. v. Commissioner, 75 T.C. 324, 329 (1980).
---------------------------------------------------------------------------
The substance over form doctrine, which is closely
associated with the business purpose doctrine, generally allows
courts to follow the economic substance of a transaction where
a court believes the taxpayer's empty form shelters a
transaction from the rules that otherwise should govern. As
indicated above, the Service has succeeded in using the
substance over form doctrine to recharacterize a variety of
transactions. Furthermore, the substance over form doctrine
offers the Service the added advantage of generally working in
the government's favor and not in the taxpayer's.\65\
---------------------------------------------------------------------------
\65\ Higgins v. Smith, 308 U.S. 473 (1940); U.S. v. Morris & E.R.
Co., 135 F.2d 711, 713 (2d Cir. 1943) (``[T]he Treasury may take a
taxpayer at his word, so to say; when that serves its purpose, it may
treat his corporation as a different person from himself; but that is a
rule which works only in the Treasury's own favor[.]''), cert. denied,
320 U.S. 754 (1943).
---------------------------------------------------------------------------
2. The step transaction doctrine.
Another version of the substance over form concept appears
in the ``step transaction doctrine,'' which also applies
throughout the tax law. The step transaction doctrine allows
the Service to collapse and treat as a single transaction a
series of formally separate steps, if the steps are
``integrated, interdependent, and focused toward a particular
result.''\66\ Thus, the step transaction doctrine ignores the
intermediate steps in a transaction where those steps
constitute an indirect path toward the transaction's endpoint
and where those steps primarily were taken to get better tax
results. Under the doctrine, tax results are determined by
looking at the ultimate result of a series of transactions.
---------------------------------------------------------------------------
\66\ Penrod v. Commissioner, 88 T.C. 1415, 1428 (1987). See M.
Ginsburg & J. Levin, Mergers, Acquisitions and Buyouts, para.608 (Oct.
1998 ed.).
---------------------------------------------------------------------------
While the boundaries of the step transaction doctrine are
subject to debate, courts have articulated three versions of
the doctrine: (1) an end result test, (2) an interdependence
test, and (3) a binding commitment test.\67\ The broadest
version is the end result test, which aggregates a series of
transactions if the transactions are prearranged parts of a
single transaction intended from the start to reach an ultimate
result. Slightly less broad is the interdependence test, which
groups together a series of transactions if the transactions
are so interdependent that the legal relations created by one
transaction would be pointless absent the other steps. The
narrowest version is the binding commitment test, which joins
together a series of transactions if, at the time the first
step is taken, a binding legal commitment requires the later
steps.\68\ While the courts have disagreed over which
particular test to apply in particular circumstances, such
uncertainty has not prevented the courts from applying the
doctrine liberally.\69\
---------------------------------------------------------------------------
\67\ Ginsburg & Levin, supra, at para.608.1.
\68\ Id.
\69\ See, e.g., Jacobs Engineering Group v. U.S. [97-1 USTC para.
50,340], No. CV 96-2662, 1997 U.S. Dist. LEXIS 3467 (C.D. Calif. March
6, 1997); Associated Wholesale Grocers v. U.S. [91-1 USTC para.
50,165], 927 F.2d 1517 (10th Cir. 1991); Security Industrial Insurance
Co. v. U.S. [83-1 USTC para. 9320], 702 F.2d 1234 (5th Cir. 1983).
---------------------------------------------------------------------------
3. Sham transaction doctrine and economic motivation test.
The sham transaction doctrine offers another route by which
courts and the Service have attacked transactions lacking in
economic substance or reality. Among the leading cases
articulating the sham transaction doctrine are Knetsch v. U.S.
\70\ and Goldstein v. Commissioner.\71\ In Knetsch, the Supreme
Court held that a transaction--the purchase of ten 30-year
deferred annuity bonds, financed by a down payment and funds
borrowed from the issuer against the cash surrender value of
the bonds--was ``a sham,'' lacking any appreciable economic
results, because ``there was nothing of substance to be
realized [by the taxpayer] beyond a tax deduction'' (364 U.S.
at 366). The court diverted its attention from the taxpayer's
tax avoidance motive and focused instead on the taxpayer's
failure to establish the presence of business purpose (the
taxpayer's subjective state of mind) or a justifying economic
substance (an objective test) in the transaction.
---------------------------------------------------------------------------
\70\ 60-2 USTC para. 9785], 364 U.S. 361 (1960).
\71\ [66-2 USTC para. 9561], 364 F.2D 734 (2d Circ. 1966), cert.
denied 385 U.S. 1005 (1967)
---------------------------------------------------------------------------
The court based its conclusions on the fact that the
taxpayer paid 3\1/2\ percent interest to the issuer of the
bonds on its financing loan, while the investment grew at only
2\1/2\ percent per year. The net annual cash loss of one
percent of the borrowed funds was incurred only to achieve a
tax deduction for the interest paid, not for an ``economic''
profit. Although the taxpayer could have refinanced the loan if
funds became available from another lender at a lower rate, he
either failed to present evidence regarding the prospect of a
decline in interest rates or failed to convince the trial judge
that refinancing was a realistic option, and the Supreme Court
implicitly assumed that it was not.\72\
---------------------------------------------------------------------------
\72\ B. Bittker, Pervasive Judicial Doctrines in the Construction
of the Internal Revenue Code, 21 How. L. J. 693 (1978).
---------------------------------------------------------------------------
In Goldstein, the taxpayer borrowed funds at 4 percent
interest to purchase bonds paying 1\1/2\ percent interest and
pledged the bonds as security for the loan. While the court
held that the loans were not sham transactions because the
indebtedness was valid, it nevertheless denied the interest
deduction because the taxpayer did not enter into the
transactions in order to derive any economic gain through
appreciation in value of the bonds. Rather, the taxpayer
borrowed the money solely in order to secure a large interest
deduction which could be deducted from other income.
The Second Circuit's approach extended the sham transaction
doctrine by adding an economic motivation requirement. As a
result, the interest expense arising from even a bona fide
indebtedness must meet an additional requirement of economic
motivation to be deductible. Courts have denied interest
deductions in transactions similar to those in Goldstein but
without calling the transaction a sham--a term now reserved for
a mere paper or ``fake'' transaction.\73\ Under the economic
motivation requirement, an interest deduction may be disallowed
if no economic gain could be realized beyond a tax
deduction.\74\
---------------------------------------------------------------------------
\73\ Rice's Toyota World, Inc. v. Commissioner, 81 T.C. 184, 200
(1983).
\74\ See, e.g., Rothschild v. U.S. [69-1 USTC para. 9224], 186
Ct.Cl. 709, 407 F.2d 404, 406 (1969).
---------------------------------------------------------------------------
More recently, in ACM, supra, the Third Circuit applied the
economic substance requirement and sham transaction doctrine to
disallow losses generated by a partnership's purchase and
resale of notes. The Tax Court, in disallowing the losses,
stressed the taxpayer's lack of any nontax business motive.
However, the Third Circuit, affirming the Tax Court, focused on
the transaction's lack of economic substance. The court held
the transaction lacked economic substance because it involved
``only a fleeting and economically inconsequential investment
by the taxpayer.'' The Tax Court pursued a similar approach in
ASA Investerings, supra, to deny a loss on the purchase and
resale of private placement notes.
The above judicial doctrines and the numerous of cases they
have generated have proven difficult to translate into clear,
bright-line rules. That difficulty stems in part from the
highly complicated facts in those cases, and in part from the
uncertainty as to which facts the courts believed credible and
which facts proved relevant to the outcome.\75\ As a result of
this uncertainty, the exact scope of those judicial doctrines
is ill-defined and potentially extremely broad. This breadth,
in effect, has acted as yet another arrow in the Service's
quiver by exerting a strong in terrorem effect. While those
judicial doctrines may not be impermeable, they represent a
broad range of weapons available to the Service to attack tax
avoidance. Moreover, those doctrines already impose high costs
on legitimate business planning and inhibit efficiency.
---------------------------------------------------------------------------
\75\ Bittker, supra n. 72.
---------------------------------------------------------------------------
C. Current anti-abuse rules in the Code.
The Code contains numerous provisions that give the
Treasury Department and the Service broad authority to prevent
tax avoidance, to reallocate income and deductions, to deny tax
benefits, and to ensure taxpayers clearly report income. An
illustrative list of more than 70 provisions that explicitly
grant Treasury and the Service such authority appears in
Appendix B.
As demonstrated by this list, Treasury and the Service long
have had powerful ammunition to challenge tax avoidance
transactions. The Service has broad power to reallocate income,
deductions, credits, or allowances between controlled taxpayers
to prevent evasion of taxes or to clearly reflect income under
section 482. While much attention has been focused in recent
years on the application of section 482 in the international
context, section 482 also applies broadly in purely domestic
situations. The Service also has the authority to disregard a
taxpayer's method of accounting if it does not clearly reflect
income under section 446(b).
In the partnership context, the Service has issued broad
anti-abuse regulations under subchapter K.\76\ Those rules
allow the Service to disregard the existence of a partnership,
to adjust a partnership's methods of accounting, to reallocate
items of income, gain, loss, deduction, or credit, or to
otherwise adjust a partnership's or partner's tax treatment in
situations where a transaction meets the literal requirements
of a statutory or regulatory provision, but where the Service
believes the results are inconsistent with the intent of the
partnership tax rules.
---------------------------------------------------------------------------
\76\ Treas. Reg. 1.701-2.
---------------------------------------------------------------------------
The Service also has issued a series of far-reaching anti-
abuse rules under its legislative grant of regulatory authority
in the consolidated return area. For example, under Treas. Reg.
Sec. 1.1502-20, a parent corporation is severely limited in its
ability to deduct any loss on the sale of a consolidated
subsidiary's stock. The consolidated return investment basis
adjustment rules also contain an anti-avoidance rule.\77\ The
rule provides that the Service may make adjustments ``as
necessary'' if a person acts with ``a principal purpose'' of
avoiding the requirements of the consolidated return rules. The
consolidated return rules feature several other anti-abuse
rules.\78\
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\77\ Treas. Reg. Sec. 1.1502-32(e).
\78\ E.g., Treas. Reg. Sec. 1.1502-13(h) (anti-avoidance rules with
respect to the intercompany transaction provisions) and Treas. Reg.
Sec. 1.1502-17(c) (anti-avoidance rules with respect to the
consolidated return accounting methods).
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D. IRS Notices.
The Service from time to time has issued IRS Notices
stating its intention to issue subsequent regulations that
would shut down certain transactions. Thus, a Notice allows the
government (assuming that the particular action is within
Treasury's rulemaking authority) to move quickly, without
having to await development of the regulations themselves--
often a time-consuming process--that will provide more detailed
rules concerning a particular transaction.
The Service has not been adverse to issuing such Notices.
Recent examples include Notice 97-21, in which the Service
addressed multiple-party financing transactions that used a
special type of preferred stock; Notice 95-53, in which the
Service addressed the tax consequences of ``lease strip'' or
``stripping transactions'' separating income from deductions;
and Notices 94-46 and 94-93, addressing so-called ``corporate
inversion'' transactions viewed as avoiding the 1986 Act's
repeal of the General Utilities doctrine.\79\ Appendix C
includes an illustrative list of these types of IRS Notices
issued in the past 10 years.
---------------------------------------------------------------------------
\79\ The General Utilities doctrine generally provided for
nonrecognition of gain or loss on a corporation's distribution of
property to its shareholders with respect to their stock. See, General
Utils. & Operating Co. v. Helvering, 296 US 200 (1935). The General
Utilities doctrine was repealed in 1986 out of concern that the
doctrine tended to undermine the application of the corporate-level
income tax. H.R. Rep. No. 426, 99th Cong., 1st Sess. 282 (1985).
---------------------------------------------------------------------------
Moreover, the Service currently has the ability to prevent
abusive transactions that occur before a Notice is issued.
Section 7805(b) expressly gives the Service authority to issue
regulations that have retroactive effect ``to prevent abuse.''
Therefore, although many Notices have set the date of Notice
issuance as the effective date for forthcoming regulations,\80\
the Service can and has used its authority to announce
regulations that would be effective for periods prior to the
date the Notice was issued.\81\ Alternatively, the Service in
Notices has announced that it will rely on existing law to stop
abusive transactions that have already occurred.\82\
---------------------------------------------------------------------------
\80\ See, e.g., Notice 95-53, 1995-2 CB 334, and Notice 89-37,
1989-1 CB 679.
\81\ See, e.g., Notice 97-21, 1997-1 CB 407.
\82\ Notice 96-39, I.R.B. 1996-32.
---------------------------------------------------------------------------
E. Legislative changes.
To the extent that Treasury and the Service may lack
rulemaking or administrative authority to challenge a
particular transaction, the avenue remains open to seek
enactment of legislation. In this regard, over the past 30
years dozens upon dozens of changes to the tax statute have
been enacted to address perceived avoidance and abuses.
Appendix D includes an illustrative list.
These legislative changes can be broken down into two
general categories. The first includes legislative changes that
respond specifically to a transaction deemed to be abusive or
otherwise outside the intended scope of the tax laws. For
example, bills (H.R. 435, S. 262) now pending before the 106th
Congress would address ``basis-shifting'' transactions
involving transfers of assets subject to liabilities under
section 357(c). The proposal first was advanced by the
Administration, in its FY 1999 budget submission, and
subsequently was introduced as legislation by House Ways and
Means Committee Chairman Bill Archer. Other recent examples of
specific legislative actions to address potential or identified
abuses would include a provision addressing liquidating REIT
and RIC transactions enacted in the 1998 \83\ and a provision
imposing a holding period requirement for claiming foreign tax
credits with respect to dividends under section 901(k), enacted
as part of the Taxpayer Relief Act of 1997.\84\ The
Administration's FY 2000 budget submission includes a number of
proposals addressing specific types of transactions. As stated
above, whether or not the tax policy rationales given by
Treasury for these proposals are persuasive, as a procedural
matter it is proper that these proposals now will undergo
Congressional scrutiny.
---------------------------------------------------------------------------
\83\ P.L. 105-277, section 3001.
\84\ P.L. 105-34, section 1053.
---------------------------------------------------------------------------
These targeted legislative changes often have immediate, or
even retroactive, application. For example, the section 357(c)
proposal currently before Congress would be effective for
transfers on or after October 19, 1998--the date that Chairman
Archer introduced the proposal in the form of legislation.
Chairman Archer took this action, in part, to stop these
transactions earlier than would have been the case under
effective date originally proposed by the Administration (the
date of enactment). Moreover, in some cases, Congress includes
language in the legislative history stating that ``no
inference'' is intended regarding the tax treatment under prior
law of the transaction addressed in the legislation. This
language is intended, in part, to preclude any interpretation
that otherwise might arise that enactment of the provision
necessarily means that the transaction in question was
sanctioned by prior law.
It should be noted that Congress and the Administration do
not always agree on the appropriateness of specific legislative
proposals advanced by Treasury that purport to address areas of
perceived abuse. In fact, more than 40 revenue-raising
proposals proposed by the Administration in its last three
budget proposals (for FY 1997, FY 1998, and FY 1999) have been
rejected by the Congress. Appendix E provides a list of these
Administration proposals.
The second category of legislation includes more general
changes to the ground rules under which corporate tax
executives and the Service operate. These ``operative rules''
include, for example, modifications to the penalty structure
applicable to tax shelters, tax understatements, and
negligence, as well as new reporting requirements. Operative
changes generally are considered by Congress far less
frequently than the changes targeting specific abuses, and for
good reason. These changes typically are intended to influence
taxpayer behavior or increase Service audit tools where
Congress sees an identifiable need for change. Changes then
usually are given time to take full effect so that their impact
can be measured to determine if they have achieved their
desired result or if additional action might be necessary.
In 1997, as discussed above, Congress enacted changes
broadening the definition of ``tax shelter'' transactions
subject to penalties and requiring that transactions be
reported to the Service when undertaken under a confidentiality
arrangement. Congress concluded that this change would
``improve compliance by discouraging taxpayers from entering
into questionable transactions.'' \85\ Because these changes
have not yet taken effect (a result of Treasury's failure to
issue regulations--to this date--that would activate the
changes), Congress has not yet had an opportunity to gauge
their impact.
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\85\ Joint Committee on Taxation, General Explanation of Tax
Legislation Enacted in 1997 222 (1997).
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Before the 1997 Act changes to the tax shelter rules,
Congress had last enacted operative changes in this area of the
tax law as part of the Uruguay Round Agreement Act of 1994,
under which Congress modified the substantial understatement
penalty for corporations participating in tax shelters.
The corporate tax shelter proposals advanced in the
Administration's FY 2000 budget that are within the scope of
this testimony would represent the most far-reaching operative
changes ever enacted by Congress. Moreover, not only would they
take effect before Congress has had a chance to evaluate the
impact of its last round of operative changes, they would take
effect even before the last round of changes has entered into
force. Such a change is unprecedented in the annals of tax
policymaking in this area.
In some instances, these newly proposed operative
provisions would allow Treasury to challenge the very same
types of transactions that have been targeted by specific
legislative changes sought by the Administration but rejected
by Congress. Given the apparent divergence of views between
Congress and the Administration on the appropriateness of
specific tax legislative changes, it would be odd for the
Congress at this time to hand Treasury and the Service
unprecedented authority to dictate tax policy.
V. RESPONSIBILITIES AND BURDENS OF CORPORATE TAXPAYERS
A. Responsibilities of corporate tax executives.
The chief tax executive of a typical U.S. corporation has
many responsibilities and burdens in the tax preparation,
collection, and enforcement process. This individual must
oversee and implement systems to collect a variety of federal
income, wage withholding, and excise taxes. He or she must be
able to analyze and implement an incredibly complex, ever-
changing and, in many instances, arcane and outdated tax system
made up of an intricate jumble of statutes, case law,
regulations, rulings, and administrative procedural
requirements.
Notwithstanding this veritable maze of complicated and many
times inconsistent rules that collectively comprises our tax
law, this individual has a further responsibility to the
management and shareholders of the corporation. He or she must
understand management's business decisions and planning
objectives, assess the tax law consequences of business
activities, and counsel management about the tax consequences
of various possible decisions. In the course of assisting
management in the formation of business decisions, the
corporate tax executive must assess the state of a very complex
and uncertain tax law and must be able to provide advice to
management on appropriate ways to minimize tax liabilities.
Once those business decisions are made, he or she must
implement them by supervising the formation of applicable
entities, creating necessary systems for capturing tax-related
information as it is generated from the business, and
implementing necessary procedures for the calculation and
remittance of taxes, information returns, and other
documentation and materials necessary for compliance under the
federal tax laws. Finally, the chief tax executive must be able
to explain the appropriateness of tax positions taken by the
company, as well as its tax collection, remittance, and
reporting systems, to the Service upon examination.\86\
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\86\ Large corporations are enrolled in the Service's coordinated
examination program (CEP) and generally are under continuous audit by
the Service to assure the appropriateness of tax return positions taken
by those corporations.
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In short, a chief tax executive must be able to understand
an incredibly complex set of federal tax rules, advise and
assist management in the formation of decisions that result in
proper minimization of taxes, implement tax collection and
reporting system for those decisions, and explain the
appropriateness of those decisions and systems in examination
discussions with the Service.
B. Tax executive's vital role to the U.S. government as tax
administrator.
Collectively, the chief tax executives of U.S. corporations
play a very significant role in the collection and remittance
of federal taxes. They shoulder the ultimate responsibility
within their corporations for adequate systems to collect and
remit corporate income taxes, federal wage withholding taxes,
and an array of excise taxes. The corporate tax department is
the private administrator of the U.S. income tax.
It is estimated that corporate income tax collections in FY
1998 were $189 billion. Individual income tax payments withheld
by corporations and remitted to the Treasury were approximately
$375 billion, or more than 40 percent of gross individual
income tax collected. Payroll tax withheld for Social Security
and unemployment insurance by corporations amounted to
approximately $315 billion, or 61 percent of payroll taxes
collected. Corporations accounted for the bulk of the $76
billion in excise and customs duties collected. In sum, of the
$1.7 trillion in tax revenue collected by the Federal
government in FY 1998, corporations either remitted directly or
withheld and remitted more than 50 percent, vastly reducing the
compliance burden on the Service and individuals.
In addition to direct tax payments and withholding,
corporations also provide information returns to the Service on
payments made to employees, contractors, suppliers, and
investors. In 1998 more than one billion information returns
were filed by U.S. businesses with the Service, accounting for
income and transactions exceeding $18 trillion.\87\ In addition
to providing this information to the Service, U.S. businesses
also provide this information (as required) to affected
taxpayers to assist them in meeting their tax filing
obligations.\88\ Corporations provided the vast majority of
these information returns.
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\87\ Not all dollar amounts reported on information returns are
included in income. For example, the 1099-B reports the gross proceeds
from the sale of certain investments. Only the gain from the sale of
these investments is included in gross income.
\88\ These information returns include Form W-2 (Wage and Tax
Statement), Form W-2G (Certain Gambling Winnings), Form 1099-DIV
(Dividends and Distributions), Form 1099-INT (Interest Income), Form
1099-MISC (Miscellaneous Income), Form 1099-OID (Original Issue
Discount), Form 1099-R (Distributions from Pensions, Annuities, etc.),
Form 1099-B (Proceeds from Broker and Barter exchange Transactions),
Form 5498 (Individual Retirement Arrangement Contribution Information),
Form 1099-A, Acquisition or Abandonment of Secured Property, Form 1098
(Mortgage Interest Statement), Form 1099-S (Proceeds from Real Estate
Transactions), Form 1099C (relating to forgiven debt), Form 5498-MSA
(Medical Savings Account Information), Form 1099-MSA (Distributions
from Medical Savings Accounts), Form 1099-LTC (Long-Term Care and
Accelerated Death Benefits), and Form 1098-E (Student Loan Interest
Statement).
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Without the help of corporate tax departments, collection
and other administrative costs to the government would be
significantly higher and rates of compliance significantly
lower.
C. Challenges and burdens presented by tax law complexity.
1. In general: burdens and costs.
The extreme complexity of the U.S. tax law is especially
burdensome for corporate taxpayers. Confronted by a jumble of
statutes, case law, and administrative rulings and notices, the
tax executives of a corporation often must take into account a
veritable library full of materials in determining the
appropriate tax treatment of a specific transaction.
There are 3,052 pages of statutory language in the Internal
Revenue Code (1994 ed.), and 11,368 pages of Treasury
regulations contained in Title 26 of the Code of Federal
Regulations. (Additionally, the Treasury Department has a
substantial backlog of unfinished guidance projects designed to
assist in the clarification of these complex rules (see list
contained in Appendix F)). Further, there are thousands of
pages of Revenue Rulings, Revenue Procedures, Notices, private
letter rulings, technical advice memoranda, field service
memoranda, and other administrative materials potentially
relevant to the determination of the appropriate tax treatment
of a particular transaction. More than 9,300 Tax Court cases
have been decided since 1949, and thousands of additional court
precedents exist in tax cases decided by the U.S. District
Courts, the U.S. Courts of Appeals, the Court of Claims, and
the U.S. Supreme Court. Further, there are about 50
international tax treaties and various other agreements that
may be applicable to the U.S. tax treatment of specific
international transactions.
Research has found that the compliance costs of the
corporate income tax resulting from this complexity are
significant. In 1992, Professor Joel Slemrod of the University
of Michigan surveyed firms in the Fortune 500 and found an
average compliance cost of $2.11 million, or more than $1
billion for the entire Fortune 500.\89\ The cost for a sample
of 1,329 large firms was more than $2 billion in the aggregate.
About 70 percent of this cost is estimated to be attributable
to the federal tax system, with the remaining 30 percent
attributable to State and local income taxes. These estimates
exclude the costs of complying with payroll, property, excise,
withholding, and other taxes.
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\89\ Joel B. Slemrod and Marsha Blumenthal, ``The Income Tax
Compliance Cost of Big Business,'' Public Finance Quarterly, October
1996, v. 24, no. 4, pp. 411-438.
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The firms surveyed by Professor Slemrod generally were
among the largest 5,000 U.S. companies. He found that
compliance costs are largest for the biggest firms, but
relative to firm payroll, assets, or sales, they are
proportionately larger for the smaller firms in this sample.
The specific sources of the complexity of the U.S. tax law
are many. In Professor Slemrod's survey, respondents were asked
to identify the aspects of the tax law that were most
responsible for the cost of compliance. Three aspects cited
most often were the depreciation rules, the alternative minimum
tax, and the uniform capitalization rules.
The depreciation and uniform capitalization rules are
examples of the complexity created through differences between
financial statement income and taxable income. The U.S. tax
accounting rules deviate significantly from financial
accounting rules, requiring substantial modifications to
financial statement income in order to compute taxable income.
This is in contrast to the tax laws of other countries, such as
Japan, where there is much greater conformity between book
income and taxable income. The depreciation and uniform
capitalization rules also are examples of areas that have
become more burdensome in recent years, with changes enacted
with the Tax Reform Act of 1986 serving to increase the
complexity.
The other area most frequently cited by the survey
respondents, the alternative minimum tax, adds yet another
layer of complexity. After making all the adjustments from
financial statement income required in computing regular
taxable income, the taxpayer then must compute alternative
minimum taxable income. The computation of alternative minimum
taxable income requires an extensive series of adjustments to
regular taxable income, including adjustments to reflect
different depreciation rules (which already is an area of
particular complexity under the regular income tax). It is not
just alternative minimum taxpayers that must make these
computations; all these computations must be made in order for
the taxpayer to determine whether it is subject to the
alternative minimum tax. Moreover, like the depreciation and
uniform capitalization rules, the alternative minimum tax rules
were made significantly more burdensome by the 1986 Act
changes.\90\
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\90\ Respondents in Professor Slemrod's survey, supra n. 89, cited
alternative minimum tax, uniform capitalization, and depreciation as
among the 1986 Act provisions that most contributed to increasing the
complexity of the U.S. tax system.
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2. Complexity in international transactions.
For a corporate taxpayer with foreign operations or
foreign-source income, compliance with complicated rules noted
above is just the beginning. These taxpayers are subject to a
set of detailed rules with respect to the U.S. tax treatment of
the taxpayer's foreign income. The United States taxes domestic
corporations on their worldwide income. The international tax
rules--both specific provisions and the body of rules in
general--were another area of complexity cited by many of the
respondents in Professor Slemrod's study.
U.S. taxpayers must calculate separately domestic-source
and foreign-source income. To do so, they must allocate and
apportion all expenses between domestic and foreign sources. In
addition, the foreign tax credit rules apply separately to nine
different categories or ``baskets'' of income.\91\ Accordingly,
U.S. taxpayers must calculate foreign-and domestic-source
income--and allocate and apportion expenses to such income--
separately for each basket. All these computations then must be
done again under the alternative minimum tax rules.
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\91\ The rules currently create additional income baskets for
dividends from each foreign corporation in which the taxpayer owns a
10-percent voting interest but which is not a controlled foreign
corporation. Although the Taxpayer Relief Act of 1997 included a
provision eliminating these additional baskets, that provision will not
be effective until 2003. (A Treasury budget proposal would accelerate
this elimination.)
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U.S. taxpayers with foreign subsidiaries must report
currently for U.S. tax purposes certain types of the foreign
subsidiaries' income, even though that income is not
distributed currently to the U.S. parent. In addition to the
complicated rules that must be applied to determine the portion
of the subsidiaries' income that is subject to current
inclusion, U.S. tax accounting rules must be applied to
determine the foreign subsidiaries' earnings and profits (which
may require a translation first from local GAAP to U.S. GAAP
and then from U.S. GAAP to U.S. tax accounting principles). The
U.S. parent also must include with its U.S. tax return detailed
information with respect to each foreign subsidiary.\92\
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\92\ Provisions enacted with the 1997 Act require similar reporting
with respect to foreign partnerships in which the U.S. taxpayer has an
interest.
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Of course, a U.S. taxpayer with foreign operations is
subject not just to the U.S. tax rules but also to the tax
rules of the country where the operations are located. For many
U.S. multinational corporations, this means that the
corporation will be responsible for compliance with the tax
laws of numerous jurisdictions around the world. The results of
each operation must be reported both for local tax purposes and
for U.S. tax purposes, under rules that may reflect significant
differences in terms of both characterization and timing.
Layered on top of the local and U.S. tax rules are the
provisions of an applicable income tax treaty between the two
countries. The treaty provisions have the effect of modifying
the impact of the internal rules of the particular countries.
Application of the treaty requires understanding of the
provisions of the treaty itself as well as any understandings
or protocols associated with the treaty and the Treasury
Department's detailed technical explanation of the treaty.
One specific example of the tax law complexities and
commensurate responsibilities confronting a chief tax executive
of a large U.S.-based multinational corporation is the planning
and analysis necessary to implement an internal restructuring
of a line of business within the company. An internal
restructuring of a particular business unit within a corporate
structure may be desired by management to build efficiencies in
the overall business, to prepare for an acquisition of a
related line of business, or to prepare for a disposition of a
line of business. In any event, the chief tax executive must
research and analyze dozens of discrete tax issues in the
implementation of this management decision, including the
choice of appropriate entity (e.g., partnership, corporation,
or single member LLC), place of organization (involving State
tax or international tax issues), possible carryover of tax
attributes (e.g., accounting methods and periods, earnings and
profits, and capital and net operating losses), consideration
of new tax elections, and consideration of the application of
complex consolidated tax return regulations. Moreover, if the
internal restructuring impacts any foreign operations of the
company, the chief tax executive also must research and analyze
all the foreign tax implications of the restructuring. The
foreign tax treatment of the internal restructuring--and of any
alternative approaches to accomplishing the business
objectives--may be very different than the U.S. tax treatment
of the same transaction or transactions.
D. Responsibility of the corporate tax executive to shareholders.
Corporate executives have a fiduciary duty to increase the
value of a corporation for the benefit of its shareholders.
Reducing a corporation's overall tax liability can increase the
value of a corporation's stock. There are, however, several
reasons that corporate tax executives will avoid undertaking
aggressive, tax-motivated transactions.
Corporate tax executives must meet professional and
company-imposed ethical standards that preclude taking
unsupported, negligent, or fraudulent tax positions.\93\ Also,
incurring significant tax penalties has the effect of reducing
shareholder value. If the reversal of a tax position and the
cost of the penalties are not properly provided for in a
company's financial statements, a restatement of those
financial statements may be required, which could be
devastating to a corporation's stock value. Financial
accounting standards require that all material tax positions
which are contingent as to their outcome must be specifically
disclosed to shareholders. Also, with most corporations focused
on preserving and enhancing their brands, corporate tax
executives are careful not to recommend a transaction to
management that later might be reported unfavorably in the
national press as being improper.
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\93\ Corporate tax executives are governed by professional conduct
standards promulgated by the American Bar Association (ABA) and the
American Institute of Certified Public Accountants (AICPA) if the
corporate tax executive is a member of either of these two professions.
In addition, a corporate tax executive is governed by ``Circular 230''
(31 C.F.R. Part 10), which provides rules of conduct for practicing
before the Service. Additionally, the existing penalty provisions
(discussed above) that apply to the corporation act as a significant
deterrent to a tax exeuctive's recommending a transaction that might
trigger penalties.
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VI. RESPONSIBILITIES OF TAX ADVISERS
This section of the testimony sets out views of the role
played by accounting firms in providing assistance to
corporations on tax issues.
A. Reasons why corporate tax executives need assistance.
As discussed previously, the chief tax executive of a
corporation has many duties and burdens in analyzing federal,
State, and foreign tax consequences of business decisions,
implementing collection and remittance systems for a variety of
federal and State income and excise taxes, and reviewing tax
return positions with Service and State tax personnel upon
examination of tax return positions. These duties require
accurate analysis of very complex federal statutes,
regulations, rulings, and administrative procedures, which in
turn requires keeping current on statutory, regulatory, and
administrative developments as well as a burgeoning body of
case law. Also, today's chief tax executive must have an
intimate knowledge of information technology systems designed
to capture necessary tax data from business operations and
provide essential compliance and remittance functions.
Only in the smallest of corporate business contexts can one
person be charged with all these disparate responsibilities. In
large corporations, even with the assistance of a significant
number of knowledgeable staff, the chief tax executive must
turn to outside advisers for professional assistance for a
variety of consulting and compliance needs.
B. Assisting tax executives fulfill duties as tax administrators.
The accounting profession provides invaluable assistance to
the chief tax executive in his or her role as a tax
administrator charged with the collection and remittance of a
variety of federal taxes. Accounting firms provide assistance
in designing and implementing information technology systems to
track data for preparation of the company's tax return, as well
as systems for collecting, remitting, and providing appropriate
information returns and schedules for employee withholding and
other taxes.\94\ In many instances, the chief tax executive of
a corporation utilizes a mix of systems provided by accounting
firms and other service providers which are then implemented by
corporate personnel; in other instances, compliance and
reporting functions are ``outsourced'' in whole or in part to
accounting firms by the corporation.
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\94\ Payroll service firms and other service providers also can
provide corporations with assistance in tax administrative functions.
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To the extent accounting firms assist in the tax
administrator role of the chief tax executive of a corporation,
the accounting firm is subject to the commensurate duties to
provide accurate data collection, retrieval, remittance, and
reporting systems. Given the sophisticated information
technology systems necessary in large corporations to comply
with the complex tax laws, it is fair to say that the
accounting profession's involvement substantially enhances
corporate tax compliance and augments Service tax
administration.
C. Assistance in addressing complex analytical issues.
The ever-changing tax law, with its lack of precision and
clarity, requires a chief tax executive to confront analytical
difficulties in assessing the tax consequences of business
activities. Many of these business activities are common to
many corporations and industries. For example, considerable
uncertainty exists currently as to the appropriate tax
classification of a variety of expenditures made by
corporations in upgrading technological business systems.
The accounting profession can bring invaluable assistance
to corporate tax executives faced with having to analyze the
tax consequences of an array of business activities where the
appropriate tax analysis is not clear from the rules and
procedures, and where the time invested by the corporation in
developing an independent analysis of the taxation of a
business activity cannot be justified given the broad
experience of professional advisors in analyzing similar
situations for other corporations.\95\ In such cases, the
accounting firm providing analytical assistance is subject to
standards of professional responsibility.\96\
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\95\ Law firms provide legal advice with respect to tax analytical
and planning issues. These comments are focused on the role of
accounting firms.
\96\ The AICPA's ``Statements on Responsibilities in Tax Practice''
(1988 Rev.) consist of advisory opinions that provide conduct
guidelines to practicing CPAs. The statements (cited as ``SRTPs'')
cover a number of common situations that the practicing CPA deals with
on a regular basis. Most importantly, SRTP No. 1 provides guidelines
for taking tax return positions.
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Also, decisions made to promote the objectives of a
corporation--for example, to expand a U.S.-based business
abroad or to divest a portion of the business deemed no longer
part of the ``focus'' of the corporation--can result in
literally hundreds of substantive tax issues that must be
researched and assessed in order to provide the chief tax
executive a degree of certainty that certain tax positions are
appropriate. Only the largest corporations have tax departments
of sufficient size and personnel specialization to afford the
company the ability to perform this necessary analysis
internally. In many cases, the accounting profession provides
essential assistance to corporations in fulfilling these
analytical responsibilities.
D. Assistance in prudent tax planning.
Corporate executives have fiduciary duties to shareholders
to consider the tax results of various potential business
decisions and appropriately to minimize the tax impact of
business operations. Accordingly, in working closely with
management, the chief tax executive of a corporation must offer
proactive assistance in structuring business decisions to meet
planning objectives while prudently minimizing tax
consequences.
As one simple example, a company may feel that the product
manufactured by a particular subsidiary no longer promotes the
business objectives of the corporation. The value of the
subsidiary exceeds the tax basis in its assets, and if the
subsidiary were sold a large capital gain would be realized and
recognized by the corporation. A prudent tax professional would
recommend to management that, as part of its overall business
decision making process regarding the subsidiary, a tax-free
reorganization be considered, possibly a spin-off of the
subsidiary to the corporation's shareholders for a valid
business purpose (the fit and focus of the remaining group)
while preserving the most value of the subsidiary to those
shareholders. The chief tax executive of a corporation would be
remiss if he or she did not focus management on the tax
implications of this potential decision and actively explore
alternative business structures to fulfill management
objectives.\97\
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\97\ It is pertinent to note that the tax law allows taxpayers to
select among a variety of structures and forms to accomplish business
objectives, some of those decisions resulting in lower ultimate tax
liability than other decisions. This deliberation and choice for
taxpayers should be considered a normal part of the income tax system,
and should not be inhibited or penalized. For example, the staff of the
Joint Committee on Taxation does not consider choosing doing business
in partnership form (subject to a single level of tax on operations)
instead of doing business in corporate form (subject to taxation at the
corporate and shareholder levels) a tax expenditure, or exception to
normal tax rules. See, Joint Committee on Taxation, Estimates of
Federal Tax Expenditures For Fiscal Years 1999-2003 (JCS-7-98),
December 14, 1998, p. 6.
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Accounting firms provide professional consulting services
to the chief tax executive as various planning ideas are
reviewed and analyzed to determine the most advantageous method
for implementing business objectives from a tax standpoint.
Such planning assistance is necessary for most corporations
that do not have sufficient internal resources to review and
understand the vast number of issues involved in assessing the
best structure or optimal course of action necessary to fulfill
corporate objectives in the most tax-efficient manner.
In some areas of business planning, many corporations may
share similar objectives. For example, many corporations across
various industries recently have been investigating mergers to
obtain essential business economies of scale. Accordingly,
accounting firms have developed specialty expertise in many
complex and sophisticated issues relating to the taxation of
merger and acquisition activity. These firms thus can advise
corporate executives in an efficient manner on merger and
acquisition issues without forcing the executives to ``reinvent
the wheel'' by devoting a significant amount of time and
resources to obtaining solutions that accounting firms have
more readily available because of specialization and
experience. Also, to the extent that the contemplated
transaction would result in potential foreign tax law
consequences, the fact that large accounting firms have
personnel or affiliated firms in multiple world-wide locations
means that they can provide efficient services to the chief
corporate executive of a U.S.-based multinational corporation.
VII. CONCLUSION
We respectfully urge Congress to reject the
Administration's broad proposals relating to ``corporate tax
shelters.'' As discussed above, the proposals could affect many
legitimate business transactions, further hamstringing
corporate tax executives seeking to navigate the maze of
federal, State, and international tax laws applicable to
corporations. Congress already has provided Treasury with ample
administrative tools--some of which Treasury has not yet self-
activated--to address situations of perceived abuse. There is
no demonstrated need at this time to expand these tools,
particularly in such a way that would give the Service's
revenue agents nearly carte blanche authority to ``deny tax
benefits.'' Instead, where specific areas of concern are
identified, Congress and the Treasury should work together--as
they have done in the past--to enact legislation targeting such
cases.
Chairman Archer. Thank you, Mr. Kies. Let me reiterate that
your printed statement will be inserted in the record, without
objection, in its entirety.
Mr. Weinberger, if you will identify yourself, you may
proceed.
STATEMENT OF MARK A. WEINBERGER, PRINCIPAL, WASHINGTON COUNSEL,
P.C.
Mr. Weinberger. Thank you, Mr. Chairman. My name is Mark
Weinberger. I am a partner with Washington Counsel, a law firm
here in Washington.
I appreciate this opportunity to testify today on the
administration's revenue proposals, specifically those relating
to corporate tax shelters. I understand and appreciate the
concern that motivated the administration to put forward the
corporate tax shelter proposals. To the extent taxpayers are
entering into transactions that are not sanctioned under
applicable law, those taxpayers extract a cost that is borne by
all taxpayers, both individuals and corporations, and may
undermine the foundation of our voluntary tax system.
However, in my opinion, the administration's corporate tax
shelter proposals are unnecessary, and certainly premature,
exceedingly vague and far-reaching, and appear to create an
unprecedented transfer of power to the executive branch, and
specifically IRS revenue agents.
I would like to make seven short observations.
First, the rhetorical and anecdotal press accounts that
have surfaced surrounding tax shelters suggests the corporate
tax base is rapidly eroding and is in imminent danger of
imploding. While the perception of a problem is in itself a
problem, and therefore requires attention, the evidence simply
does not suggest the entire corporate tax base is at risk.
Corporate tax receipts have risen for the last 9 years, and
are projected to increase in the coming years. Moreover, the
administration's own estimates of the savings its proposals are
projected to achieve are modest, less than 0.2 percent of the
total projected tax receipts over the next 5 years.
Second, the administration's proposals are sweeping
separately and collectively. The subjective nature of the
definitions will create significant uncertainty and lead to
widely disparate treatment of similarly situated taxpayers.
They impose new taxes on seemingly legitimate and ordinary
business transactions, something I am sure this Committee is
not intent on doing.
Third, the proposal represents an unprecedented delegation
of power to the executive branch and IRS revenue agents to
override laws enacted by Congress, and to institute new laws by
administrative fiat. The Super section 269 proposal would give
the executive branch authority to disregard its own regulations
and the laws duly enacted by this Congress when the Secretary
does not like the results. The rules would clearly diminish
congressional prerogative. An interesting question would be,
how many of the revenue raisers previously rejected by this
Committee or accepted, but in alternative form, would have been
unnecessary to even submit to Congress for consideration if
these rules were in place?
Fourth, while the expanded authority would technically vest
with the Secretary, it will be exercised by the IRS agents all
around the country. Such power can be abused by agents and used
to threaten taxpayers to settle unrelated tax issues that arise
in annual audits. This is a one-way street that can only be
used to the taxpayers' detriment. It is contrary to the steps
this Committee and Congress took last year in enacting the IRS
Restructuring and Reform Act.
Fifth, Congress must act judiciously. Once such power is
transferred to the executive branch, it would be very hard for
Congress to reclaim it. Any attempt by Congress to reverse such
action would be scored as a revenue loser under current scoring
conventions. Some of the issues raised by the alternative
minimum tax discussion earlier would also exist here.
Sixth, the executive branch already has considerable tools
at its disposal to address tax-abusive transactions. The IRS
has been aggressive and often successful in attacking
transactions through exam and litigation, and has stepped up
the issuances of notices and regulations to address what it
perceives as abuses. In addition, this Committee addressed
legislatively situations brought to its attention by Treasury
when it deemed proper.
Importantly, as recently as in 1997, this Committee and
ultimately Congress, passed a law expanding the definition of
what qualifies as a tax shelter for purposes of reporting
requirements and the substantial understatement penalty
provisions. Treasury, in asking for this proposal, explained
that the provision would help the IRS get information about
deals in a timely manner so that it could audit and take
appropriate action. Treasury has not even implemented this
provision yet, and the administration is asking for more power,
broader authority, and more punitive weapons.
Seventh, if the current rules are inadequate, the Committee
should review them and their effect before adding another layer
of penalties and rules on top of the existing system. This only
creates more complexity and potential pitfalls for taxpayers.
It goes in the exact opposite direction of the IRS
Restructuring and Reform bill's mandated study to review
penalty and interest rules with an eye toward simplifying
penalty and interest administration and reducing taxpayer
burden.
In conclusion, Mr. Chairman, as I said at the outset, I
understand and appreciate the concern that motivated the
administration to put forward the proposals being discussed. I
am eager to work with the Committee Members and staff, along
with Treasury, to address the many imperfections in our tax
system. With all due respect, I think a more appropriate
approach to deal with the problems the administration raised
would be to more thoroughly evaluate the scope of the problem,
and analyze the effectiveness of the tools the IRS already has
in its exposure, including those that have been enacted but
have not yet been utilized. Only when the necessary tools are
proved wanting should the Committee provide additional tools.
Even then, such provisions should be narrowly crafted.
I will be happy to answer any questions the Committee has
at the appropriate time. Thank you.
[The prepared statement follows:]
Statement of Mark A. Weinberger, Principal, Washington Counsel, P.C.
MR. CHAIRMAN and Members of the Committee, I appreciate
this opportunity to testify today on certain of the
Administration's revenue raising proposals addressing so-called
``corporate tax shelters.'' While my written testimony
discusses the ``tax shelter proposals,'' I will be happy to
answer questions regarding other provisions in the President's
FY2000 Budget that I am familier with. I am appearing today on
behalf of a number of companies who share your objective of a
tax system that is fair, easy to understand and administer, and
does not undermine the ability of business to create jobs at
home and compete in our global economy. However, the testimony
I am submitting today represents my own views and may not
reflect the view of each company.
The unifying theme of the companies I represent is a desire
to work with Congress, and the Treasury Department, to ensure
that we have a fair and administrable tax system from both the
taxpayer's and the government's perspective. To the extent that
taxpayers are entering into transactions that are not
sanctioned under the applicable law, those taxpayers extract a
cost that is born by all other taxpayers--both individuals and
corporations, and may undermine the foundation of our voluntary
tax system. We are concerned, however, that several of the
current corporate tax shelter proposals in the President's
FY2000 budget are unnecessary and certainly premature,
exceedingly vague and far reaching, and appear to create an
unprecedented transfer of power to the Executive Branch and
specifically IRS revenue agents. As a result, we believe they
can cause problems in policy and practice. We would like to
offer our support, however, in working with your staff, and
with the Administration, in addressing the many imperfections
that plague our complex and burdensome tax system.
It is difficult to address in detail the Administration's
corporate tax shelter proposals because they have not yet been
drafted, the Administration has not yet released statutory
language nor its promised ``White Paper,'' and because the
proposals are a radical departure from historic norms of income
taxation. Nonetheless, as you review the Administration's
proposals, we urge you to consider two significant points:
First, any legislative action should be
commensurate with the problem, if and when articulated.
Second, any legislative action should not create
unintended adverse consequences that outweigh any expected
benefits.
I. Overview of the Administration's Proposals
The Administration has proposed several general provisions
aimed at curbing corporate tax shelters, as well as a number of
specific provisions intended to attack the results of
particular transactions. Following is a brief overview of the
general provisions.
A. The Administration Has Proposed Broad Definitions of
Corporate Tax Shelters
The Administration's Budget suggests that ``corporate tax
shelters'' may take several forms but often share common
characteristics, including (i) marketing by promoters to
multiple corporate taxpayers, (ii) arranging transactions
between corporate taxpayers and persons not subject to U.S.
tax, (iii) high transaction costs, (iv) contingent or
refundable fees, (v) unwind clauses, (vi) financial accounting
treatment that is significantly more favorable than the
corresponding tax treatment, and (vii) property or transactions
unrelated to the corporate taxpayer's core business. These
factors are incorporated into four broad definitions included
in the Administration's proposals that potentially could extend
to a broad sweep of corporate transactions not ordinarily
considered inappropriate.\1\
---------------------------------------------------------------------------
\1\ Even the Treasury Department has acknowledged that its proposed
definitions may unintentionally target ``good transactions.'' Bureau of
National Affairs, Daily Tax Report G-3 (March 5, 1999).
---------------------------------------------------------------------------
1. A corporate tax shelter would be defined as any entity,
plan or arrangement (to be determined based on all facts and
circumstances) in which a direct or indirect corporate
participant attempts to obtain a tax benefit in a tax avoidance
transaction.
2. A tax benefit would be defined to include a reduction,
exclusion, avoidance or deferral of tax, or an increase in a
refund, but would not include a tax benefit clearly
contemplated by the applicable provision (taking into account
the congressional purpose for such provision and the
interaction of such provision with other provisions of the
Code).
3. A tax avoidance transaction would be defined as any
transaction in which the reasonably expected pre-tax profit
(determined on a present value basis, after taking into account
foreign taxes as expenses and transaction costs) of the
transaction is insignificant relative to the reasonably
expected net tax benefits (i.e., tax benefits in excess of the
tax liability arising from the transaction, determined on a
present value basis) of such transaction. In addition, a tax
avoidance transaction would be defined to cover certain
transactions involving the improper elimination or significant
reduction of tax on economic income (emphasis added).
4. A tax indifferent party would be defined as a foreign
person, a Native American tribal organization, a tax-exempt
organization, and domestic corporations with expiring loss or
credit carryforwards. For purposes of this definition, loss and
credit carryforwards would generally be treated as expiring if
the carryforward is more than 3 years old.
B. Summary Description of the Administration's Proposals
1. Modify Substantial Understatement Penalty for Corporate
Tax Shelters.--This proposal would increase the substantial
understatement penalty applicable to corporate taxpayers for
any item attributable to a ``corporate tax shelter'' from 20
percent to 40 percent of the tax associated with the
understatement. In addition, the reasonable cause exception
would be eliminated for any item attributable to a corporate
tax shelter. The penalty could be reduced to 20 percent if the
corporate taxpayer (i) discloses the transaction to the IRS and
files copies of the transaction documents within 30 days of the
transaction's closing, (ii) files a statement with its tax
return verifying that such disclosure has been made and (iii)
provides adequate disclosure on its tax returns as to the book/
tax differences resulting from the corporate tax shelter item
for the taxable years in which the tax shelter transaction
applies.
2. Deny Certain Tax Benefits to Persons Avoiding Income Tax
as a Result of Tax Avoidance Transactions.--This ``Super
Section 269'' proposal would expand the scope of the
government's existing authority to disallow certain benefits
when certain acquisitions are undertaken for the principal
purpose of evading or avoiding federal income tax by securing
the benefit of a deduction, credit or allowance. As proposed,
Section 269 would be expanded to allow the government to
disallow any deduction, credit, exclusion or other allowance
obtained in a ``tax avoidance transaction.'' \2\
---------------------------------------------------------------------------
\2\ All Section references are to Sections of the Internal Revenue
Code of 1986, as amended (the ``Code'').
---------------------------------------------------------------------------
3. Deny Deductions for Certain Tax Advice and Impose an
Excise Tax on Certain Fees Received.--This proposal would deny
a deduction to a corporate taxpayer that participates in a
``tax avoidance transaction'' for fees paid or incurred in
connection with the purchase and implementation of ``corporate
tax shelters'' and the rendering of tax advice related to
``corporate tax shelters.'' In addition, the proposal would
impose a 25 percent excise tax on the receipt of such fees.
4. Impose Excise Tax on Certain Rescission Provisions and
Provisions Guaranteeing Tax Benefits.--This proposal would
impose a 25 percent excise tax on the maximum payment under a
``tax benefit protection arrangement'' entered into in
connection with the purchase of a ``corporate tax shelter'' by
a corporate taxpayer. The Administration would define a ``tax
benefit protection arrangement'' to include a rescission
clause, guarantee of tax benefits arrangement or any other
arrangement that has the same economic effect (e.g., insurance
purchased with respect to the transaction).
5. Preclude Taxpayers from Taking Tax Positions
Inconsistent with the Form of Their Transactions.--This
proposal would prohibit a corporate taxpayer from taking any
position (on any return or refund claim) that the federal
income tax treatment of a transaction is different from that
dictated by its form if a ``tax indifferent party'' has a
direct or indirect interest in the transaction. This rule would
not apply if (i) the taxpayer discloses the inconsistent
position on a timely filed original federal income tax return
for the taxable year in which the transaction is entered into,
(ii) if reporting the substance of the transaction more clearly
reflects the income of the taxpayer (but only to the extent
allowed by regulations), or (iii) to certain transactions
identified in regulations, such as publicly available
securities lending and sale-repurchase transactions.
6. Tax Income from Corporate Tax Shelters Involving Tax-
Indifferent Parties.--This proposal would provide that any
income allocable to a ``tax indifferent party'' with respect to
a ``corporate tax shelter'' is taxable to such party,
regardless of any statutory, regulatory or treaty exclusion or
exception. Moreover, all other taxpayers involved in the
``corporate tax shelter'' would be jointly and severally liable
for the tax.
II. The First Objective Should Be to Assess Causes and the Severity of
``The Problem'' and Ensure Any Remedies Do Not Risk Causing More Harm
than Good.
The rhetoric, and anecdotal press accounts, that have
surfaced surrounding ``tax shelters'' suggest that the
corporate tax base is rapidly eroding and in imminent danger of
imploding. In his testimony before this Committee last month,
Treasury Secretary Rubin stated that the targeted transactions
``not only erode the corporate tax base, they also breed
disrespect for the tax system both by people who participate in
the corporate tax shelter market and by others who perceive
corporate tax shelter users as paying less than their fair
share of tax.'' \3\ While the perception of a problem is in
itself a problem and therefore, requires attention, the data we
have reviewed simply does not support the claims that the
entire corporate tax base is at risk.\4\
---------------------------------------------------------------------------
\3\ Hearing on the President's Fiscal Year 2000 Budget Before the
House Committee on Ways and Means, 106 Cong. (1999) (statement by the
Honorable Robert E. Rubin, Secretary U.S. Department of the Treasury).
\4\ The following table is compiled from data set forth in Office
of Management and Budget, Historical Tables, Budget of the United
States Government, Fiscal Year 2000 (February 1999).
---------------------------------------------------------------------------
These statistics indicate that, despite the
Administration's belief that certain transactions are
contributing to the erosion of the corporate tax base,
corporate taxpayers in the United States have paid more money
to the federal government for each of the past nine years, and
that the percentage of corporate income tax receipts as
compared to both total federal receipts and gross domestic
product has remained steady over the past decade.\5\ Indeed,
the Administration's own revenue estimates suggest that the
scope of the problem is limited.\6\
---------------------------------------------------------------------------
\5\ Moreover, the Administration's estimates for the next five
years indicate that this trend will continue, with corporate income
taxes as a percentage of gross domestic product remaining at
approximately 2.1 percent for each of those years and annual corporate
payments continuing to trend up.
\6\ The Administration estimates that the six proposals outlined
above would increase revenues by $1.76 billion over five years--less
than 0.2% of total projected corporate tax receipts over that period.
Of this amount, $830 million relates to the proposal to tax income
attributable to tax indifferent parties.
---------------------------------------------------------------------------
One of the reasons cited by government agencies and
officials for surpluses higher than expected over the past
couple years, and in the future, is a stronger than expected
economy resulting in higher than expected profits and in turn
taxable revenue. U.S. businesses have become more efficient in
their business operations and have been able to raise capital
to effectively compete in the global market place.
Corporate Income Tax Receipts
----------------------------------------------------------------------------------------------------------------
Corporate Income Percent of Percent of
Year Tax Receipts Total Receipts Total GDP
----------------------------------------------------------------------------------------------------------------
FY1989.......................................... $103,291,000 $991,190,000 10.4% 1.9%
FY1990.......................................... $93,507,000 $1,031,969,000 9.1% 1.6%
FY1991.......................................... $98,086,000 $1,055,041,000 9.3% 1.7%
FY1992.......................................... $100,270,000 $1,091,279,000 9.2% 1.6%
FY1993.......................................... $117,520,000 $1,154,401,000 10.2% 1.8%
FY1994.......................................... $140,385,000 $1,258,627,000 11.2% 2.1%
FY1995.......................................... $157,004,000 $1,351,830,000 11.6% 2.2%
FY1996.......................................... $171,824,000 $1,453,062,000 11.8% 2.3%
FY1997.......................................... $182,293,000 $1,579,292,000 11.5% 2.3%
FY1998.......................................... $188,677,000 $1,721,798,000 11.0% 2.2%
----------------------------------------------------------------------------------------------------------------
However, the Congressional Budget Office (CBO) notes that
``corporate profits are beginning to be squeezed by higher
labor costs and the inability of firms to raise prices in the
face of strong opposition from home and abroad.'' \7\ CBO also
notes that corporate profits will decline primarily because of
a projected increase in GDP share devoted to depreciation.\8\
CBO predicts that some decline in corporate profits from recent
levels is ``inevitable'' because of the sensitivity of
corporate profits to business-cycle fluctuations.\9\ In an era
of projected budget surpluses, the size of which is due in part
to increased corporate profits and taxes thereon, the Congress
should think seriously before enacting proposals that would
restrict the ability of corporate taxpayers to operate
efficiently and respond to changing market conditions.\10\ This
is especially true when CBO is predicting increased pressures
on future corporate profits.
---------------------------------------------------------------------------
\7\ CBO, Economic and Budget Outlook, Fiscal Year 2000-2009,
January 1999, p. 24.
\8\ Ibid, p. 27.
\9\ Ibid.
\10\ This comment refers to the potential stifling effect the tax
shelter proposals may have on legitimate corporate transactions as well
as several other proposals in the President's FY2000 budget aimed at
making it more difficult for taxpayers to efficiently restructure and
raise capital (e.g., tax increase proposals listed in sections entitled
``Financial Products'' and ``Corporate Provisions'' in the General
Explanation of the Administration's Revenue Proposals, (February
1999)).
---------------------------------------------------------------------------
Accordingly, the Committee should not let anecdotal
evidence and targeted press accounts attacking various
transactions lead to enacting hastily contrived legislation
that remains vague and over reaching. The threshold for
enacting legislation in the area remains high. In my view, tax
shelters do not threaten the entire corporate tax base.
Accordingly, responses to the problem, when appropriately
articulated, should not be left vague and far reaching in a way
that threatens the ability of U.S. businesses to operate
efficiently and, ultimately, corporate profits and the Federal
revenues they generate.
III. Treasury Has Several Existing Tools to Combat its Perceived
Problem Which Should Be Evaluated Before Piling on New Ones.
Much of the rhetoric relating to the Administration's
proposals suggests that the government needs the tools proposed
therein because it is not aware of transactions and tax
planning arrangements which it might deem inappropriate. That
is why the Administration proposed numerous specific provisions
to attack transactions that it does not like, plus the general
provisions in case there are others which they have not yet
found.
The IRS has several old and some new tools at its disposal
to deal with the issue. Before enacting new proposals, existing
proposals should be carefully and thoroughly reviewed. If they
do not work or are inadequate perhaps they should be repealed
and replaced with new ones. However, adding another layer of
penalties and rules to overlay existing ones merely creates
more complexity and potential pitfalls for taxpayers. It goes
in the exact opposite direction of the intent of the study
authorized as part of the Internal Revenue Service
Restructuring and Reform Act of 1998 (IRS Reform Act) which
requires a study reviewing the ``administration and
implementation by the Internal Revenue Service of interest and
penalty provisions .... and legislative or administrative
recommendations....to simplify penalty or interest
administration and to reduce taxpayer burden.'' \11\
---------------------------------------------------------------------------
\11\ See, Joint Committee on Taxation Press Release, 98-2 (December
21, 1998).
---------------------------------------------------------------------------
As recently as 1997, this Committee and ultimately the
Congress, passed a law that expanded the definition of what
qualifies as a ``tax shelter'' for purposes of registering such
transactions with the IRS.\12\ When Treasury proposed the
registration in February 1997, it explained that the provision
would help get the IRS useful information about corporate deals
at an early stage to help identify transactions to audit and
then take appropriate action--presumably seeking additional
legislative and regulatory action when necessary.\13\
---------------------------------------------------------------------------
\12\ See Section 1028 of the Taxpayer Relief Act of 1997(adding
Section 6111(d) to the Internal Revenue Code).
\13\ See the U.S. Treasury Department's General Explanations of the
Administration's Revenue Proposals, at 81 (February 1997). According to
Treasury: Many corporate tax shelters are not registered with the IRS.
Requiring registration of corporate tax shelters would result in the
IRS receiving useful information at an early date regarding various
forms of tax shelter transactions engaged in by corporate participants.
This will allow the IRS to make better informed judgments regarding the
audit of corporate tax returns and to monitor whether legislation or
administrative action is necessary regarding the type of transactions
being registered.
---------------------------------------------------------------------------
The filing requirement becomes effective when Treasury
Regulations are prescribed. To date, such regulations have not
been issued. Putting aside the many issues to be resolved once
Treasury releases its view of the expansive new definition of
corporate tax shelters, there appears to have been little
effort to assess the effectiveness of existing programs,\14\ as
modified in 1997, before compounding it with this myriad of new
proposals.
---------------------------------------------------------------------------
\14\ Section 6111 was added to the Code in the Tax Reform Act of
1984. In 1989, the Commissioner's task force Report on Civil Tax
Penalties concluded that ``[v]irtually no empirical data exists'' about
the Section 6111 penalty (VI-22 and n. 29 (1989)). See also, New Tax
Shelter Penalties Target Most Tax Planning, Mark Ely and Evelyn Elgin,
Tax Notes (December 8, 1997).
---------------------------------------------------------------------------
The new expansive definition of tax shelters was also
carried over to Section 6662, the substantial understatement
penalty provision. Accordingly, the increased exposure to the
penalty, as a result of the 1997 changes, is virtually brand
new and has not been assessed.\15\ In this case, unlike the
registration requirement discussed above, there is no
requirement that the arrangement involve a corporation, a
confidentiality agreement or minimum promoter fees. As a
result, it is worth noting, that under current law a corporate
taxpayer can fully disclose a position on a tax return and can
have substantial authority for such position but still be
subject to penalty if the transaction is considered a tax
shelter. The only way to avoid a penalty is to establish
reasonable cause which, by regulation, Treasury has already
circumscribed so that for example, a taxpayer's reasonable
belief that it is more likely than not to prevail may not be
sufficient.\16\ The Administration would remove even the
reasonable cause escape hatch, in addition to doubling the
penalty rate in certain circumstances.
---------------------------------------------------------------------------
\15\ As suggested by the staff of the Joint Committee on Taxation
in their description of the Administration's revenue proposals, ``it
may be premature to propose new measures to deal with corporate tax
shelters when provisions have already been enacted that are intended to
that, but where there has been no opportunity to evaluate the
effectiveness of those already-enacted provisions because they have not
yet become effective because of the lack of the required guidance.''
Staff of the Joint Committee on Taxation, Description of Revenue
Provisions Contained in the President's Fiscal year 2000 Budget
Proposal, JCS-1-99 at 165 (Feb. 22, 1999) (hereinafter the ``JCT
Report'').
\16\ See Sections 6662(d)(2)(c)(ii) and 6664(c) establishing the
reasonable cause exception. See Treas. Reg. Section 1.664-(4)(e)(3)
discussing the limitation.
---------------------------------------------------------------------------
Many have argued that the success of the 1997 changes to
the substantial understatement penalty rules will turn on how
artfully the term tax shelter is defined by the Treasury
Department and enforced by IRS agents. There is great concern
in the business community that the expanded definition will
provide a strong incentive for revenue agents to set up
penalties as bargaining chips in negotiations. Before
considering giving these agents more authority and larger
weapons, I believe it is important to evaluate the effect of
these most recent changes. It seems premature, if not
unnecessary, to be exploring the Administration's 16 new
proposals even before the most recent changes take effect.
Moreover, as a practical matter, when it does identify what
it perceives as ``abuses,'' the IRS has been aggressive (and
often successful) in attacking those transactions through
examination and litigation. Significant cases that the
government has won in recent years include: Ford Motor Co. v.
Commissioner, 102 T.C. 87 (1994), aff'd 71 F.3d 209 (6th Cir.
1995) (Tax Court limited a current deduction for a settlement
payment, stating that tax treatment claimed by the taxpayer
would have enabled it to profit from its tort liability);
Jacobs Engineering Group, Inc. v. United States, 97-1 USTC
87,755 (CCH para. 50,340) (C.D. Cal. 1997) (applying Section
956 to a transaction despite the fact that a literal reading of
the regulations would not have subjected the taxpayer to that
provision); ACM Partnership v. Commissioner, 73 T.C.M. (CCH)
2189 (1997), aff'd 157 F.3d 231 (3d Cir. 1998) (not respecting
a partnership's purchase and subsequent sale of notes, stating
that the transaction lacked economic substance); ASA
Investerings Partnership v. Commissioner, 76 T.C.M. (CCH) 325
(1998) (applying an intent test to determine that a foreign
participant in a partnership was a lender, rather than a
partner, for federal income tax purposes); but see, Wolff v.
Commissioner, 148 F.3d 186 (2nd Cir. 1998) (reversing the Tax
Court's denial of an ordinary loss in connection with the
extinguishment of an unregulated futures contract, stating that
the fact that the taxpayer selected the cancellation method (as
opposed to closing the contract by offset) does not justify
imposition of the legal ``substance over form'' fiction).
Likewise, the Administration regularly addresses what it
perceives as ``abuses'' through notices and regulations. In
recent years, the Treasury Department has promulgated a number
of regulations and other rules intended to stop certain so
called ``inappropriate'' tax planning. These include the
partnership anti-abuse regulations,\17\ the anti-conduit
financing regulations,\18\ the temporary regulations targeting
the improper use of tax treaties by hybrid entities \19\ and
the recently proposed regulations targeting fast-pay stock
arrangements.\20\ Moreover, on a number of occasions in recent
years, the Treasury Department has issued notices to target
specific tax planning techniques, typically announcing its
intention to issue regulations addressing such techniques,
effective as of the date of the notice. Examples of this
approach include notices attacking inversion transactions,\21\
fast-pay stock arrangements,\22\ transactions involving the
acquisition or generation of foreign tax credits \23\ and
transactions involving foreign hybrid entities.\24\
---------------------------------------------------------------------------
\17\ Treas. Reg. Sec. 1.701-2.
\18\ Treas. Reg. Sec. 1.881-3; Prop. Treas. Reg. Sec. 1.7701(l)-2.
\19\ Temp. Treas. Reg. Sec. 1.894-1T.
\20\ Prop. Treas. Reg. Sec. 1.7701(l)-3.
\21\ Notice 94-46, 1994-1 C.B. 356.
\22\ Notice 97-21, 1997-1 C.B. 407.
\23\ Notice 98-5, 1998-3 I.R.B. 49.
\24\ Notice 98-11, 1998-6 I.R.B. 13.
---------------------------------------------------------------------------
Under the present system, when the Treasury Department
identifies a perceived ``abusive'' transaction, whether through
rulemaking or by way of a specific legislative proposal, this
Committee and its counterpart in the Senate have not hesitated
to enact legislation to curb transactions that they perceive as
inappropriate. For example, two years ago, Mr. Chairman, you
announced a proposal targeting certain Morris Trust
transactions, and, working with the Senate and the Treasury
Department, enacted a solution through the tax legislative
process. Similarly, last May you introduced legislation to
eliminate certain tax benefits involving the liquidation of a
regulated investment company or real estate investment trust,
and, working with the Senate and the Treasury Department,
enacted a solution effective as of the date of your
announcement. The solutions that Congress provides to the
perceived problems identified by the Treasury Department are
not always the solutions proposed by the Administration, but
that is merely a reflection of our system of government, which
separates the executive and legislative functions in
independent branches. Thus, the Morris Trust legislation
imposes a tax at the corporate level, whereas the Treasury
Department's original proposal would have imposed a tax at both
the corporate and shareholder levels.
We are not suggesting that there are no transactions which
generate unanticipated and inappropriate tax consequences. To
the contrary, these results are the inevitable outcome of a tax
system that is too complex and burdensome. We also recognize
the obvious--taxpayers and their advisors move quickly to take
advantage of perceived tax planning opportunities. However,
wholesale new laws with vague and punitive components do not
further a cooperative environment for taxpayers and the
government. We believe there is a great difference between
disclosure requirements and punitive tax increases. The
concepts should be separated.
On that note, disclosure of appropriate information to the
IRS is an important element of successful enforcement. This
Committee approved enhanced disclosure of tax shelters in the
1997 IRS Restructuring and Reform Act. This is on top of
existing disclosure requirements. In this regard, we note that
corporate taxpayers generally are required to reconcile their
book and taxable income on the face of the corporate income tax
return.\25\ As indicated above, the Administration has
suggested that many ``corporate tax shelters'' involve
differences between the financial accounting treatment and the
federal income taxation of a transaction. To the extent that
this is correct, corporate taxpayers already are required to
show this difference to the IRS. Every book-tax difference is
subject to a fairly full set of IDRs, which probably exceeds
the information the IRS will get in disclosure. Because the
vast majority of large corporate taxpayers participate in the
large case examination program, in which revenue agents work at
the taxpayer's headquarters in order to conduct continual
audits of the taxpayer's returns, and because these agents have
ready access to the taxpayer's corporate tax department, the
IRS already has the information it needs to identify potential
``corporate tax shelters.'' If this information proves
inadequate, perhaps modification of existing disclosure laws is
in order.
---------------------------------------------------------------------------
\25\ Internal Revenue Service Form 1120, Schedule M-1.
---------------------------------------------------------------------------
IV. The Administration Is Seeking an Unprecedented and Inappropriate
Delegation of Power
To the extent that this Committee determines that
legislative action is required in this area, such action should
be commensurate with the problem. Moreover, the Committee
should balance carefully the expected benefit of any
legislative proposal with the likely adverse consequences of
enacting such a proposal. As discussed below, the
Administration's proposals are not commensurate with the
problem, and, in fact, represent an unprecedented delegation of
legislative authority to the Executive Branch and IRS revenue
agents.
The breadth of the operative definitions for the proposals,
outlined above, indicates that the Treasury Department is
casting a very wide net with its proposals. The subjective
nature of the definitions would create significant uncertainty
as to their applicability in many circumstances, as well as
lead to the potential for widely disparate treatment of
similarly situated taxpayers. Of particular concern is the
proposed definition of a ``tax avoidance transaction,'' which
requires a comparison of the ``reasonably expected pre-tax
profit'' and the ``reasonably expected net tax benefits,'' as
well as a determination of whether a transaction involves the
``improper elimination or significant reduction of tax on
economic income.'' \26\ The proposed definition of a ``tax
benefit'' suffers from similar flaws, in that it requires an
evaluation of whether a tax benefit is ``clearly contemplated''
by a particular Code provision ``taking into account the
congressional purpose'' for the provision, as well as the
``interaction of such provision with other provisions of the
Code.'' The proposed definition of a ``tax indifferent party,''
on the other hand, would ignore congressional purpose, allowing
the IRS to tax Native American tribal organizations or tax-
exempt organizations, despite the fact that Congress has
provided those categories of taxpayers with exemptions from
tax. Moreover, the latter definition would add another kind of
uncertainty for taxpayers, in that parties to a transaction
could wind up subject to deficiencies and penalties for the
simple reason that they did not know whether another party to
the same transaction had expiring loss or credit carryforwards.
Quite simply, these sweeping definitions are a recipe for
attacks on legitimate tax planning, Executive Branch
nullification of laws duly enacted by Congress, and endless
litigation and confrontation between taxpayers and agents.
---------------------------------------------------------------------------
\26\ It should be noted that this definition would encompass a
number of the Administration's other legislative proposals, including
some that the Congress has rejected out of hand. For example, more than
three years ago the Treasury Department proposed legislation that would
impose an average cost basis regime for securities. This proposal,
which the Congress has rejected repeatedly, would end the current
practice of allowing taxpayers to determine which particular stock to
sell, when the only factor in that decision today is the amount of gain
that will be subject to tax as a result. Undoubtedly, the taxpayer's
decision in such cases is tax motivated, has no impact on expected pre-
tax profits, and could lead to a ``reduction of tax on economic
income.''
---------------------------------------------------------------------------
What is particularly troubling about the unprecedented
delegation of authority to the Executive Branch and revenue
agents are the proposals, such as the ``Super Section 269''
proposal, which would allow the Executive Branch and revenue
agents to reverse substantive results otherwise required under
particular Code provisions based on their determination that a
transaction involves the improper elimination or reduction of
tax on economic income or otherwise comes within the proposed
definition of a ``tax avoidance transaction.'' In the real
world, corporate taxpayers regularly enter into transactions or
arrange their affairs in such a manner as to reduce their
income taxes. The capital markets tend to reward corporations
that can increase financial income without increasing taxable
income.
Notwithstanding these realities the ``Super Section 269''
proposal, as described by the Administration, would apply to an
endless number of routine transactions and tax planning
activities that no reasonable observer would consider
``abusive.'' As Judge Learned Hand observed over sixty years
ago:
A transaction, otherwise within an exception of the tax law,
does not lose its immunity, because it is actuated by a desire
to avoid, or, if one choose, to evade, taxation. Any one may so
arrange his affairs that his taxes shall be as low as possible;
he is not bound to choose that pattern which will best pay the
Treasury; there is not even a patriotic duty to increase one's
taxes.\27\
---------------------------------------------------------------------------
\27\ Helvering v. Gregory, 69 F.2d 809, 810 (2nd Cir. 1934), aff'd
293 U.S. 465 (1935).
This basic principle would be reversed in one grand gesture
if the Congress enacts ``Super Section 269.'' Under that
provision, taxpayers could be penalized for merely arranging
their transactions in such a manner as to obtain the lowest
amount of tax required under the Code.
To date, the breathtaking scope of this particular proposal
has been defended on two grounds. On occasion, it has been
claimed that it is narrower than current law. This seems odd--
if true, however, there is no reason to enact it. The other
defense is the classic ``trust me'' claim--we're from the
government, we can tell the good from the bad, and we won't
abuse our power. While perhaps well intentioned, policy
initiatives of the Treasury and National Office of the IRS are
sometimes ill-advised, and often implemented by IRS agents in
ways unanticipated and unintended. Whether it is because the
laws are so complex or the agents use them as a means to
extract other concession, such broad authority is dangerous.
The proposal provides too much authority to the Executive
Branch and revenue agents and will be difficult to undo once
such power is transferred.
In order to fathom the Administration's intended scope of
the ``Super Section 269'' proposal, we urge you to pose the
following questions to the Treasury Department:
How many of the specific proposals presented by
the Administration would be redundant if the Congress enacts
the ``Super Section 269'' proposal?
How many of the dozens of revenue raising
provisions enacted by the Congress in the past twenty years
addressing transactions characterized as loopholes, tax
shelters and the like would be redundant if the Congress enacts
the ``Super Section 269'' proposal?
How many of the dozens of revenue raising
provisions presented by this Administration (as well as those
presented by the two prior Administrations) but that have been
rejected by the Congress would effectively become law if the
Congress enacts the ``Super Section 269'' proposal?
We respectfully suggest that you reject the
Administration's proposals dealing with corporate tax shelters
until they provide you with convincing and satisfactory answers
to these and similar questions.
As a substantive matter, the ``Super Section 269'' proposal
would give the Executive Branch authority to disregard its own
regulations, and the laws duly enacted by the Congress, when
``the Secretary'' does not like the results.\28\ The problem
with this is that it would allow ``the Secretary'' to determine
both (i) whether there is a problem, and (ii) how to address
the perceived problem. Once ``the Secretary'' changed the law
under this authority, any attempt by the Congress to reverse
such an action as bad policy would be scored as a revenue loser
under the current scoring conventions in the Federal Budget
process. Congress would find itself in the odd position of
having extreme difficulty overturning Treasury's rules. This is
an extraordinary proposal, and one that we urge you to reject.
---------------------------------------------------------------------------
\28\ For example, the proposal to tax income allocable to ``tax
indifferent parties'' specifically states that it would tax such income
``regardless of any statutory, regulatory or treaty exclusion or
exception.''
---------------------------------------------------------------------------
Moreover, no one should be fooled by the delegations to
``the Secretary.'' The real world implication of the
Administration's proposals is that, although the proposals
undoubtedly would authorize ``the Secretary'' to disallow
deductions, impose excise taxes or otherwise implement the
proposals, at the end of the day it is the IRS revenue agents
sitting in the corporate offices of corporate taxpayers who
will be deciding what is ``clearly contemplated'' by a
particular Code provision.
This new power for revenue agents requested by the
Administration could be abused, such as by being used to
threaten taxpayers to settle unrelated tax issues that may
arise during an audit.\29\ For example, it is not difficult to
imagine a revenue agent setting up assessments based on an
alleged ``corporate tax shelter,'' including the proposed 40
percent substantial understatement penalty, in an attempt to
obtain concessions from the taxpayer on other issues. Although
the Internal Revenue Service is in the process of remaking
itself in response to Congress's goal in last year's IRS
Restructuring and Reform Act, we urge you to think carefully
before delegating such significant power to revenue agents.
---------------------------------------------------------------------------
\29\ See JCT Report, supra note 14, at 166.
---------------------------------------------------------------------------
The penalty suggested by the Administration for corporate
taxpayers that engage in transactions that the Administration
does not like is unprecedented. The overlapping proposals would
have the effect of taxing corporate income not twice, as is the
norm under our current system, but three or more times. For
example, a corporate taxpayer could (i) lose expected tax
benefits under the ``Super Section 269'' proposal, (ii) lose
deductions for fees paid in a transaction, (iii) pay an excise
tax on fees in a transaction, (iv) pay an excise tax on a ``tax
benefit arrangement'' entered into in connection with the
transaction, (v) pay taxes attributable to a ``tax indifferent
party'' involved in the transaction, and (vi) pay a forty
percent (40%) penalty on top of the underlying tax. The
cumulative effect in some cases could be treble or quadruple
taxation, or worse. Never before has the Congress sought to tax
the same transaction so many times. What is even more striking
is that, as noted above, such onerous penalties could be
imposed on taxpayers who comply with the specific Code
provisions enacted by Congress and regulations issued by the
Treasury Department. That is, the taxpayer loses even if it
follows the rules.
V. The Administration's Proposals Violate Fundamental Notions of
Neutrality and Fair Play
In many ways, what is most striking about the
Administration's proposals is their blatant disregard for
fundamental notions of neutrality and fair play. This disregard
is evident in four respects.
First, the Administration fails to acknowledge that many of
the ``uneconomic'' tax consequences of which it complains are
the direct result of its own ``uneconomic'' rules--rules that
the Administration crafted for the purpose of over-taxing
taxpayers. Perhaps the single best way for the Administration
to curb transactions with results that it finds troublesome
would be for the Administration to write rules that are even-
handed and neutral in their application. For example, when the
IRS successfully asserted in litigation and other guidance that
Section 357(c) applies to a liability even when the
transferring taxpayer remains liable for it (thereby leading to
an assessment that substantially exceeds its ``economic
income,''), other taxpayers reached the reasonable conclusion
that this rule of law would apply in all circumstances, not
just when it helped the IRS and hurt taxpayers. Section 357(c)
applies when the liability is secured by another asset that the
transferor retains. Mr. Chairman, your bill to address such
transactions would not be necessary if the IRS had adopted a
more even-handed approach in the first instance.\30\
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\30\ See H.R. 18, 106th Cong., 1st Sess. (1999).
---------------------------------------------------------------------------
Second, the Administration fails to acknowledge that many
of the ``problems'' of which it complains are the by-product of
the way we tax enterprise income and our system of double
taxation. Unfortunately, it appears that the Administration has
chosen not to work through these difficult structural issues.
It is as though they have thrown up their hands in surrender
and said, ``we give up on principled solutions; just let us do
what we want based on what we think is fair.''
Third, the Administration's proposals are a one way street.
In some respects, the ``Super Section 269'' proposal is a
request for equitable powers--let the IRS do ``right'' when the
law as written has consequences ``not clearly contemplated'' by
Congress. Setting aside the uncertainties created by this
concept, and setting aside the wisdom of delegating such power
to the IRS, one question remains. What about all of those
circumstances where the law as written has unanticipated
consequences that are adverse to taxpayers? We suggest you ask
whether the Administration would support an ``equitable
relief'' provision that runs both ways. Would the
Administration support a provision that would entitle taxpayers
to the ``right'' answer when a literal application of the law
would give rise to unfair results--unless, of course, those
unfair results were ``clearly contemplated'' by Congress?
Mechanical rules seem to be binding on taxpayers, why not the
IRS? Our fear is the proposals put forth by the Administration
would have the unintended effect of eliminating any incentive
for the Administration to write fair and even-handed rules.\31\
---------------------------------------------------------------------------
\31\ For example, if Congress enacted the ``Super Section 269''
proposal, it is quite possible that the IRS could use that authority to
attack transactions without trying to develop fair rules to address
perceived problems. To illustrate, the Administration's proposal to
prevent the importation of ``built-in losses'' would apply equally to
gains and losses. Thus, when a foreign individual with appreciated
property becomes a resident of the United States, the basis of that
property would be marked to market, so that the individual would be
taxable upon a sale of the property only to the extent of any gain
attributable to the period after immigration. If the ``Super Section
269'' proposal is enacted, but the ``built-in loss importation''
proposal is not, then the IRS would be able to target built-in loss
importation transactions, but at the same time would continue to tax a
lifetime of earnings not attributable to an individual's residence in
the United States.
---------------------------------------------------------------------------
Fourth, the Administration has offered few proposals to
remedy the many defects of our system that adversely affect
corporate taxpayers. There are no comprehensive proposals to
simplify the tax law. There are no proposals to remedy the mess
created by INDOPCO, Inc. v. Commissioner.\32\ There are no
proposals to ameliorate the over-taxation of economic income
and the repeated taxation of that income. There are no
proposals to enhance the competitiveness of American companies
in the global economy.
---------------------------------------------------------------------------
\32\ 503 U.S. 79 (1992).
---------------------------------------------------------------------------
VI. Conclusion
As I stated at the outset, Mr. Chairman, we understand and
appreciate the concern that motivated the Administration to put
forward the proposals that the Committee is discussing today.
We are eager to work with you and your colleagues, and with the
Administration, to address the many imperfections in our tax
system--flaws that disadvantage taxpayers, as well as flaws
that harm the federal fisc. With all due respect, however, it
is clear that the path suggested by the Administration is a
radical and unwarranted departure from long-standing norms--a
departure that would not do justice to taxpayers and the tax
system.
A more appropriate approach to the problems suggested by
the Administration is to evaluate (i) the true scope of the
perceived problem, (ii) the ability of the IRS to identify
imperfections in our tax system through the tools it already
has, and (iii) the ability of the government to address the
problems that it does identify, either through the rulemaking
process or in the courts. Only when the Treasury Department and
the IRS do not have the necessary tools to address the problems
that they identify, or when the Treasury Department identifies
problems that it cannot address through its existing regulatory
authority, should this Committee provide additional tools and
delegations of authority to the IRS.
Chairman Archer. Thank you, Mr. Weinberger.
Mr. Wamberg, you are next. If you will identify yourself
for the record, you may proceed.
STATEMENT OF W.T. WAMBERG, CHAIRMAN OF THE BOARD, CLARK/BARDES,
DALLAS, TEXAS
Mr. Wamberg. Good afternoon. My name is Tom Wamberg. I am
the chairman of the board of Clark/Bardes, a publicly traded
company, headquartered in Dallas, Texas.
Our company designs insurance-based programs for financing
employee benefit plans. Our clients include a broad range of
businesses. They use these insurance products as assets to
offset the liabilities of these employee benefit plans and to
supplement and secure plans for senior executives.
I am here today to express Clark/Bardes' strong opposition
to the administration's proposal that would increase taxes on
companies that purchase insurance covering the lives of their
employees. This same proposal was included in the
administration's budget last year, but was wisely not enacted.
I would like to express our appreciation to the Members of the
this Committee who last year raised strong objections to the
administration's proposed tax increase on insurance products. I
am pleased to know that this opposition remains strong this
year.
There are many reasons why Congress again, should not adopt
the administration's proposal. The first is, employer-owned
life insurance has long been used by businesses to fund a
variety of business needs, including the need to finance their
growing retiree health and benefit obligations. The rules under
ERISA generally make it impossible for businesses to set aside
funds to secure these benefits. Investment in life insurance,
which does not run afoul of the ERISA rules, allows employers
to meet their future benefit obligations.
Second, the tax policy concern that caused Congress to
target leverage COLI in 1996 do not support the
administration's proposal before us today. The current proposal
would deny deductions for interest payments for any employer
that happens to own life insurance, even though there is no
direct link between the loan interest and the life insurance.
Unlike the 1997 provision targeting the use of COLI with
respect to nonemployees, this proposal attacks the very
traditional uses of employer-owned life insurance.
Third, the administration's proposal represents yet another
move by the administration to deny deductions for ordinary and
necessary business expenses. If the proposals were enacted,
companies would see expenses that they have deducted for years
suddenly becoming nondeductible. For example, interest on a
loan taken out 10 years ago to finance the creation or startup
of a business. This is not a fair result.
Fourth, the administration's proposal is a thinly disguised
attempt to tax the inside buildup on life insurance policies.
Congress in the past has rejected proposals to change the tax
treatment of inside buildup, and for good reason. The
investment element inherent in permanent life insurance is a
significant form of savings and long-term investment. I think
you would agree that these are things that we should be
encouraging and not taxing.
Finally, I would like to address the Treasury's attempt to
brand employer-owned life insurance as a corporate tax shelter.
This is a totally unwarranted characterization intended to
build unthinking support for a failed proposal. A tax shelter
is defined under the Code as any entity, plan, or arrangement,
with respect to which tax avoidance or evasion is a significant
purpose. It is difficult to see how traditional employer-owned
life insurance programs could be viewed as meeting this
definition.
For example, consider a situation where a company owning
life insurance policies on the lives of its employees decided
independently to borrow money totally unrelated to its life
insurance program. Suppose they did that to construct a new
manufacturing plant. The administration apparently believes
that these separate actions can be collapsed down and viewed as
a tax avoidance transaction. But it would be absurd to suggest
that the company in this situation should be hit with stiff
penalties that apply to true tax shelter transactions.
Under a broader view, a tax shelter might be thought of as
an arrangement involving an unintended application of tax laws.
It is impossible to argue that current employer-owned life
insurance programs involve an unintended application of tax
laws. In fact, few areas of the tax law have received such
thorough scrutiny in recent years. Indeed, the use of employer-
owned life insurance was expressly sanctioned in legislation in
1996 and 1997.
In closing, I would respectfully urge the Committee to
reject the administration's misguided proposal to tax employer-
owned life insurance as it did last year. The administration
once again has failed to articulate a clear or compelling tax
policy concern in respect to the current rules, and now has
sought to couch employer-owned life insurance, altogether
inappropriately, as a tax shelter. If enacted, the
administration's proposal would represent a significant
departure from current law and tax policy regarding the
treatment of life insurance. It would have a significantly
adverse impact on the ability of businesses to solve a variety
of their needs, including the ability to finance meaningful
health benefits to retired workers.
Thank you for your attention to this important matter.
[The prepared statement follows:]
Statement of W.T. Wamberg, Chairman of the Board, Clark/Bardes, Dallas,
Texas
Clark/Bardes appreciates the opportunity to testify before
the House Ways and Means Committee on the revenue-raising
proposals included in the Administration's FY 2000 budget
submission. Our testimony focuses specifically on a proposal
that would increase taxes on companies purchasing insurance
covering the lives of their employees.
Clark/Bardes is a publicly traded company headquartered in
Dallas, Texas, and with offices around the country. We design,
market, and administer insurance-based employee benefit
financing programs. Our clients, which include a broad range of
businesses, use insurance products as assets to offset the
liabilities of employee benefits and to supplement and secure
benefits for key executives.
Clark/Bardes strongly opposes the Administration's proposed
tax increase on ``corporate-owned life insurance'' (``COLI'').
The same proposal was floated by the Administration in its FY
1999 budget submission and wisely rejected by Congress. Perhaps
in recognition of the fact that Congress last year found no
coherent tax policy justification for such a change, the
Administration this year has branded COLI as a ``corporate tax
shelter''--an egregious characterization intended to build
visceral support for the proposal. Regardless of the
Administration's rhetoric, the reasons for rejecting the COLI
tax increase remain the same:
Employer-owned life insurance remains an effective
means for businesses to finance their growing retiree health
and benefit obligations.
The Administration's proposal shares none of the
same tax policy concerns that drove Congressional action on
COLI in 1996 and 1997 legislation.
The current-law tax treatment of COLI was
sanctioned explicitly by Congress in the 1996 and 1997
legislation.
The Administration's proposal is a thinly
disguised attempt to tax the ``inside buildup'' on insurance
policies--i.e., a tax on a long-standing means of savings.
The Administration's proposal represents yet
another move by the Administration--along a slippery slope--to
deny deductions for ordinary and necessary business expenses.
Use of Employer-Owned Life Insurance
Before turning to the Administration's proposal, Clark/
Bardes believes it is important to provide background
information on employer-owned life insurance--a business
practice that does not appear to be well understood.
Many employers, large and small, provide health and other
benefits to their retired employees. While ERISA rules
generally make ``dedicated'' funding impossible, employers
generally seek to establish a method of financing these
obligations. This allows them not only to secure a source of
funds for these payments but also to offset the impact of
financial accounting rules that require employers to include
the present value of the projected future retiree benefits in
their annual financial statements.
Life insurance provides an effective means for businesses
to finance their retiree benefits. Consultants, like Clark/
Bardes, and life insurance companies work with employers to
develop programs to enable the employers to predict retiree
health benefit needs and match them with proceeds payable under
the life insurance programs. A simplified example may help to
illustrate:
ABC Company guarantees its employees a generous health
benefits package upon retirement. ABC Company is required to
book a liability on its balance sheet for the eventual
retirement of its employees, and needs to find ways to fund
these obligations.
ABC Company, working with consultants, takes out a series of
life insurance policies on its employees. It pays level
insurance premiums to the insurance carrier each year. The cash
value on the life insurance policy accumulates on a tax-
deferred basis. In the event that the contract is surrendered,
ABC Company pays tax on any gain in the policy. In the event
that employees die, ABC Company receives the death benefit and
uses these funds to make benefits payments to its retired
employees. Actuaries are able to match closely the amount of
insurance necessary to fund ABC Company's liabilities.
The Administration's COLI proposal effectively would take
away an employer's ability to finance retiree benefit programs
using life insurance, and thus could force businesses to
severely limit or discontinue these programs. It is ironic that
the President's proposal would hamstring a legitimate means of
funding post-retirement benefits when a major focus of Congress
is to encourage private sector solutions to provide for the
needs of our retirees.
The Administration's COLI Proposal
The Administration's proposal to tax employer-owned life
insurance should be viewed in light of the basic tax rules
governing life insurance and interest expenses and recent
changes made by Congress to the tax treatment of COLI.
Since 1913, amounts paid due to the death of an insured
person have been excluded from Federal gross income. The
present-law provision providing this exclusion is section 101
of the Internal Revenue Code of 1986, as amended (the
``Code''). Amounts paid upon the surrender of a life insurance
policy are excluded from taxable income to the extent of the
aggregate amount of premiums or other consideration paid for
the policy, pursuant to section 72(e) of the Code.
Section 163 of the Code generally allows deductions for
interest paid on genuine indebtedness. However, sections
264(a)(2) and (a)(3) of the Code, enacted in 1964, prohibit
deductions if the interest is paid pursuant to (i) a single
premium life insurance contract, or (ii) a plan of purchase
that contemplates the systematic direct or indirect borrowing
of part or all of the increases in the cash value of such
contract, unless the requirements of an applicable exception to
the disallowance rule are satisfied. One of the exceptions to
this interest disallowance provision, known as the ``four-out-
of-seven'' rule, is satisfied if no part of four of the annual
premiums due during a seven-year period (beginning with the
date the first premium on the contract is paid) is paid by
means of indebtedness.
The Tax Reform Act of 1986 (the ``1986 Act'') amended
section 264 of the Code to limit generally deductions for
interest paid or accrued on debt with respect to COLI policies
covering the life of any officer, employee, or individual who
is financially interested in the taxpayer. Specifically, it
denied deductions for interest to the extent that borrowing
levels on corporate-owned policies exceeded $50,000 of cash
surrender value per insured officer, employee, or financially
interested individual.
Congress in the Health Insurance Portability and
Accountability Act of 1996 (the ``1996 Act'') eliminated
deductions for interest paid on loans taken against the tax-
free earnings under the life insurance contract. Specifically,
the 1996 Act denied a deduction for interest paid or accrued on
any indebtedness with respect to any life insurance policies
covering an officer, employee, or financially interested
individual of the policy owner. The 1996 Act provided a phase-
out rule for indebtedness on existing COLI contracts,
permitting continued interest deductions in declining
percentages through 1998.
The 1996 Act provided an exception for certain COLI
contracts. Specifically, the Act continued to allow deductions
with respect to indebtedness on COLI covering up to 20 ``key
persons,'' defined generally as an officer or a 20-percent
owner of the policy owner, subject to the $50,000 indebtedness
limit, and further subject to a restriction that the rate of
interest paid on the policies cannot exceed the Moody's
Corporate Bond Yield Average-Monthly Corporates for each month
interest is paid or accrued.
The Taxpayer Relief Act of 1997 (the ``1997 Act'') added
section 264(f) to the Code. This provision generally disallows
a deduction for the portion of a taxpayer's total interest
expense that is allocated pro rata to the excess of the cash
surrender value of the taxpayer's life insurance policies over
the amounts of any loans with respect to the policies,
effective for policies issued after June 8, 1997. However,
section 264(f)(4) provides a broad exception for policies
covering 20-percent owners, officers, directors, or employees
of the owner of the policy. Thus, the interest deduction
disallowance provision in the 1997 Act generally affected only
COLI programs covering the lives of non-employees.
The COLI proposal in the Administration's FY 2000 budget,
submitted on February 1, 1999, would extend the section 264(f)
interest deduction disallowance to COLI programs covering the
lives of employees.\1\ The proposal therefore would apply a
proportionate interest expense disallowance based on all COLI
cash surrender values. The exact amount of the interest
disallowance would depend on the ratio of the average cash
values of the taxpayer's non-leveraged life insurance policies
to the average adjusted bases of all other assets.
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\1\ By eliminating the section 264(f)(4) exception that currently
exempts COLI programs covering the lives of employees, officers, and
directors.
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Lack of Tax Policy Justification
The Treasury Department, in its ``Green Book'' explanation
of the revenue proposals in the Administration's FY 2000
budget, implies that the COLI measures taken by Congress in
1996 and 1997 were incomplete in accomplishing their intended
goals. A closer inspection of the tax policy considerations
that gave rise to the 1996 and 1997 changes would suggest
otherwise.
The 1996 Act changes to the tax treatment of COLI focused
on leveraged COLI transactions (i.e., transactions involving
borrowings against the value of the life insurance policies),
which it believed represented an inappropriate and unintended
application of the tax rules. The ``Blue Book'' explanation of
the 1996 Act, prepared by the staff of the Joint Committee on
Taxation, states that leveraged COLI programs ``could be viewed
as the economic equivalent of a tax-free savings account owned
by the company into which it pays itself tax-deductible
interest.'' \2\ The Blue Book further states:
---------------------------------------------------------------------------
\2\ Joint Committee on Taxation, General Explanation of Tax
Legislation Enacted in the 104th Congress (JCS-12-96), December 18,
1996, p. 363.
... Congress felt that it is not appropriate to permit a
deduction for interest that is funding the increase in value of
an asset of which the taxpayer is the ultimate beneficiary as
recipient of the proceeds upon the insured person's death.
Interest paid by the taxpayer on a loan under a life insurance
policy can be viewed as funding the inside buildup of the
policy. The taxpayer is indirectly paying the interest to
itself, through the increase in value of the policy of which
the taxpayer is the beneficiary.\3\
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\3\ Id, at 364.
The 1997 Act COLI provision grew out of concerns over plans
by a particular taxpayer, Fannie Mae, to acquire corporate-
owned life insurance on the lives of its mortgage holders. The
1997 Act changes, therefore, specifically targeted COLI
programs developed with respect to non-employees. Both the
House Ways and Means Committee Report and the Senate Finance
Committee Report on the 1997 Act discuss an example involving a
---------------------------------------------------------------------------
Fannie Mae-type fact pattern:
If a mortgage lender can ... buy a cash value life insurance
policy on the lives of mortgage borrowers, the lender may be
able to deduct premiums or interest on debt with respect to
such a contract, if no other deduction disallowance rule or
principle of tax law applies to limit the deductions. The
premiums or interest could be deductible even after the
individual's mortgage loan is sold to another lender or to a
mortgage pool. If the loan were sold to a second lender, the
second lender might also be able to buy a cash value life
insurance contract on the life of the borrower, and to deduct
premiums or interest with respect to that contract.\4\
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\4\ H.R. Rep. No. 105-148, 105th Cong., 1st Sess. p. 501; S. Rep.
No. 105-33, 105th Cong., 1st Sess., p. 186.
The COLI proposal in the Administration's FY 2000 budget
lacks any similarly compelling tax policy justification. Unlike
the 1996 Act provision targeting leveraged COLI programs, the
Administration's proposal would apply where there is no link
between loan interest and the COLI program.\5\ And unlike the
1997 Act provision targeting the use of COLI with respect to
non-employees, this proposal does not involve a newly conceived
use of COLI.
---------------------------------------------------------------------------
\5\ Current law is quite specific that interest deductions
resulting from both direct and indirect borrowing, i.e., using the
policy as collateral, are disallowed. Sec. 264(a)(3).
---------------------------------------------------------------------------
In explaining the rationale underlying the proposal, the
Treasury Department argues that the ``inside buildup'' on life
insurance policies in COLI programs gives rise to ``tax
arbitrage benefits'' for leveraged businesses.\6\ Treasury
argues that businesses use inside buildup on COLI policies to
fund deductible interest payments, thus jumping to the
conclusion that COLI considerations govern decisions regarding
when businesses incur debt. This view is clearly erroneous.
Businesses incur debt for business reasons (e.g. business
expansion).
---------------------------------------------------------------------------
\6\ General Explanation of the Administration's Revenue Proposals,
Department of the Treasury, February 1999, p.118.
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COLI is Not a ``Tax Shelter''
Clark/Bardes strongly objects to the Administration's
characterization of COLI as a ``corporate tax shelter.'' The
penalty provisions of the Internal Revenue Code define a tax
shelter as any entity, plan, or arrangement with respect to
which tax avoidance or evasion is a significant purpose.\7\ A
separate proposal in the Administration's FY 2000 budget
proposes a new definition of ``corporate tax shelter'' under
section 6662 that would apply to ``attempts to obtain a tax
benefit'' in a ``tax avoidance transaction,'' defined as any
transaction in which the reasonably expected pre-tax profit is
insignificant relative to the reasonably expected net tax
benefits.\8\
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\7\ Section 6662(d)(2)(C)(iii)
\8\ As a separate matter, Clark/Bardes believes the
Administration's proposed new definition of ``corporate tax shelter''
is unnecessary, ill-advised, and could be broadly applied by IRS agents
to attack many legitimate business transactions.
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It is difficult to see how traditional COLI programs might
reasonably be viewed as meeting any of these ``tax shelter''
definitions. As discussed above, the Administration's proposal
would deny interest deductions on borrowings totally unrelated
to COLI, for example, where a company owning life insurance
policies on the lives of employees borrows money to construct a
new manufacturing plant, or conversely, where a company that
borrowed ten years ago to construct a plant now considers
purchasing life insurance to help finance retiree benefits. The
Administration apparently believes that these disparate actions
can be collapsed and viewed as a tax-avoidance transaction or
as an attempt to obtain tax benefits. It is difficult to see
just what tax might be avoided in this situation or what tax
benefit is being sought. Does Treasury seriously suggest that
such a company should be hit with the stiff penalties that
apply to tax shelter transactions? These are serious questions
that do not appear to have thought through completely under the
Treasury proposal.
Under a broader view, a ``tax shelter'' might be thought of
as an arrangement involving an unintended application of the
tax laws. It is impossible to argue that current COLI programs
involve an unintended application of the tax laws. Few other
areas of the tax law have received as thorough scrutiny in
recent years. In the 1996 Act, Congress explicitly allowed COLI
programs to continue in the future so long as they were not
leveraged. In the 1997 Act, Congress carefully crafted a
specific exception (designed to preserve longstanding use of
unleveraged COLI) to the pro rata interest expense disallowance
provisions for COLI programs covering employees. In other
words, current COLI programs involve an intended application of
the tax law.
Attack on ``Inside Buildup,'' Savings
The Administration's COLI proposal, at its core, is not
about ``tax shelters'' at all. Rather, it is a thinly veiled
attack on the very heart of traditional permanent life
insurance--that is, the ``inside buildup'' of credits (or cash
value) within these policies that permits policyholders to pay
level premiums over the lives of covered individuals. Although
couched as a limitation on interest expense deductions, the
proposal generally would have the same effect as a direct tax
on inside buildup. Thus, the proposal would reverse the
fundamental tax treatment of level-premium life insurance that
has been in place since 1913.
Congress in the past has rejected proposals to alter the
tax treatment of inside buildup, and for good reason. The
investment element inherent in permanent life insurance is a
significant form of savings. Congress and the Administration in
recent years have worked together in the opposite direction,
considering new incentives for savings and long-term investment
and removing obvious obstacles. It is odd that the
Administration at this time would propose making it more
difficult to save and invest through life insurance.
Inappropriate Limitation on Business Deductions
In some respects, Treasury's proposed denial of deductions
for interest expenses for companies owning life insurance is
not surprising. This proposal comes on the heels of other
Clinton Administration proposals to chip away at deductions for
expenses that long have been treated as ordinary and necessary
costs of doing business. Another recent example is the
provision in the Administration's FY 2000 budget to deny
deductions for damages paid by companies to plaintiffs groups.
But the proposal is troubling nonetheless, as illustrated
by a simple example. The XYX company in 1997 borrows funds to
build a new manufacturing facility. The XYZ company in 1997 and
1998 is able to deduct interest paid on these borrowings. In
1999, the XYZ company, responding to concerns over mounting
future retiree health obligations, purchases insurance on the
lives of its employees. IRS agents tell the XYZ company that it
has just entered into a ``tax shelter.'' Suddenly, the XYZ
company finds that a portion of the interest on the 1997 loan
is no longer viewed by the government as an ordinary and
necessary business expense. XYZ therefore is taxed,
retroactively, on its 1997 borrowing.
The proposal becomes even more troubling when one considers
the logical extensions of the Administration's rationale with
respect to COLI. Might the IRS, using the same reasoning,
someday deny home mortgage interest deductions for individuals
who also own life insurance? Might the government deny
deductions for medical expenses for individuals that enjoy tax-
preferred accumulations of earnings in 401(k) accounts or IRAs?
Conclusion
Clark/Bardes respectfully urges the Committee on Ways and
Means to reject the Administration's misguided COLI proposal,
as it did in 1998. As discussed above, the Administration once
again has failed to articulate a clear or compelling tax policy
concern with respect to the current-law rules, and now has
sought to couch COLI, altogether inappropriately, as a ``tax
shelter.'' If enacted, the Administration's proposal would
represent a significant departure from current law and tax
policy regarding the treatment of life insurance. It would have
a significantly adverse impact on the ability of businesses to
solve a variety of needs including the ability to finance
meaningful retiree health benefits. It also would provide a
disincentive for savings and long-term investment and would
represent yet another attack on deductions for ordinary and
necessary business expenses.
Clark/Bardes commends the 31 Members of the House Ways and
Means Committee who have urged, in a February 4 letter,
Chairman Bill Archer (R-TX) and Ranking Minority Member Charles
Rangel (R-TX) to oppose enactment of the Administration's
``unwarranted'' revenue proposals targeting life insurance. We
share your views.
Chairman Archer. Thank you, Mr. Wamberg.
Mr. Hernandez, if you will identify yourself for the
record, you may proceed.
STATEMENT OF ROBERT HERNANDEZ, ALLIANCE OF TRACKING STOCK
STAKEHOLDERS, AND VICE CHAIRMAN AND CHIEF FINANCIAL OFFICER,
USX CORPORATION, PITTSBURGH, PENNSYLVANIA
Mr. Hernandez. Thank you. I am Bob Hernandez, vice chairman
and chief financial officer of USX Corp. I would also like to
thank you, Mr. Chairman, for inviting USX to testify today. I
would like to thank you on behalf of Vic Beghini, president of
Marathon Oil, which as you know is headquartered in your
district and the many Marathon employees that are there.
My testimony is on a subject that affects many communities,
many jurisdictions, and many other corporations. My testimony
will be on a little-known, but very serious proposal in the
administration's fiscal year 2000 budget to tax the issuance of
tracking stock. This proposal should be rejected by Congress
and formally withdrawn by Treasury. It would impair companies'
ability to invest in new business and technology development.
It would harm existing stockholders. It would cost jobs. It
would impose enormous costs, reduce business expansion, and
although I am not a tax expert, there is no sound basis in tax
theory or policy for taxing the issuance of parent company
stock.
I would like to submit my statement for the record on
behalf of the Alliance for Tracking Stock Stakeholders. This
alliance is an informal group of companies that share concern
for their continued ability to meet business objectives through
the issuance of tracking stock.
Tracking stocks are separate classes of common stock issued
by companies in more than one line of business. The holders of
tracking stock receive dividends based on the earnings of a
specified segment of the corporate issuer. My company, USX, for
example, currently has two tracking stocks. One follows our
steel business, the other tracks our energy business. The steel
shareholders receive their dividends based on the performance
of the steel segment. The energy stockholders get their
dividends based on the performance of the energy side of the
house.
Tracking stock developed in our case because stock markets
prefer ``pure play'' securities, while debt markets prefer the
more stable cash flows associated with companies in more than
one business. This is an opportunity to appeal to both markets.
The ability to issue these tracking stocks permitted my company
to raise more than $2.5 billion of equity that was vitally
needed to revitalize our businesses, (and $3.5 billion of lower
cost debt) since we adopted it in 1991.
Fifteen companies have issued 37 separate tracking stocks
since 1991. Specific reasons the other companies have issued
tracking stock vary, but include: growth of startup businesses
as a source of equity capital, stock-based employee incentive
programs, maintaining consolidated credit as we did to enhance
borrowing arrangements, enhancing stock market value, and so
forth.
I hope you can see that tracking stock is motivated by
compelling business needs. It has unlocked shareholder value
and opened up new capital markets to many diversified
companies.
The administration's proposed tax legislation would have a
chilling effect on those markets. It could force companies to
recapitalize up to $400 billion of equity securities.
Provisions actually could adversely impact tax revenues. They
would destroy the operating financial and administrative
synergies that are found in these combined entities. Therefore,
the revenue raising estimates are not realistic, and actually
could be negative.
As chief financial officer of USX, and a member of our
board since 1991, I have been involved in every aspect of our
planning and implementation of our tracking stock structure.
From the start, we have always viewed our structure as one that
is based on sound business considerations. I can state for the
record we never considered tax avoidance as a reason to
establish our tracking stock structure.
Without tracking stock though, it is quite likely that U.S.
Steel, which is our steel unit, would have substantially scaled
back operations and suffered severe financial distress.
Instead, it has become the most viable integrated steel company
in its industry, with good-paying jobs, and operations
resulting in substantial payments of income and payroll taxes
to Federal, State, and local governments. Similarly, because of
the investments we have been able to make by virtue of the
financial flexibility afforded by our structure, our Marathon
energy unit is considered to have one of the best growth
production profiles in the industry.
But Treasury asserts that tracking stock might be an
indirect way to accomplish tax-free spinoffs under section 355
of the Code. To the contrary, tracking stock is used to keep
businesses together instead of divesting of them. Tracking
stock is not the economic equivalent of a disposition of a
business.
USX, for example, issued what we called Delhi tracking
stock in 1992, to create a separate group in order to grow the
gas gathering and transmission business. Five years later, we
decided to exit that business. Delhi assets were sold to a
third party and a taxable transaction resulted in $208 million
of taxes payable. In addition, Delhi tracking stock
shareholders were subsequently taxed as a result of the taxable
redemption of their shares. If taxes were our primary
consideration, the original transaction in 1992 would have been
rearranged to avoid taxes through a spinoff to shareholders.
Finally, there appears to be a Treasury concern that
tracking stock will become a widely used tax avoidance
mechanism in the future. Corporations don't issue tracking
stock for tax reasons. USX, for example, looked at a variety of
alternatives in 1991 when we implemented it. We were under
pressure at that time to bust up the company into two
companies--a steel company and an energy company. This could
have been accomplished as a section 355 tax-free spinoff. We
rejected the spinoff alternative, purely for sound business
reasons, the most notable of which was a concern about the
economic viability of our steel unit at that time as a stand-
alone company.
So, in summary, let me say a tax on tracking stock would be
counterproductive for job creation and capital formation. It
would accomplish no meaningful improvement in U.S. tax policy
or revenues. Indeed, it would have a contrary effect. Treasury
can utilize existing tools, such as regulations and
pronouncements to deal with inappropriate uses of tax tracking
stock if and when they arise.
Thank you very much.
[The prepared statement and attachments follow:]
Statement of Robert Hernandez, Alliance of Tracking Stock Stakeholders,
and Vice Chairman and Chief Financial Officer, USX Corporation,
Pittsburgh, Pennsylvania
Position Statement
The Administration's proposal to impose a tax on the
issuance of tracking stock (Tracking Stock) is unsound tax
policy which, if enacted, will restrain new business and
technology investment and development, cost jobs, cause severe
harm to companies with Tracking Stock presently outstanding,
and reduce business expansion. Therefore, this proposal should
be rejected.
The issuance of Tracking Stock is motivated by
compelling business needs. It provides a market-efficient
source of capital, particularly to corporations attempting to
grow lines of business that would not be valued appropriately
by the equity markets without Tracking Stock.
The proposal, if passed, would not only eliminate
a valuable source of capital to new businesses, but could also
force companies with approximately $400 billion of equity
securities outstanding to recapitalize at a considerable cost
to them and to their shareholders.
Treasury has authority to deal with Tracking Stock
under current law. If Treasury becomes aware of inappropriate
uses of Tracking Stock, it should resolve the issues
administratively (through Treasury regulations and
pronouncements) in a way that avoids adverse consequences to
business-driven Tracking Stock issuers.
The revenue estimates are unrealistic. The
proposal would economically eliminate the use of Tracking Stock
and provide little if any revenue to the Treasury.
Definition of Tracking Stock
Tracking Stock is a type of equity security issued by some
companies to track the performance or value of one or more
separate businesses of the issuing corporation. The holder of
Tracking Stock has the right to share in the earnings or value
of less than all of the corporate issuer's earnings or assets.
The Tracking Stock instrument has developed largely in response
to the dual economies arising from the equity market's
preference for ``pure-play'' securities (i.e., pure, single
line of business companies) and the debt market's preference
for diversified corporate balance sheets.
Business Considerations
Since General Motors first used it as an acquisition
currency in September 1984, to acquire Electronic Data Systems
Corporation (EDS), Tracking Stock has found wide receptivity by
shareholders in North America.
To date, a total of 15 public companies have issued 37
separate Tracking Stocks for a variety of business reasons
including :
Acquisitions
Growth of start-up businesses
Source of equity capital
Creation of stock-based employee incentive
programs
Continuation of economies of scale for
administrative costs
Retention of operating synergies
Maintenance of consolidated credit and existing
borrowing arrangements
Valuation enhancement
Increasing shareholder knowledge, and
Broadening of the investor base
Numerous real-life examples demonstrate the beneficial
impact that capital, raised through the issuance of Tracking
Stock, has had on the U.S. economy:
USX Corporation raised sufficient capital, through
its U.S. Steel Tracking Stock, to modernize its steel
operations and transform U.S. Steel from a company that
generated billions of dollars in losses throughout most of the
80's into a more efficient steel company. It is the largest
employer in the domestic steel industry, with high paying jobs,
generating taxable income rather than losses and paying
substantial income and payroll taxes to federal, state and
local governments.
Genzyme Corporation, a biotechnology company
founded in 1981, develops innovative products and services to
prevent, diagnose, and treat serious and life-threatening
diseases. It initiated its use of Tracking Stock in 1994 when
it founded a new program to develop tissue repair technologies.
More recently, it adopted a new Tracking Stock to fund
molecular oncology research, including cancer vaccine clinical
trials in breast, ovarian and skin cancer.
Perkin-Elmer, a high technology company, chose
Tracking Stock for several business reasons including:
facilitating new business and technology development;
recruiting and retaining key employees; exposing and
facilitating appropriate valuation for new technology
opportunities; and providing flexibility for raising future
capital and optimizing further development and expansion of
each of its businesses.
For more detail, see the attached case histories of these
companies.
Barring a replacement source of capital, the economic
benefits of Tracking Stock, to these and other companies, will
be substantially eliminated if a tax is imposed on issuance.
Financial Market Impact of the Administration's Budget Proposal to Tax
Tracking Stock
Should the Tracking Stock proposal be enacted and
any future issuances of Tracking Stock deemed a taxable sale,
companies currently capitalized with Tracking Stock, and their
shareholders, would be severely impacted. The imposition of
corporate tax upon the issuance of equity effectively would
shut down a Tracking Stock company's ability to access the
equity capital market.
Their ability to raise capital through the debt
market would be severely reduced. Such a provision would
undermine Tracking Stock companies' credit worthiness in the
market place since they would be unable to strengthen their
balance sheets and build their business in a cost efficient
manner.
This proposal precludes companies with Tracking
Stock from being able to engage in ordinary non-taxable
corporate reorganizations (e.g., stock for stock exchanges)
thus limiting their ability to compete with companies with
traditional stock structures.
As a result of these consequences, investors would
see Tracking Stock as an inefficient capital structure and
equity valuations would suffer.
Ultimately, as a result of this Tracking Stock
proposal, approximately $400 billion of equity securities could
need to be restructured at great cost and under intense market
pressure causing a loss of shareholder investment and
competitive vulnerability.
For the high-technology industry in particular,
those companies would lose a medium used to attract and retain
key personnel.
Tax Considerations
Treasury expresses a concern that Tracking Stock has been
used to circumvent established corporate tax rules in
Subchapter C, in particular the spin-off requirements of
section 355, including the recently enacted Morris Trust
provisions. The case histories included herein and the facts of
other Tracking Stock issuances establish that Tracking Stock
transactions have been carried out for compelling business
reasons. These transactions have not been tax motivated and in
particular have not circumvented the section 355 rules.
Tracking Stock is consistent with Subchapter C of
the Internal Revenue Code because the tracked business remains
in the same corporation and the Tracking Stock represents
equity in that same corporation. For the same reasons, Tracking
Stock does not reduce a corporation's tax liability compared to
its tax liability prior to the issuance of Tracking Stock.
Thus, revenues to the U.S. Treasury are the same before and
after the initial transaction. If the tracked business is
successful, however, it will generate taxable income, create
jobs and pay additional taxes to federal, state and local
governments. Likewise, increased equity valuations generate
additional capital gains for individuals.
Unlike Morris Trust transactions, corporations do
not use Tracking Stock to dispose of businesses tax-free.
Tracking Stock is a vehicle used for building and maintaining
business assets within a single corporation.
Tracking Stock does not result in a sale of the
tracked business. Subsequent to adopting Tracking Stock, a
corporation will recognize gain on any future disposition of
its assets, unless all of the provisions of Section 355 are
satisfied.
Corporations do not issue Tracking Stock for tax
reasons. The fiduciary responsibilities incumbent on the
directors of a corporation with Tracking Stock (i.e., to
multiple shareholder interests) far outweigh any conceivable
tax motivation.
Legislation is unnecessary. Treasury has authority
to address transactions it perceives as inappropriate under
current law, through regulations and pronouncements, in a way
that avoids adverse consequences to business-motivated Tracking
Stock issuers.
A statutory attack is unnecessary and
inappropriate because:
--It harms innocent corporations, impairing their equity
and adversely impacting their ability to raise capital.
--It harms shareholders, by reducing the market value of
their shares.
--It harms employees and customers. Unless a replacement
source of capital is found, businesses will scale back
operations, adversely impacting employees, customers, and the
communities in which the companies operate.
--It adds more complexity to the Internal Revenue Code.
Tracking Stock transactions undertaken to-date
have been driven by business considerations. The complexities
associated with the issuance of Tracking Stock should prevent
it from becoming a tax motivated vehicle. Tracking Stock is
only appropriate for a small number of companies for which the
business advantages outweigh the complexities. These
complexities include:
--The fiduciary responsibilities of the Board of Directors
to shareholders of all classes of common stock, which may
create conflicts
--Each Tracking Stock business has continued exposure to
the liabilities of the consolidated entity.
The published revenue estimates for the proposal
to tax issuance of Tracking Stock are unrealistic. Subjecting
future issuances to tax would increase costs to a level that
would preclude future issuances, except in dire circumstances.
Thus, the legislation would generate little or no revenue.
Conclusion
The issuance of Tracking Stock is motivated by
compelling business needs. Treasury's Tracking Stock proposal
will disrupt financial markets and cause severe harm to
companies with Tracking Stock since it will not only restrict
access to capital in the future, but also require massive
financial re-engineering for some companies. Individual
investors, and possibly entire communities in which Tracking
Stock companies operate, will be adversely affected as a result
of the competitive pressures this tax would impose.
Three Tracking Stock Case Studies are also Submitted as
Attachments to this Statement:
USX Corporation
Genzyme Corporation
The Perkin-Elmer Coporation
Alliance of Tracking Stock Stakeholders.--The Alliance is an
informal group of companies that currently utilize or are
considering using Tracking Stock. These companies share a
common concern for the value of shareholder investment in
tracking stocks, as well as their continued ability to meet
various business objectives through the issuance of tracking
stock. For further information, contact Scott Salmon, Manager,
Governmental Affairs, USX Corporation, 202-783-6797.
USX Corporation Tracking Stock Case Study
Company Overview
USX Corporation is a diversified corporation headquartered
in Pittsburgh, PA, engaged in the energy business through its
Marathon Oil Group and in the steel business through its U.S.
Steel Group. USX, formerly United States Steel Corporation, was
founded in 1901 and acquired Marathon Oil Company in 1982
(Marathon was formed in 1887). U.S. Steel is the largest steel
producer in the U.S. and today employs approximately 19,600,
down dramatically from about 149,000 in 1980. Marathon is a
significant worldwide producer of oil and gas and the fourth
largest refiner in the U.S., employing almost 33,000.
USX Corporation is currently represented in the equity
market by two classes of tracking stock--USX Marathon Group
Common Stock (``MRO'') and USX U.S. Steel Group Common Stock
(``X''). Total market capitalization at December 31, 1998, was
$12.6 billion. Consolidated revenues for 1998 were $28.3
billion; with net assets of $21.1 billion.
USX Tracking Stock Business Considerations
In the late 1980's, USX' largest shareholder, Carl Icahn,
held 13.3% of USX' stock, and advocated a proposal to spin-off
the steel division as a separate company due to his belief that
USX presented a confusing mix of businesses to investors and
that the Marathon energy business was significantly undervalued
relative to its energy sector peers.
Although a tax-free spin-off could have been accomplished,
management objected to the Icahn proposal for a number of
compelling business reasons:
USX was facing significant internal challenges
including heavy capital expenditure requirements for plant
modernization, reserve development and environmental
compliance, as well as substantial debt maturities and
significant retiree pension and medical costs;
USX was facing a challenging external economic
environment for both its energy and steel businesses;
A spin-off was not judged to be in the best
interests of USX's creditors, stockholders, and employees;
There were concerns about the economic viability
of a standalone steel company;
Incremental costs to operate standalone companies
would have been in excess of $70-$90 million per year in
increased administrative costs, state and local taxes, interest
costs and insurance costs;
Neither of the standalone entities would have been
investment grade.
The Icahn spin-off proposal was defeated at the May 1990
shareholders meeting. However, as an alternative to the Icahn
proposal, USX management soon thereafter proposed creating U.S.
Steel and Marathon Tracking Stocks. The Tracking Stock
proposal:
Established separate equity securities to trade
based upon the performance of the U.S. Steel and Marathon
businesses
Retained the benefits of a consolidated
corporation while providing for separate equity market
valuations for its steel and energy businesses. The USX
Tracking Stock capital structure results in incremental cost
savings of approximately $70 to $90 million annually. These
cost savings are achieved through savings in insurance costs,
administrative costs, State and Local taxes, and interest
savings.
Created flexibility for shareholders to hold the
stock of either the steel business, the energy business or both
businesses, and
Maintained flexibility for USX to continue to
pursue other alternatives for its steel business, including a
joint venture or sale.
USX did not seek to circumvent the rules under Section 355
when it opted to issue Tracking Stock. USX did consider a tax-
free spin-off of stock of its steel business to its
shareholders and was advised by outside counsel that a tax-free
spin-off would qualify under Section 355. The USX fact pattern
strongly supported this opinion because USX owned 100% of the
steel operations; a spin-off would have effected complete
separation of the steel assets from USX through the
distribution to the USX shareholders; both the steel and oil
businesses were 5-year active businesses within the meaning of
Section 355(b); and, there were good business reasons for a
complete separation of the businesses.
USX Market Valuation and Tracking Stock
Prior to the announcement of the Tracking Stock Proposal,
it was clear that the valuation of USX was heavily penalized by
the market. Although USX was valued in line with its steel
peers, the stock traded at a significant discount to its energy
peers. This occurred despite the fact 75% of the company's
total value was attributable to Marathon's activities.
On January 31, 1991, the day following the announcement of
its Tracking Stock Proposal, USX's stock closed 8.2% higher--
increasing its market value by more than $600 million. The
Tracking Stock Proposal received a 96% vote of approval at
USX's shareholders' meeting on May 6, 1991. As a direct result
of the Tracking Stock structure, USX also experienced a pick-up
of 29 additional equity research analysts.
Currently, Marathon's Tracking Stock trades based on the
fundamentals of its energy business. U.S. Steel's Tracking
Stock trades based on the performance of the steel business,
however, during weak steel business cycles, U.S. Steel trades
at a premium to its peers due to its stronger consolidated
balance sheet (a result of the Tracking Stock structure). To
date, USX has raised over $2.5 billion in eight equity
offerings using Tracking Stock.
The USX Delhi Gas Gathering and Transmission Business
On September 24, 1992, USX created its third Tracking Stock
through a $144 million initial public offering (IPO) of its
Delhi natural gas gathering Tracking Stock. The Delhi issuance
represented the first IPO of a Tracking Stock.
USX sold the assets comprising the Delhi business to Koch
Industries in late 1997 in a taxable transaction incurring $208
million of taxes payable, including $193 million in federal
taxes. Net proceeds of $195 million were used to redeem all of
the Delhi Tracking Stock, a taxable transaction to the
shareholders.
Delhi Transaction Results
------------------------------------------------------------------------
------------------------------------------------------------------------
Delhi Sale Price ($MM).................................. $762
Less: Debt, Other Liabilities and Adjustments ($MM).... 359
Less: Corporate Taxes Payable by USX ($MM)............. 208
Net Proceeds to Delhi Shareholders ($MM)............... $195
Net Proceeds to Delhi Shareholders Per Share........... $20.60
Delhi IPO Share Price in 1992.......................... $16.00
% Increase to IPO Share Price.......................... 28.8%
------------------------------------------------------------------------
If USX had chosen to spin-off Delhi to shareholders in 1992
(instead of issuing Tracking Stock), it could have disposed of
the subsidiary to its shareholders at approximately the IPO
price and USX would not have incurred taxes on the disposition.
In addition, if USX had issued conventional common stock in
the IPO of Delhi (instead of issuing Tracking Stock), USX could
have completed a spin-off, merger or joint venture transaction
at a comparable value to the sale price without incurring
taxes.
Tracking Stock Facilitates Capital Formation not Tax Avoidance
Tracking Stock is a financing innovation that allows
companies with more than one line of business to raise capital
efficiently by tapping the value securities markets place on
``pure play'' equity instruments.
Tracking Stock is consistent with the intent of Subchapter
C because businesses remain in the same corporation and
Tracking Stock will not reduce a corporation's tax liability
compared with its tax liability prior to the issuance of
Tracking Stock. Corporate tax revenues to the U.S. Treasury are
essentially the same before and after a Tracking Stock
transaction.
Tracking Stock does not result in a ``sale'' of the tracked
business. A corporation will recognize gain on any future
disposition of its assets unless all of the provisions of
Section 355 are satisfied. Tracking Stock involves the
antithesis of situations giving rise to the anti-Morris Trust
legislation and, therefore, does not threaten Section 355(e).
Legislation is unnecessary--Congress and the IRS have
recognized the existence of Tracking Stock, and abusive
transactions can be addressed under current law. Section
355(d)(6)(B)(iii), for example, prevents a third-party from
buying up Tracking Stock in order to spin-off the tracked
business. In addition, the IRS has issued several Section 355
rulings to corporations that have Tracking Stock outstanding
(e.g. GM).
Due to the business complexities of Tracking Stock, it
should remain appropriate only for companies for which the
business advantages outweigh the complexities. These same
considerations augur against it ever becoming a tax-motivated
vehicle.
Conclusions
The Administration's proposal to impose a tax on the
issuance of Tracking Stock is unsound tax policy which, if
enacted, will restrain new business and technology investment
and development, cost jobs, cause severe harm to companies (and
their investors) with Tracking Stock outstanding, and reduce
business expansion.
Treasury's new tax proposal to Tax the Issuance of Tracking
Stock should be rejected.
Genzyme Corporation: Background Use of Tracking Stock
Genzyme Corporation (Cambridge, MA) is a biotechnology
company that develops innovative products and services to
prevent, diagnose, and treat serious and life-threatening
diseases. The company was founded in 1981 and has developed
extensive capabilities in research and development,
manufacturing, marketing, and other disciplines necessary for
success in the health care marketplace. One of the top five
biotech companies in the world, Genzyme had 1997 revenues of
$609 million, R&D expenses of $90 million, pre-tax income of
$26 million, and income taxes of $12 million.\1\
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\1\ Consolidated financial data for all company operations. Audited
financial data for 1998 not yet available.
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Current corporate structure
Genzyme has adopted a corporate structure that best
supports the needs of its developing businesses. This structure
consists of three divisions, each of which has its own common
stock intended to reflect its value and track its performance.
These stocks are known as ``tracking stocks.'' \2\
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\2\ Genzyme Transgenics Corporation (Nasdaq:GZTC) is a separate
corporation in which Genzyme Corporation holds a minority stake (about
41%) of outstanding stock. These shares have been assigned to Genzyme
General. Genzyme Transgenics develops and produces recombinant proteins
and monoclonal antibodies in the milk of genetically engineered animals
for medical uses.
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Genzyme General (Nasdaq:GENZ) develops, manufactures, and
markets pharmaceuticals for a variety of unmet medical needs,
but has a special focus on treatments for rare genetic
disorders that disable or kill children (such as Gaucher
disease, Fabry disease, Pompe disease, and cystic fibrosis).
This division also makes a variety of diagnostic test kits,
provides genetic diagnostic services, and has a significant
surgical product business.
Genzyme Tissue Repair (Nasdaq:GZTR) develops, manufactures,
and markets therapies consisting of human cells which are
cultured from a tiny sample of a patient's healthy tissue and
surgically implanted to repair or replace damaged tissue, such
as skin for severe burn victims and knee cartilage for injured
athletes. This division is also investigating the use of brain
cells from pig fetuses to treat Parkinson's and Huntington's
diseases.
Genzyme Molecular Oncology (Nasdaq:GZMO) is developing a
new generation of chemotherapy products, focusing on cancer
vaccines and angiogenesis (tumor blood vessel) inhibitors. It
has initiated cancer vaccine trials in melanoma patients and
expects to initiate trials in breast and ovarian cancer
shortly.
Administration's proposal to tax the issuance of tracking stocks
The Administration proposes to tax the issuance of tracking
stocks. According to the Treasury Department's ``Green Book,''
this proposal is based on Treasury's assumption that companies
use tracking stock to sell subsidiaries without incurring tax
liability on their profits. Treasury claims enactment of this
proposal would raise $600 million in new revenues over the next
5 years. Treasury also claims its proposal would not be
retroactive, though it is unclear whether companies who issue
new shares of existing tracking stocks would be subjected to
the tax.
This proposal reflects a fundamental misunderstanding about
why companies issue tracking stocks. The faulty premise is
discussed in detail below, but is illustrated by the following:
Genzyme's use of tracking stocks has not--and will not--
produce any tax benefits for the company. The company pays
taxes based on the earnings of the entire corporation, which is
a single entity for tax purposes regardless of the types of
securities it issues to its investors.
Genzyme instituted its tracking stock structure as a means
of financing the acquisition of the companies that comprise the
principal assets of the new divisions. This use is the opposite
of Treasury's contention that tracking stocks are used to
achieve tax-free sales.
Only 12 companies have issued tracking stocks in the last
15 years. If tracking stocks truly offered a means for
achieving permanent tax avoidance on the divestiture of
subsidiaries, one would expect it to have attracted many more
adherents than have appeared during a period of vigorous merger
and acquisition activity in which hundreds of companies have
divested themselves of subsidiaries.
Tracking stock issuance does not transfer ownership. When a
company replaces a single class of shareholder equity with two
(or more) classes of tracking stock equities, the total value
of the newly issued equities equals the total value of the
original equities which must be forfeited in exchange. The
newly-issued tracking stocks literally replace the original
shares in the portfolios of the company's investors.\3\ This
substitution is not a divestiture: no corporate assets are
transferred, no management control is forfeited, no cash or
other consideration is paid, and no corporate liabilities are
relieved.\4\ Furthermore, the subsequent issuance of new
tracking stock shares will raise capital for the exclusive use
of the tracked division and does not increase the assets of any
other division.
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\3\ When investors sell these tracking stocks, they will be
required to pay tax on their capital gains if the sale price exceeds
their adjusted basis in the tracking stock shares.
\4\ For example, if an investor were to purchase 100% of Genzyme
Tissue Repair tracking stock--which would cost $54 million at current
market prices--he would gain neither ownership nor management control
of that division. He would, however, possess the right to any and all
future dividends attributable to that division, as well as voting and
liquidation rights equal to the small portion of Genzyme Corporation
represented by these shares.
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This proposal would create a substantial new tax burden. In
effect, the Administration proposes taxing tracking stock
companies each time they raise capital for R&D and other
legitimate business activities merely because newly issued
shares would track a single division, rather than the entire
company. Tracking stock companies would become the only
companies in the country to be taxed on paid-in capital.
This proposal would not raise revenue. Tracking stock
issuance is currently tax-neutral. If it were it to be taxed,
no company would ever issue it and it would not raise $600
million.
Benefits of tracking stocks over consolidation
Enhances capital formation by enlarging the pool of
investors for whom Genzyme could offer a stock consistent with
their investment goals. Tracking stocks provide investors with
the ability to select the single business unit that best
reflects their growth expectations and risk tolerance, rather
than the traditional all-or-nothing investment choice offered
by most diversified companies. Genzyme is the most diversified
company in the biotech industry, with respect to both its
product/service/technology mix and the investment risk
associated with its businesses. For example, Genzyme General
offers proven earnings, consistent growth, moderate volatility,
and high liquidity, while Genzyme Tissue Repair and Genzyme
Molecular Oncology are earlier-stage, longer-term investments
that represent ``pure plays'' in their respective technologies.
Each Genzyme stock is likely to appeal to some investors who
would not find a consolidated common stock to meet their
investment criteria.
Improves overall shareholder value by providing visibility
to pipeline products whose value might otherwise be overlooked.
Once a biotech company launches its first products, stock
analysts tend to switch their focus from the value of the
company's pipeline to its ability to sustain revenue and
earnings growth for currently marketed products. Tracking stock
is a mechanism which forces an independent valuation of
unprofitable, R&D-intensive divisions.
Reduces disincentives to making large investments in long-
term R&D programs. Once a company achieves profitability,
management is often judged on earnings performance and must
contend with a shareholder base that is not always tolerant of
early-stage R&D programs. Such programs rarely increase the
price-earnings multiple, so managers who make such investments
are almost always penalized with reduced stock prices. By
creating an investment vehicle that attracts more risk-tolerant
investors, management can invest more in science and technology
programs without eroding the company's market value.
Provides investors with more information about the various
business units of the company. Genzyme tracking stockholders
receive more detailed information than is ordinarily reported
by individual business units of public companies (such as
separate financial statements, management's discussion and
analysis, descriptions of business, and other information).
Benefits of tracking stocks over divestiture
Maintains access to a seasoned management team and other
resources that would not be available to a small independent
company. Genzyme's expertise in such areas as R&D, clinical and
regulatory affairs, manufacturing, and administration are
generally broader and deeper than is typically available to
start-up companies similar to its smaller divisions.
Provides access to debt capital based on the financial
strength of the entire corporation. Biotech companies have huge
capital requirements, lengthy product development cycles, and
high risks of failure. Businesses with these attributes find it
difficult to borrow funds and risk the possibility that poor
stock market conditions, rather than poor corporate
performance, could destroy them. Weak equity markets for small
cap companies outside of the Internet industry have forced many
start-ups (including both Genzyme Tissue Repair and Genzyme
Molecular Oncology) to cancel or postpone public offerings. As
units of Genzyme Corporation, however, these businesses can
borrow from the company, which can access a $200+ million bank
line of credit and $250 million in public convertible debt.
Enhances incentives for the management and staff of each
division to increase shareholder value. The use of tracking
stock options enables the company to motivate employees with a
share of the value they help to create.
CONCLUSION:
Tracking stocks have legitimate business uses and are not
vehicles for tax avoidance. Proposals to tax their issuance are
misguided because they would more likely result in re-
consolidation than in new federal revenues. This outcome would
undermine investor choice, shareholder value, and start-up
business stability in companies like Genzyme that use tracking
stocks to grow their businesses.
Appendix: Genzyme's Capital Formation History
Genzyme's 17-year history of capital formation--during
which it raised more than $1 billion to support R&D, technology
development, manufacturing, and other activities--illustrates
how tracking stocks can be used to build a strong and
diversified company.
During the five years after its founding in 1981, Genzyme
was a privately-held company whose operations were funded by
venture capital and private placements totaling $4 million. The
company went public in 1986, raising $22 million in its initial
public offering (IPO). Follow-on offerings, which were made in
1989 and 1991, raised an additional $173 million. Off-balance
sheet offerings contributed an additional $122 million in
research and development funding for specified projects.
In 1991, Genzyme obtained FDA approval for its first
product, a drug to treat a rare (and sometimes fatal) genetic
disorder called Gaucher disease. To facilitate continued growth
and innovation, the company engaged in a number of
acquisitions, seeking out other biotechnology companies whose
research programs, while promising, were not financially
sustainable without additional capital resources that were more
readily available to Genzyme.
Ironically, it was to accomplish such an acquisition--and
not for purposes of divestiture--that Genzyme adopted its use
of tracking stocks in December 1994. The acquired company was
another Massachusetts company, BioSurface Technology, which had
developed exciting techniques for re-growing human tissue for
transplantation.
To finance the acquisition, Genzyme common stock was
replaced by two stocks: one tracking a newly created division--
named Genzyme Tissue Repair (GTR)--into which BioSurface was
merged, and the other tracking the remainder of the company--
renamed Genzyme General. BioSurface shareholders were granted
GTR tracking stock in exchange for their BioSurface shares. And
since additional Genzyme assets were allocated to GTR, GTR
tracking stock was also issued to all Genzyme Corporation
shareholders as a non-taxable dividend.
In 1995, GTR issued additional shares in an initial public
offering (IPO) in which it raised $42 million. In 1996, a
second offering raised $29 million; in 1997, a third offering
raised $13 million. In addition, GTR has access to an $18
million line of credit from the corporation.
In 1998, Genzyme General purchased another biotech
company--Pharmagenics--which had developed a new technology to
analyze the differences in how genes are expressed in cancerous
tissue versus healthy tissue. This technology appears to be a
powerful tool in the development of new approaches to treating
cancer. Once again, Genzyme combined the acquired company with
some existing General division assets, and created another
tracking stock, Genzyme Molecular Oncology (GMO). Due to poor
market conditions for biotech start-ups, GMO has postponed its
IPO and has instead obtained a private placement of $19 million
of convertible debt. It also has access to a line of credit
from the corporation under terms similar to those provided to
GTR.
Last year, Genzyme General also raised $250 million in a
private placement of convertible debt.
The Perkin-Elmer Corporation
Background and Decision to Utilize Tracking Stock
Perkin-Elmer is a sixty year-old high technology company,
headquartered in Wilton, Connecticut.
The company was founded during World War II when Germany
was the dominant worldwide supplier of optical equipment such
as telescopes and sighting instruments.
Perkin-Elmer's business evolved from optics into
several other technologies, including scientific equipment,
guidance and navigation equipment, semiconductor manufacturing
equipment and biotech systems.
The company has distinguished itself with its
long-term consistency and success in developing new
technologies into successful products and businesses
Currently, Perkin-Elmer is divided into three
primary business units: Analytical Instruments, Biosystems, and
the recently formed Celera Genomics
These units involved different technologies,
markets and financial models
In order to survive constantly over its history as a high
technology company, Perkin-Elmer has been forced to evolve,
particularly as technology development accelerates and becomes
more competitive.
Currently, several factors have prompted management to
broadly assess structural alternatives to facilitate further
evolution and success. The clear structure of choice has been
determined to be tracking stock. Motivating factors include the
following:
--Meeting investor demands, involving business and
technology comprehension, appreciation, focus and ``pure play''
--Accommodating various investor risk/reward interests,
recognizing that each business/technology has a substantially
different financial profile
--Recruiting and retaining employees in businesses ranging
from start-ups to relatively mature businesses, while also
facilitating employee movement between business units
--Providing an optimal ``incubator'' for development of new
technologies--where a fast moving and focused start-up
environment can be supported by broader and proven resources.
These resources include management, technology, capital,
administrative resources and reputation (both for customers and
investors)
--Facilitating ongoing visibility and appreciation of
business, financial, and technological progress for investors,
customers, and employees through increased disclosure and
separate financial statements
--Maximizing total shareholder value, particularly by
exposing technologies and opportunities that may otherwise be
``buried'' within a larger business structure
--Distinguishing related businesses in their respective
markets while facilitating ongoing technology synergies
--Optimizing an acquisition currency for further
development and expansion of each business
--Providing an optimal tool for raising future capital,
even though Perkin-Elmer's current tracking stock offering is
not being used to raise capital
For Perkin-Elmer's new genomics business, tracking stock
was identified as best accommodating all of these interests,
and the company has taken extensive steps to accomplish
tracking stock, all in reliance on current law.
These steps include: creating our new Celera Genomics
business unit, recruiting employees, granting stock options and
filing with the SEC--all with tracking stock as a foundation:
Although tracking stock has yet to be officially
implemented, anticipation of such has been enthusiastically
received by investors, employees and customers
Proposed New Tax Legislation and Effects on Perkin-Elmer
Tracking stock was also chosen as the structure of choice
based on facilitating Perkin-Elmer's further evolution and
likely issuances of additional classes of tracking stock.
Throughout all of the analysis and considerations addressed
above, taxes were not a factor.
While not a factor, critical reliance was placed on the
fact that the tracking stock restructuring would not carry any
tax penalties versus the status quo.
The presumption that tracking stock is used to disguise
spin-offs and save taxes is totally inapplicable to Perkin-
Elmer. Although a separate tracking stock, Perkin-Elmer's
Celera Genomics will necessarily continue to be an integral
part of the Perkin-Elmer family.
A spin-off of Celera Genomics was not feasible for many
reasons, including the ongoing need for, and synergies with,
Perkin-Elmer's management, technologies, capital availability
and reputation
Highlighting the inappropriateness of assuming
that tracking stocks are disguised spin-offs is the current
example of Perkin-Elmer's Analytical Instruments business. Due
to the lack of comparable synergies toward that business,
Perkin-Elmer has specifically decided not to make its
Instruments business another class of tracking stock; it has
decided to sell that business to a third party. Tax
considerations were not a motivating factor in either case
Perkin-Elmer management has not considered current tax law
as an advantage or ``loophole'' with respect to our proposed
tracking stock because no alternative involved spinning off or
selling the genomics business. A spin-off or sale would be
unhealthy and perhaps fatal to the young business and would be
detrimental to shareholders, employees and the development of
science and technology. Management views tracking stock to be a
neutral tax event as compared to viable alternatives, all of
which involve retention of the genomics business within the
Perkin-Elmer family.
The current tax proposal could represent a fatal blow to
Perkin-Elmer's proposed restructuring. From Perkin-Elmer's
perspective, the proposed legislation would not eliminate a tax
loophole; it would eliminate tracking stock as a viable
alternative by imposing a significant tax penalty on the
structure. This, in turn, would represent an obstacle to
Perkin-Elmer's further success and evolution. As such, it would
impede the effective development of science, technology,
medicine and corresponding contributions toward employment and
success for American companies.
Chairman Archer. Thank you, Mr. Hernandez.
Mr. Kies and Mr. Weinberger, I think both of you were in
the room during the testimony of the previous panel. You
listened to what Mr. Tucker, representing the ABA, said about
tax shelters. Where do you differ with him?
Mr. Kies. Well, Mr. Chairman, Mr. Tucker was careful I
think to say that actually his statements were not on behalf of
the American Bar Association itself, other than his opposition
to taxing the investment income of their trade association, of
which I am a member. So his position is not yet the official
position of the ABA.
I think where we basically differ is a different view of
the tools that are available to the Service today. The IRS has,
as we said in our testimony, a substantial array of tools at
its disposal to deal with what are real abuse situations, and
indeed has been reasonably successful in using them.
The concern that we have is that the kind of discretion
that would be given to the Service would go way beyond anything
that is necessary for them to deal with problem situations that
they legitimately have to deal with, and that what they should
really do is use the tools that are at their disposal,
including what was enacted in 1997 that has not yet been
implemented through regulations.
Chairman Archer. Mr. Weinberger, do you have anything to
add to that?
Mr. Weinberger. No, other than to say that when you look at
the written testimony of the ABA, I think there is a lot more
in common with what we said than was apparent in the verbal
testimony. One of the suggestions in the ABA's written
testimony was ``we recommend that congressional response to the
tax shelter problem be measured and appropriate. It should not
overreach. It should not risk inhibiting legitimate business
transactions.''
That is, I think, on all fours with what we are saying.
They did not reference anywhere in their verbal or written
testimony the changes that were made in 1997 expanding the tax
shelter reporting requirement and substantial understatement
penalty definition or the reason they were enacted. So I think
that I would just focus more on the existing tools at hand.
Chairman Archer. He, I believe, alluded to a need for
greater disclosure. Would you agree with that?
Mr. Kies. Well again, what the 1997 act would do is require
disclosure of tax shelter activities where there is
confidentiality involved. The Service ought to implement the
authority that they have got so that they can take advantage of
that.
Overdisclosure, though, should be looked at cautiously. If
you cause taxpayers to have to disclose every transaction they
enter into, what you will get is a blizzard of paper at the IRS
that will not be useful as an effective tool in enforcement.
Right now, the tax returns filed by corporate taxpayers, as you
have seen in other testimony before this Committee, measure
many feet in height. There is a tremendous amount of disclosure
that goes on today. Effective auditing can address most of the
problems to the extent that they actually exist.
Mr. Weinberger. Mr. Chairman, I want to concur with that.
In fact, when the Treasury asked Congress to pass the proposal
that you passed in 1997, providing expanded tax shelter
registration rules that have not yet been implemented, they
specifically said in the Green Book, ``many corporate tax
shelters are not registered with the IRS . . . [R]equiring
registration of tax shelters would result in the IRS receiving
useful information at an earlier date regarding various forms
of tax shelter transactions engaged in by corporate
participants. This will allow the IRS to make better informed
judgments regarding audits, and so on, and so on.''
We think that is why it is premature for these sweeping new
proposals to take place before those proposals are even
implemented.
Chairman Archer. In the opinion of each of you, are there
abuses out there?
Mr. Kies. There certainly are bad actors. There always have
been. But the government has not decided, for example, to take
away everybody's driver's license because there are a few
speeders. To impose sweeping or give sweeping discretion to the
IRS which could be used against all corporate taxpayers because
there are a few problem actors, we think would be a misguided
thing to do.
The audit process and the other tools available to the
Service can be effectively used to police bad actors. We think
most corporate taxpayers are trying to actually get the answer
right, file returns that correctly report their liability,
while serving the responsibility they have to their
shareholders to not overpay their liability. We think that is
what most corporate tax managers are trying to accomplish. For
those that are the bad players, the Service ought to go after
them. I don't think anybody would defend protecting those types
of taxpayers.
Chairman Archer.
Mr. Doggett.
Mr. Doggett. Thank you very much. Mr. Kies, I read in the
Sunday New York Times that you have been assigned the lead role
of drafting the Republican Social Security plan. How are you
coming?
Mr. Kies. I am unaware of that assignment.
Mr. Doggett. It's inaccurate? You are not doing that?
Mr. Kies. I am happy to talk to anybody about Social
Security, both Democrats and Republicans, and I have. I
participated in the White House Conference on Social Security
at the White House's request. I have been happy to talk about
the issue.
Mr. Doggett. But the New York Times story is in error and
you are not drafting the Republican plan?
Mr. Kies. I am no longer with the Congress. I provide would
be happy to provide informal advice to anybody who is
interested in it.
Mr. Doggett. So the report is erroneous?
Mr. Kies. That is correct.
Mr. Doggett. Thank you. If I understand your written and
oral testimony correctly, you oppose every single proposal that
the administration has advanced relating to corporate tax
shelters?
Mr. Kies. That is precisely correct.
Mr. Doggett. You feel that the best thing for this Congress
to do about tax shelter hustlers for the time being is to do
nothing?
Mr. Kies. I think the best thing that Congress could do is
to give stern and direct directions to Treasury and to the
Internal Revenue Service to utilize the tools that they have at
their disposal to address these kind of problems.
Mr. Doggett. And you recommend that the Congress take no
further legislative action of any kind concerning corporate tax
shelter hustlers this year?
Mr. Kies. I think the Congress ought to wait and see if
what was given to the Service in 1997 is effectively addressing
the problems that were identified then.
Mr. Doggett. Which is another way of saying do nothing, as
far as legislative proposals. Correct?
Mr. Kies. That is correct.
Mr. Doggett. Now I want to be sure I understand how this
process works, and whether the reports of it are accurate. At
your firm, is it correct that contingency fees of up to 30
percent are charged on tax savings for corporate tax shelters
and tax avoidance schemes?
Mr. Kies. Actually, I think you are referring to the Forbes
article. That was a reference to, I believe, the proposal at
the beginning of the article, which dealt with another firm's
proposal.
Mr. Doggett. I am asking the question generically, though
the Forbes article does refer specifically to your firm and to
comments made by one of your partners here in the Washington
office. But my question, without regard to Forbes, is whether
or not it is true that there are charges of up to 30 percent on
a contingency fee basis on tax avoidance schemes?
Mr. Kies. Mr. Doggett, we don't advise people on tax
avoidance schemes. But if you are asking do we ever have
contingency fee arrangements, there are situations--they are
somewhat unusual--in which we provide advice which has
contingencies associated with it, whereby we tell our clients
that we are prepared to stand behind our advice, and if it
turns out to be incorrect, to return fees that have been paid.
Mr. Doggett. So in short, if the corporate tax shelter, if
you prefer that term, works, you get 30 percent of the amount
that they save. If it doesn't work, they don't owe you
anything. Is that the way it works?
Mr. Kies. The 30 percent, frankly, I don't know if we have
any 30-percent arrangements.
Mr. Doggett. Your partner indicated you did, though I think
it goes down to as low as 8 percent, he said.
Mr. Kies. Again, what I am saying is that there are
contingency fee arrangements. The exact percentage, I am not
aware of.
Mr. Doggett. That is the way it works though, whether it is
30 percent or 8 or 25, if you succeed on the tax shelter, your
company shares in a good chunk of the savings, and if you don't
succeed, the corporation owes your company nothing for the
advice?
Mr. Kies. There are circumstances like that.
Mr. Doggett. Your partner also described this as a ``new
pricing model.'' Does that mean that this use of the
contingency fee system on corporate tax shelters is relatively
new?
Mr. Kies. Actually, there have been contingency fee
arrangements for many years. Litigators use contingency fee
arrangements both in tax and nontax.
Mr. Doggett. He also described what he referred to as black
box products that are sold by your firm. Is that term familiar
to you?
Mr. Kies. Actually I have never heard it used, but the
context in which it appeared in the article was to describe a
unique planning transaction. Frankly, every piece of advice
that we give to a specific taxpayer is unique to that taxpayer.
So the black box kind of sounds like it's mysterious, but I am
not sure that it connotes any kind of unusual----
Mr. Doggett. He suggested that staffers at your office were
required to come up with one new idea of this type per week. Is
that correct?
Mr. Kies. No. That is not correct.
Mr. Doggett. And is it correct that there are up to 40
newly hired professional salesmen to pitch these corporate
shelter ideas just in this office?
Mr. Kies. No. That's not correct. Firm-wide we have people
who are actually relationship persons with the clients that we
serve. Those people, part of their job is to bring to the
attention of clients the range of services that we provide,
which include State and local, pension planning, multinational.
I mean there are people whose job is to help educate our
clients about the range of services we provide. That is true of
most of the professional firms today.
Mr. Doggett. Thank you.
Mr. Kies. Sure.
Chairman Archer.
Mr. Collins.
Mr. Collins. Thank you, Mr. Chairman.
Mr. Kies, I believe in your testimony you referred to a
Judge Learned Hand.
Mr. Kies. Yes, sir.
Mr. Collins. A quote that is often referred to by Mr. Hand
or by Judge Hand. What was that quote, sir?
Mr. Kies. Well, I don't know the precise quote, but the
basic message that he had was that people don't have an
obligation to maximize the tax liability that they pay.
The exact quote was, ``A transaction, otherwise within an
exception of the tax law, does not lose its immunity'' that is,
it's not available, ``because it is actuated by a desire to
avoid or if one chose, to evade taxation. Anyone may arrange
his affairs that his taxes shall be as low as possible; he is
not bound to choose the pattern which will best pay the
Treasury; there is not even a patriotic duty to increase one's
taxes.''
What Judge Hand was basically saying is people are
perfectly entitled to plan their transactions legally in a way
that will lower their tax liability.
Mr. Collins. In other words, a taxpayer can seek advice as
to how they would result in a minimum of taxation?
Mr. Kies. Not only can they do that, but as a matter of
fact, corporate tax managers have the fiduciary obligation to
their shareholders to plan their transactions that way.
Mr. Collins. Very good. Thank you, sir.
Thank you, Mr. Chairman.
Chairman Archer.
Mr. Houghton.
Mr. Houghton. Thank you, Mr. Chairman. You know, I am
really interested in sort of the macro issues here in terms of
the revenue provisions. There are a lot of different categories
of taxes. One is if a tax is different. I think you have a 32.6
percent corporate tax average. That could be different. It
could be split up different ways. It could be an unfair tax.
The thing I am most interested in is the consequence taxes.
When these tax provisions are put forward, what are the ones
that have economic and national consequences? What are those
ones that you think are important? That is what I am interested
in. To anybody who wants to talk to it.
Mr. Kies. Mr. Houghton, in terms of--you mean the proposals
that the administration has?
Mr. Houghton. Right. Right.
Mr. Kies. Which ones would have economic consequences?
Mr. Houghton. Right.
Mr. Kies. Well, obviously it depends on the amount of
revenue they are raising. I mean ironically, the tax shelter
provisions are only predicted by the Joint Committee to raise
$300 million a year, so the economic consequence wouldn't seem
to be very substantial. The consequence in terms of the ability
of people to have any confidence as to what the rules are could
be quite sweeping.
There are other proposals in here that have clear economic
consequence. If you raise the cigarette taxes by $69 billion or
whatever the number is, the economic consequence is that people
that smoke, which is mainly low- and middle-income individuals,
are going to experience an economic penalty. Consumption taxes
clearly would get borne by the consumer. So an increase in the
cigarette excise tax, an increase in the airline ticket fees,
clearly get borne by the consumer.
Other proposals in here, for example, there is a wide range
of proposals----
Mr. Houghton. I guess what I am searching for is if you
increase the airlines tax, does that mean that one fewer person
flies? What is the economic consequence of some of these
things?
Mr. Kies. The economists certainly predict that increases
in excise taxes do decrease consumption. Indeed, if you ask the
Joint Committee, they could tell you from their model what
would be the decreased consumption as a result of increasing
those excise taxes. Same thing in the case of taxes, excise
taxes on airline travel. There would be an impact in terms of
decreased consumption.
Mr. Houghton. Would you like to----
Mr. Weinberger. Well, Mr. Houghton, I guess to your generic
question, I think any of the proposals that restrict the
ability of companies to raise capital or to reorganize
efficiently are going to hurt the overall profit to the
company, which are a large reason for our continued surplus
according to CBO. Part of the reasons we have expanding
surpluses over the original projections was due to corporate
profits, and there should be a high threshold to enact
proposals that will have a negative effect on these companies'
ability to either raise capital or effectively reorganize in an
efficient manner.
Mr. Kies. That is an important point, because it gets to,
for example, the tracking stock proposal.
Mr. Hernandez. To that point, the Treasury's revenue
estimates of I think it's $600 million, are unrealistic,
because people just wouldn't issue tracking stock. But it does
reduce the ability of companies to raise capital.
Mr. Houghton. So that is a very significant issue.
OK. Well, thank you very much.
Chairman Archer.
Mr. Portman.
Mr. Portman. Thank you, Mr. Chairman.
Following up on that question, my questions go to the
issues you raised with regard to the life insurance provisions.
And particularly, Mr. Wamberg, as it relates to the personal
savings rate, which as you know is at a low ebb right now.
Probably not since 1933 have we seen such a low personal
savings rate in this country. In fact, it was even negative a
couple months late last year. Everyone in the economic field,
right, left or center, across the ideological spectrum, seems
to agree that that is a very important indicator of the healthy
economy into the future, that we can't sustain our economic
growth without higher savings rates and more capital formation.
You talked about the administration's proposal to tax
employer-owned life insurance. I am looking at your testimony.
You focus more on the health insurance side, saying that that
could affect fringes on the health side. The examples you use
are primarily in that area. How would it affect the pension
side? In particular, defined benefit plans, but also on the
defined contribution side. In other words, a 401(k) or another
kind of profit-sharing plan. How would that tend to affect the
way it would work in the real world? Kind of following on Mr.
Houghton's statement, what are the real-world impacts of these
proposals?
Mr. Wamberg. The question is a good one. It would have a
severe impact for corporations to be able to keep their
executive team together and put retention devices in and make
sure that they stay with that company for the duration.
We have a labor shortage in this country in a lot of
different sectors, but clearly in top management. Because of
ERISA and because of continuing government limitations on what
can be provided through a qualified pension plan, what can be
provided through qualified defined contribution and profit
sharing plans, and how much an employee can contribute to a
401(k) plan, there is significantly low limits.
What companies do is they will supersede those programs,
not take a tax deduction to do it, but they will offer benefits
to those executives with vesting and other components to make
sure that they stay, and stay focused with that company. They
will use life insurance to match that liability. They are
creating a long-term liability by creating these plans for
their management team. They are putting life insurance on these
executives as a long-term asset so that when the benefits come
due, they have the money to pay it.
So if you took that benefit away from corporations, you
would have a very severe take-away from management's ability to
do what is right for their management teams, for their
shareholders, and so forth.
Mr. Portman. Apart from what is right for the management
team, and what is right in terms of retaining as you say,
management employees, what would the impact be on savings? I
assume many of these products you are talking about, whether it
is enhancing a qualified plan, or whether it is a supplement to
that, these are plans that involve saving. The life insurance
is what helps to finance that longer term liability you talked
about.
Mr. Wamberg. Exactly. We would be talking in very large
numbers. I do not have a specific number, but understand what
we are doing, is we are taking money out of the consumption
stream and we are putting it away and we are saving it for the
future.
Mr. Portman. Other comments on this general issue?
Mr. Kies. I think, Mr. Portman, clearly the provisions of
current law that assist employers to either help save for
retiree health or retiree retirement benefits both are a major
plus in terms of total national savings. They facilitate the
ability of employers to deliver those benefits to their
employees.
In the case of retiree health benefits, if it weren't for
the programs like the corporate-owned life insurance programs
that help fund retiree health benefits, in many cases employers
wouldn't be able to afford to provide them, and people would be
looking to the Federal Government for those type of benefits.
So I think they play a critical role in helping the private
sector deliver a key part of those benefits.
Mr. Weinberger. I just have a quick point, which would be,
as we look at Social Security and the problems we have with
unfunded benefits there, I think that we wouldn't want to take
away funding sources for retirement benefits outside the Social
Security system. We would run into the same problem that we
have with the Social Security system.
Mr. Portman. I would hope, given the situation we are in
with regard to our savings and with regard to our pension
system, where only half of all workers are now covered by any
kind of a pension, and beyond that, as you say, the problems we
have with our public retirement system, Social Security, that
proposals would come from the Congress and the administration
to help companies encourage savings and encourage pensions.
That would be one of my major concerns with the
administration's proposals on the insurance side.
Thank you, Mr. Chairman.
Mr. Kies. Mr. Chairman, could I ask your indulgence for 1
minute? I would just like to go back to Mr. Doggett's question
on my role in Social Security, because I want to make sure that
I was clear.
Mr. Doggett, I have talked to probably 40 Members of
Congress in the past year about Social Security issues, both
Democrat and Republican, and have also been available to
participate in the White House conference. So I have been
available to talk to anybody who is interested in the issue.
Only the Republican Members of the Congress could decide what
their own plan is going to be. I just wanted to make sure I was
clear that I actually have participated in a lot of discussions
with----
Mr. Doggett. But other than attending the conference, you
are not drafting the language and forwarding drafts or
participating in drafting in any way?
Mr. Kies. I have actually drafted a variety of different
approaches to Social Security that people have sometimes been
interested in looking at.
Mr. Doggett. So to that extent, maybe the New York Times
article is not erroneous? You are drafting provisions for a
Republican plan?
Mr. Kies. No. I am not. I have drafted and shared with a
variety of people different ideas. In fact, I intend to publish
something soon, as a number of other people have.
Mr. Portman. Mr. Chairman.
Chairman Archer. Who seeks recognition?
Mr. Portman.
Mr. Portman. One further question, if I might just briefly.
I have not had the opportunity to talk to Mr. Kies about Social
Security, and I would like to go on record saying I would be
delighted to. When you have time, I would like to sit down and
talk to you about your ideas on Social Security. I am getting
them from a broad array of people and your expertise would be
most welcome.
Mr. Kies. Certainly, Mr. Portman.
Chairman Archer. The Chair is not sure what the gentleman
from Texas is driving at. Let me make it perfectly clear that
if there is a Republican plan--and I hope there will be because
we certainly don't have a Democrat plan--it would be very nice
to have a specific plan that will save Social Security for 75
years. Further, it will be drafted in-house, in the Congress of
the United States, and it will be put in statutory language by
our staff, and the normal drafting staff on Capitol Hill. So
that should be very clear.
Let me ask you just a final question on tax shelters. For
the benefit of the Committee, what is the definition of a tax
shelter?
Mr. Kies. Well, Mr. Chairman, there are a variety of
definitions. But the one that is contained in the
administration proposal includes any transaction in which the
reasonably expected pretax profit of the transaction is
insignificant relative to the reasonably expected net tax
benefit.
One of the reasons we are very concerned about that is that
we believe a number of legitimate business transactions could
fall within that definition. For example, a wildcat oil driller
who spends $5 million, who has only a 10 percent expectation of
hitting oil, under current law would clearly be permitted to
deduct those expenses against his other income if he doesn't
strike oil. Clearly he does not have a reasonable expectation
of a net profit if he only has a 10 percent likelihood of
striking oil.
Those are the kind of circumstances that we are extremely
concerned about the scope of this kind of authority. It is
particularly concerning because the Treasury is proposing to
eliminate any reasonable basis exception where the taxpayer had
reasonably relied on current law. But the definition almost
becomes in the eye of the beholder if it has that kind of
breadth to it.
Chairman Archer. Does anybody want to add anything?
Mr. Weinberger.
Mr. Weinberger. Quickly, Mr. Chairman. I share the same
concern for the definition of tax shelter. When you look at
pretax profit versus tax benefits, any kind of recapitalization
of preferred stock equity for debt could be considered to be a
tax shelter because there is no pretax profit, although there
is clearly a business purpose for doing it.
But what I wanted to just point out is that not even all of
the transactions in the President's budget that we are
concerned about, including the most troublesome, the section
269 proposal, is triggered off a tax shelter. It is triggered
off of tax avoidance transaction, which also is--any
transaction involving the improper elimination or significant
reduction of tax on economic income. That is the only
definition we have right now to understand what that proposal
means.
Chairman Archer. Under my Chairmanship of this Committee,
we are going to attempt to eliminate every abuse that is being
used to circumvent the clear ends of the Tax Code. But we do
not want to have a net that drags in everybody, simply because
we want to get some people who have abused. We have to find a
way. I hope anybody who has ideas will give them to us. How we
can get at the abusers without extending the long arm of the
IRS into everybody's business?
It just points up to me, once again, as almost every panel
and witness has pointed up to me, we will never fix the income
tax. Income is such a gray area, by definition, that we will
never fix it. We will keep trying and trying and trying. I hope
I can win more converts to getting rid of it completely and
totally, and getting to a specific form of taxation rather than
a gray area form of taxation.
I thank you for your contribution. I think we will be ready
now for the next panel.
Our next panel will include Michael Marvin, Delores ``Dee''
Thomas, Eldred Hill, Gery Chico, and Rene Bouchard. The Chair
would invite all of our guests to cease chatter so we can
continue with our last panel.
Our first witness will be Michael Marvin. Once again, we
hope you can keep your verbal presentation to 5 minutes or
less. Your entire written statement, without objection, will be
included in the record, as will all of the statements for all
of the witnesses on the panel.
With that, if you will identify yourself for the record,
you may proceed.
STATEMENT OF MICHAEL MARVIN, EXECUTIVE DIRECTOR, BUSINESS
COUNCIL FOR SUSTAINABLE ENERGY
Mr. Marvin. Thank you, Mr. Chairman. I am Michael Marvin,
the executive directive of the Business Council for Sustainable
Energy. It is a pleasure to appear before this Committee to
present the Council's perspective on proposed tax incentives
for clean energy technologies.
The Council was created in 1992 by energy executives who
were concerned about the economic, national security, and
environmental ramifications of our Nation's energy policies.
Our membership ranges from large multinational corporations, to
smaller companies, to national trade groups. The administration
has introduced tax legislation providing incentives for the
purchase or development of clean energy technologies.
Separately, other Members of this Committee, Mr. Matsui, Mr.
Thomas, and many others have introduced some similar provisions
to the administration's package.
The administration's initiative is incorporated within the
so-called Climate Change Technology Initiative, which is a 5-
year $3.6 billion package that addresses a range of
technologies across the utility, housing, and transportation
sectors. This is a modest package of incentives that moves us
toward becoming a more efficient economy. I would like to
highlight briefly a few incentives I believe are indicative of
the goals that the administration is trying to achieve.
To encourage the purchase of efficient homes, families
would receive a $1,000 to $2,000 tax credit for the purchase of
homes substantially above energy code. While the
administration's provision represents a strong start, we
believe the legislation introduced last Congress by
Representative Thomas is even more persuasive. Mr. Thomas'
legislation would expand that credit to include significantly
retrofitted existing homes, and make other technical changes
that will make this work better in the real world marketplace.
The Thomas legislation has been endorsed by organizations
ranging from the National Association of Home Builders to the
Alliance to Save Energy.
To promote renewable energy development, the package
includes a 5-year extension of the wind and biomass production
tax credit. Legislation has been sponsored by a majority of
Democrats and Republicans on this Committee to continue that
for 5 years. In particular, Congressmen Thomas, Matsui, and
McDermott have led that charge. It provides a modest incentive
for the purchase of solar rooftop power systems, and creates
short-term incentives for many other energy technologies such
as natural gas water heaters, heat pumps, advanced central air
conditioners, and combined heat and power.
I want to underscore what I think are two important
characteristics of this package. First, every provision has a
cap on the maximum amount of credit a consumer could receive,
usually between $1,000 and $4,000. Second, each credit sunsets
within 3 to 6 years, giving this Committee greater control over
energy tax policy.
We believe these provisions make sense, whether you believe
the climate is the most compelling threat to our society or
whether you believe it lacks scientific merit. Regardless of
climate change, there are concerns about energy independence,
about local and regional air pollution, about diversification
of the Nation's fuel supply, about helping U.S. business thrive
in the increasingly competitive global marketplace. The fact
that climate change has become so talked about in terms of
energy and environmental policy does not minimize the
importance of these other issues.
The Council believes that the key to greater market
penetration and more effective, more efficient technologies is
accelerated capital stock turnover. How do we encourage
businesses and consumers to replace equipment like clothes
washers, automobiles, and heat pumps, with more efficient and
cleaner alternatives, when the up front costs of that equipment
may be slightly higher than less efficient equipment?
Let me offer an example that is not covered by this
package. Maytag recently developed a clothes washer that uses
about 48 percent less water, and up to 70 percent less energy,
but that machine costs more than does the average washer. By
implementing a tax measure that reduces the up front cost to
the consumer, a number of important objectives can be
accomplished. Consumers get the value of higher efficiency
equipment. Consumers save money. The environment benefits from
reduced energy and water consumption. By increasing the
efficiency of the products, U.S. companies stand to gain a
larger share of rapidly expanding export markets.
According to the U.S. Energy Information Administration, 60
percent of the greenhouse gases that this country is expected
to emit in the year 2010 will be emitted from products that
have not yet been purchased. If we have to set and achieve any
significant national goals of carbon emissions without command
and control regulation, it is this 60 percent that this
Committee can affect. Incentivizing, not requiring companies to
increase efficiency, is a necessary first step.
Now it is important that we be honest here and recognize
that a $700 million per year tax package in the energy world,
while not insignificant, pales in comparison to the roughly
$280 billion that we spend in natural gas and electricity each
year. Key opportunities were missed in this package. For
natural gas vehicles, other appliances, insulation, and even
outdoor power equipment, short-term tax credits can help move
companies in a direction that benefits consumers, the economy,
and the environment. In other words, the markets for these
products can be influenced by tax policy without government
picking winners.
Thank you again for your time. The Council and its members
want to continue working with the Committee to ensure the voice
of business is heard in this debate.
[The prepared statement follows:]
Statement of Michael Marvin, Executive Director, Business Council for
Sustainable Energy
The Business Council for Sustainable Energy is pleased to
offer testimony to the House Ways and Means Committee on the
Administration's proposed FY 2000 tax incentives to encourage
the expanded use of clean energy technologies throughout the
nation.
The Council was formed in 1992 and is comprised of
businesses and industry trade associations which share a
commitment to pursue an energy path designed to realize our
nation's economic, environmental and national security goals
through the rapid deployment of efficient, low-and non-
polluting natural gas, energy efficiency, and renewable energy
technologies. Our members range from Fortune 500 enterprises to
small entrepreneurial companies, to national trade
associations.
Few activities have a greater impact on our nation's
economy, environment, and national security than the production
and use of energy. Our economic well-being depends on energy
expenditures, which account for approximately 7 to 8 percent of
the nation's gross domestic product and a similar fraction of
that value in U.S. and world trade. Energy production and use
also account for a large share of environmental problems, such
as regional smog, acid rain, and the accumulation of greenhouse
gases in the atmosphere. Finally, our national security is
increasingly linked to energy production and use, given our
nation's increasing dependence on foreign oil sources,
including those from the politically unstable Middle East.
To expand the nation's portfolio of energy resources, the
Council has worked with this Administration as well as many
Members of Congress to promote tax incentives for clean energy
technologies. Strong leadership has come from this Committee in
the past as well, including Rep. Bob Matsui, who introduced
legislation similar to the Administration's Clean Energy tax
package in the 105th Congress, and Rep. Bill Thomas, a long-
time leader for energy efficiency in homes and renewable energy
development.
In commenting on the Administration's package, the Council
has identified a number of key areas that the FY 2000 budget
addresses (as well as some that are not included). We urge this
Committee to give the following provisions every consideration.
Energy Efficient Homes
Provide a Flat $2,000 Credit
The BCSE supports the adoption of a flat $2,000 credit
which will ensure that all homes will be constructed or
renovated to be energy efficient, not merely the most expensive
models. With implementation of this credit, builders will have
an incentive to construct modestly-priced, energy efficient
homes and low and middle-income homeowners will be encouraged
to renovate their homes with new energy efficient technologies.
Offer New Home Credit to the Home Builder
Rather than provide an incentive directly to the new home
buyer, the Council supports a flat $2,000 tax credit for the
new home builder, who can pass it along to the buyer at
closing. A tax credit to the builder will encourage the
construction of a large number of new energy efficient homes,
which will expand the percentage of energy efficient homes in
the marketplace, thereby stimulating additional builder and
consumer interest in these dwellings. A credit for the home
builder will also reduce the financial burden of using existing
technology to increase energy efficiency.
Offer Existing Home Credit to the Home Owner
The Council supports a tax credit for the owner of existing
homes that have been upgraded by the home owner to be 30
percent or more efficient than the IECC. To achieve a 30
percent increase in energy efficiency will require a major
effort by the homeowner, and the $2,000 credit will only cover
a small percentage of the marginal cost of upgrading home
energy efficiency, relative to the new home credit.
Employ 1998 International Energy Conservation Code
Instead of relying on the 1993 Model Energy Code as a
measure of energy efficiency, the Council supports the 1998
IECC, given this measure's accuracy in accounting for the
impact of seasonal and climatic variations on energy
efficiency. This reduces the likelihood that one region of the
country will have an advantage in the measurement of energy
efficiency. The BCSE also supports other conservation tools
which use total energy efficiency analysis.
Utilize Systems of Energy Efficient Technologies
Rather than provide incentives for specific technologies
within new and existing energy efficient homes, the BCSE
recognizes that a wide array of energy efficient natural gas,
windows, insulation, lighting, geothermal, and photovoltaic
technologies can be used in concert to enable new and existing
homes to be 30 percent more efficient than the IECC. Examples
of energy efficient technologies which could be used to achieve
the 30 percent standard could include advanced natural gas
water heaters, heat pumps, furnaces and cooling equipment,
fiber glass, rock wool, slag wool and polyisocyanurate
insulation, energy efficient exterior windows, geothermal heat
pumps, and fluorescent and outdoor solar lighting.
Energy Efficient Building Equipment
The BCSE is pleased with the Administration's proposal
which provides a 20 percent tax credit for fuel cells, natural
gas heat pumps, high efficiency central air conditioners, and
advanced natural gas water heaters (subject to a cap). However,
the Council recognizes the need for incentives for energy
efficient building technologies to be broadened for the benefit
of consumers and the environment. The BCSE recommends
consideration of a 20 percent tax credit for advanced natural
gas water heaters with an energy factor (EF) of .65, a 20
percent tax credit for natural gas cooling equipment with a
coefficient of performance of .6, and a 20 percent tax credit
for advanced natural gas furnaces with an annual fuel
utilization efficiency of 95 percent. Given the significant
reduction in greenhouse gas emissions which can be achieved
through the expanded use of small-scale distributed generation
technologies, the BCSE supports a 20 percent tax credit for all
fuel cells, regardless of their minimum generating capacity.
Other technologies which could be included in a broadened tax
incentive package include variable frequency drives and motors,
building automation systems, and compressed air systems.
Alternative Fuel Vehicles
While the BCSE recognizes the Administration's efforts to
provide tax incentives to encourage consumer demand for
vehicles with two and three times the base fuel economy of
vehicles on the road today, we are concerned that it has not
provided an incentive for natural gas vehicle (NGV) technology.
While NGVs are more expensive than gasoline and diesel
vehicles, these technologies reduce CO2 emissions by
30 percent below that of gasoline vehicles currently on the
road. The BCSE supports a 50 cent per gallon income tax credit
for each ``gasoline gallon equivalent'' of compressed natural
gas, liquified natural gas, liquified petroleum gas, and any
liquid with at least 85 percent methanol content used in a
newly purchased alternative-fueled vehicle which meets
applicable federal or state emissions standards. These tax
incentives will increase demand for clean fuel vehicles,
especially in fleet markets, accelerate production of NGVs, and
lower the initial purchase cost of the technology.
Wind Energy
The BCSE supports the Administration's proposal to provide
a straight 5-year extension (through July 1, 2004) of the
existing wind energy production tax credit (PTC) provision
providing a 1.5 cent per kilowatt hour tax credit (adjusted for
inflation) for electricity generated by wind energy. An
extension of the current credit prior to its expiration on June
30, 1999 will stimulate investments and current project
planning that are now threatened due to the uncertainty
surrounding the PTC's extension. In addition to the
Administration's proposal, legislation was introduced during
the 105th Congress (H.R. 1401/S. 1459) to provide a 5 year
extension for the wind energy PTC. The Council also supports a
30 percent tax credit for small wind turbines with generating
capacities of 50 kilowatts or less. (H.R. 2902) which was
introduced during the 105th Congress. The goal of the new
program is to stimulate the U.S. domestic market, increase
production volumes and reduce production costs. Growing export
markets for small wind turbines provide effective leverage of
the federal investment in job creation.
Biomass
The BCSE supports the expansion of the biomass energy PTC
from its current ``closed loop'' definition to include a 1.5
cent per kilowatt hour tax credit for electricity produced from
landfill gas, wood waste, agricultural residue, and municipal
solid waste. In addition to offsetting greenhouse gas
emissions, the use of biomass energy can address problems of
landfill overcapacity, forest fires, and watershed
contamination.
Combined Heat and Power Systems
The following points should be added to the
Administration's proposed investment tax credit for combined
heat and power systems.
``The proposed definition of a qualified CHP system in the
Administration's proposal is equipment used in the simultaneous
or sequential production of electricity, thermal energy
(including heating and cooling and/or mechanical power) and
mechanical power.''
Language in the current proposal could be construed to
limit the credit solely to those taxpayers that produce
mechanical power in conjunction with electric or thermal energy
production. In addition, specificity is needed as to what
``equipment'' is included in the CHP definition. A better
definition of a qualified CHP system is: equipment and related
facilities used in the sequential production of electricity
and/or mechanical power and thermal energy (including heating
and cooling). Eligible equipment shall include all necessary
and integral to the CHP process including prime movers
(turbines, engines, boilers), heat recovery boilers, air and
water filtration, pollution and noise control, and paralleling
switchgear but may exclude buildings, fuel handling and storage
and electrical transmission.''
Items such as thermal insulation, controls, and steam traps
should be included within tax incentives for CHP systems. Tax
credits instituted from a systems standpoint will enhance the
overall efficiency of CHP technologies.
BCSE supports the addition of language concerning thermal
distributing networks to the CHP investment tax credit:
Distribution piping used to transport thermal energy
including steam, hot water and/or chilled water as well as
condensate return systems shall be included as part of a
qualifying CHP system. Thermal distribution systems added to
existing electricity-only energy facilities which then meet the
definition of CHP facilities shall be eligible for the tax
credit.
Furthermore, the BCSE supports the addition of the
following language concerning backpressure steam turbines to
the CHP investment tax credit:
``Backpressure steam turbines can be highly efficient
generators of electricity and thermal energy. When used in
distributed thermal energy systems to replace pressure reducing
valves these turbines convert higher pressure thermal energy
into lower pressure thermal energy along with electricity.
Backpressure steam turbines with a capacity of between 50 kw
and 3000 kw that reduce steam pressure and generate electricity
qualify for the CHP Investment Tax Credit.
White Good Appliances
The BCSE supports a 25 percent tax credit for the purchase
of Energy-Star-certified white good appliances. Such
a credit would give consumers an incentive to purchase the
highest efficiency appliances, expanding the market for the
technologies, and encouraging the manufacturer participation in
this voluntary program. At a minimum, the Council would urge
the Administration to adopt credits for the most energy
efficient clothes washers and refrigerators which are in the
market today.
Residential Biomass
Fuel pellets are a residential biomass technology used to
heat residences throughout the U.S. The BCSE supports a 15
percent tax credit for fuel pellets used for residential home
heaters and a 20 percent tax credit for fuel pellets used in
residential and commercial water heaters, a market which is not
as mature as the market for residential home heaters.
Research and Experimentation
The BCSE supports a permanent extension of the research and
experimentation (R&E) tax credit. In response to a request by
Council member Gas Research Institute, the Policy Economics
Group of KPMG Peat Marwick examined the most recent economic
evidence and official IRS statistical information to determine
whether a permanent extension of the R&E tax credit was
warranted. Conclusions were that the credit's effectiveness
warranted a permanent extension, which may improve its
effectiveness. The current short-term approach to subsidizing
long-lasting research and development investments imposes
unnecessary additional risks on R&D-performing companies, and
does not best serve the country's long-term economic interests.
Residential Solar Technologies
The BCSE supports a tax credit equal to 15 percent of a
qualified investment for neighborhood solar systems which
enable energy consumers within multifamily dwellings, rented
housing, and homes with roofs not suitable for direct
photovoltaic (PV) installation to heat and cool their homes.
The inclusion of tax incentives for neighborhood solar systems
will reduce the cost of these investments while reducing
overall greenhouse gas emissions. The Council also recommends a
flat $400 credit for residential solar water heating or space
heating systems certified by the Solar Rating and Certification
Corporation or comparable agency. The credit could be added to
the Administration's hot water efficiency credit. The BCSE also
supports a $100 tax credit for pool heaters for family
households with income under $85,000 or single households with
income under $65,000.
Clean and Fuel Efficient Outdoor Power and Lighting Equipment
BCSE supports a tax credit for the purchase of clean and
fuel efficient outdoor power and lighting equipment used in
residential, commercial, and industrial applications. The
credit would equal 10 percent of the purchase price of outdoor
power and lighting equipment. Outdoor power equipment that
meets Environmental Protection Agency Tier II emissions
standards prior to their implementation or effective dates
would be eligible for this tax credit. The creation of an
analogous tax credit for manufacturers of these technologies
could also result in substantial fuel savings and other
environmental benefits.
Conclusion
The Council recognizes the leadership this Committee has
shown in the past to promote incentives for clean energy
technologies as well as the positive impact these provisions
have had on our nation's economy, environment, and national
security. We pledge to continue working with the Committee, the
Congress, and the Administration to pursue comprehensive
initiatives which will accelerate new developments in the way
we produce, generate, and consume energy. Many of us in the
business community are willing to stand behind comprehensive
clean energy tax incentive proposals and those who support
them.
Note: Where appropriate, the BCSE identifies legislation that
was introduced in the 105th Congress which includes similar or
identical language to that recommended here.
Chairman Archer. Thank you, Mr. Marvin.
Ms. Thomas, if you will identify yourself for the record,
you may proceed.
Mrs. Thurman. Mr. Chairman
Chairman Archer. Certainly, Mrs. Thurman.
Mrs. Thurman. Thank you. Mr. Chairman, I actually would
like to take an opportunity here to thank Ms. Thomas for being
here. She actually is one of my constituents.
Chairman Archer. I suspected that when you asked to be
recognized.
Mrs. Thurman. Yes. I kind of thought you might. I want you
to know that she runs a 100-percent, employee-owned business.
She has been very active. She is going to be the first woman to
be the national president of the ESOP group. I think you are
going to find her testimony dynamic, informative, and one that,
as we heard the administration say this morning, for all of you
actually that are sitting there, that they are listening and
paying attention. So I just wanted to have this opportunity.
I am really glad you are here, particularly when it's sunny
and warm in Florida.
Chairman Archer. We are happy to have you here. If you will
identify yourself for the record, you may proceed.
STATEMENT OF DELORES L. ``DEE'' THOMAS, VICE PRESIDENT, EWING &
THOMAS, INC., NEW PORT RICHEY, AND SEBRING, FLORIDA, AND VICE
CHAIR, EMPLOYEE STOCK OWNERSHIP PLANS ASSOCIATION
Ms. Thomas. Thank you, Chairman Archer. Thank you ladies
and gentlemen, for the opportunity to speak with you today. My
name is Dee Thomas. I am vice president of an independent
physical therapy company located in New Port Richey and
Sebring, Florida. Important for today's hearing is the fact
that Ewing & Thomas is the only 100-percent, employee-owned
physical therapy company in America through an ESOP, an
employee stock ownership plan, and that is a sub S. Of our 45
employees, 38 are employee-owners, owning 100 percent of our
company. I testify today on behalf of those employee-owners,
and on behalf of the ESOP Association. It has over 2,000
members representing 1 million employee-owners in America.
My purpose here today is to express my concern and
opposition to the administration's proposal to repeal the 1997
law which was designed to encourage the creation of employee-
ownership in S corporations, and in particular, those with high
percentage ESOPs, such as my own company.
Ewing & Thomas provides physical therapy services to a
community in the second poorest district in Florida. Our
industry is becoming increasingly controlled by large companies
and megaconglomerates. Many of the small independents are
either being sold or going out of business as a result of
changes in the healthcare laws. The conscience of American
healthcare is becoming an extinct species.
I am convinced that Ewing & Thomas continues to survive in
this ever-competitive environment because of our employee-
ownership culture and the current single tax status as a sub S
ESOP. ESOP transactions have cost our little company great
amounts of money because the ESOP laws are complex and we
require a lot of lawyers and administrators to keep us straight
and make sure that our employee-owners are all well protected.
But ESOPs are more than laws and regulations. They are a
way of life at Ewing & Thomas. We have employee-owners on all
levels at our six-member board of directors. We have
participation in decisionmaking at all levels with our ESOP
Committee. We share and discuss all of our financial
information. Our little company has paid for 10 needy employee-
owners to go to college so that they can be better employee-
owners and they can better our company.
Each day, incredible unselfish acts are performed by this
group of uncommon employee-owners. This past year during tough
times, our higher paid salaries unanimously agreed to take a
freeze on all of their wages and benefits so that our
nonmanagement hourly people would not be laid off and would not
lose their jobs. This is employee-ownership at its best. We are
in this for the long haul.
Your esteemed colleague, Congresswoman Karen Thurman, has
visited our company and met with our employee-owners first
hand. You can also take a minute and speak with Al Maxime and
Gary Walz, who have traveled with me today. They each have
their own special employee-ownership story.
This Committee has to make a basic choice because this
issue is not just about sub S ESOPs, but about your belief in
the value of employee-ownership in America. You can reject the
administration's proposal or you can modify it, and in so
doing, stand with employee ownership. Or you can accept the
proposal and in doing so, repudiate support for employee
ownership, a message that will be heard by 1 million employee-
owners and 2.2 million sub S companies in this country.
In simple language, my objections are: the retroactive
clause applied to companies such as mine because our account
balances would fall sharply. Number two, it is not rational to
reverse something that is only 14 months old. Number three, the
proposal is incredibly complex. What a bunch of gobbley-goop.
No businessperson in their right mind would go into some kind
of deal like this. The proposal by permitting a tax deduction
for distribution for the ESOP against the UBIT is an incentive
for the corporation to make distributions as rapidly as
possible. This is not a sound way of saving.
The proposal puts the S corporation with an ESOP at a
distinct disadvantage to the C corporation with the ESOP. The S
corporation will pay a much higher tax and without any ESOP
incentive. This is a much bigger issue than the tax
consequences of a sub S ESOP. It is about your stand for
employee-ownership in America. It is about your belief in
increasing the distribution of wealth in our country. It is
about workers having a voice, respect, and dignity in the place
that they work, and security for their retirement years. The
100-percent, sub S ESOP companies are the best this country has
to offer. We have done all the right things for all the right
reasons, our employee-owners.
Members of this Committee, we ask for your protection from
this proposal. We are prepared to work with you and your staff
to ensure the multitude of sub S companies the promise of
employee-ownership. I urge you to allow us to work together to
spread employee-ownership as a commonly accepted way of doing
business as we enter the next century. I thank you all for
letting this small company be heard. It's a great system that
we have.
[The prepared statement follows. Attachments are being
retained in the Committee files.]
Statement of Delores L. ``Dee'' Thomas, Vice President, Ewing & Thomas,
Inc., New Port Richey, and Sebring, Florida, and Vice Chair, Employee
Stock Ownership Plans Association
Thank you. My name is Delores L. ``Dee'' Thomas. I am Vice
President of an independent physical therapy company, Ewing &
Thomas, Inc. located in New Port Richey and Sebring, Florida.
Important for today's hearing is the fact that Ewing &
Thomas is the only physical therapy company in America
operating as a 100% employee-owned company, through an employee
stock ownership plan, or ESOP. Ewing & Thomas is also an S
corporation. There are 38 employee owners at Ewing & Thomas,
which is nearly all of our current employees.
Today, I testify not only on behalf of the employee owners
of Ewing & Thomas, but also for The ESOP Association, a
national 501(c)(6) association with over 2000 members
representing nearly1 million employee owners.
My purpose is to express the ESOP community's opposition to
the revenue raising proposal in the Administration's proposed
budget to repeal a 1997 law that has proven to be a needed
incentive for the creation and operation of companies which are
100%, or near 100% employee-owned companies. The proposal is
set forth on page 110 of the Treasury Department's so-called
``Green Book'' describing the Administration's revenue raising
proposals in the Fiscal Year 2000 budget.
I ask your indulgence as I make a few general remarks. I do
so because in the employee ownership world our focus is on the
long-term, not the short-term.
We believe that significant employee ownership does improve
the performance of a corporation, and just as important does
maximize human potential and self-dignity of all employees as
they share in the wealth they help to create.
Our beliefs are backed-up by solid evidence, such as a
recent study by Dr. Melhad of Northwestern University's Kellogg
of Business and Management, which reviewed the performance of
over 400 companies over 4 years. Attachment 1 to this statement
is a synopsis of the research conducted over the past 15 years
that supports our beliefs.
I am very active in The ESOP Association, nationally, and
in our Florida Chapter. On May 1, I will become the Chair of
the Association, our highest elected office.
But clearly I can testify best about employee ownership
through the experience as an executive of Ewing & Thomas.
In 1987, Mrs. Ewing and I, who started our independent firm
in 1969, faced the potential demise of our company, as Mrs.
Ewing had reached an age where she did not want to practice
each day, and I had a serious illness. We needed an exit
strategy, but were afraid of what would happen to our employees
and our community involvement if we sold out to a large
national or regional chain. Fortunately, Congress has provided
a wonderful alternative--selling to the ESOP for the benefit of
the employees.
Did we take advantage of the tax laws favoring exiting
shareholders of closely-held companies? Yes, we did. Did we
have to pay high fees to lawyers, valuators, administrators,
and accountants to make the ESOP happen, so that the complex
ESOP laws would be honored to protect the employees? Yes, we
did.
But let me emphasize, the ESOP is more than laws and
regulations to our employees. It has become their way of life.
For example:
We have employee owners from all levels on our
six-person Board of Directors.
We have employee owners participating in decision-
making at all levels.
We share and discuss all of our financial
information with all employee owners.
It was a joint decision that our company has sent
ten needy employee owners to college to better themselves and
our company.
Each day incredible unselfish acts are performed
by this group of employee owners.
We all participate in state and local meetings
where we share our ESOP experience and learn from other
employee-owned companies.
Attachments 2 are articles recognizing Ewing & Thomas as a
special place to work.
If you do not believe me, or the articles, ask your
colleague Congresswoman Thurman, who has visited on several
occasions with our employee owners.
And if you don't believe me, Congresswoman Thurman, or the
newspapers, ask Alphonso Maxime or Gary Walz, employee owners
from Ewing & Thomas now standing. They will be more than
willing to speak with you or your staff about employee
ownership, and their experience at Ewing & Thomas.
Is Ewing & Thomas unique? No.
When I think of employee ownership I think of Bimba
Manufacturing in Illinois; Reflexite in Connecticut; Austin
Industries in Texas; Acadian Ambulance in Louisiana; the Braas
Company in Minnesota; and the list goes on and on.
Many members of this Committee know these companies and
their employee owners up close and personal.
This Committee has a basic choice.
The Committee can accept the Administration's proposal, and
take a stand to retard the expansion of employee ownership; or
this Committee can reject, or significantly alter the
Administration's proposal, and take a stand with the employee
ownership community.
Clearly, we must respond to the specific proposal from the
Administration, and explain why its enactment would retard
employee ownership growth; but keep in mind, if you want
employee ownership to grow, as practiced in the companies I've
cited, then you will discard the Administration's proposal.
To summarize the Administration's proposal: The proposal is
designed to raise taxes by imposing on an S corporation an
unrelated business income tax, or UBIT, on the ESOP's share of
the income of that corporation. The proposal goes on to provide
that when the ESOP makes a distribution to an employee owner
when he or she retires or leaves the company, the S corporation
can take a tax deduction against the UBIT owed for the year in
which the distribution is made.
The proposal's effective date is meaningless as it is to
apply to all S corporation ESOPs after enactment, and is to
lower the tax deduction for distributions made by those
companies who did not pay the UBIT between January 1, 1998, and
the date when the new law is effective.
Contrast this proposal with current law, which was adopted
by Congress, and signed by President Clinton approximately
fourteen months before the Administration proposed the drastic
change summarized above. Current law provides that the ESOP's
share of the S corporation's taxable income is deferred from
current taxation until the ESOP makes distributions to the ESOP
participants, who are in essence the shareholders of the S
corporation.
To understand the Administration's proposal fully requires
some history.
Shortly after the enactment of the Tax Reform Act of 1986,
the ESOP community urged Congress to enact law to permit S
corporations to sponsor employee ownership through ESOPs.
Our efforts gained momentum in 1990 when your colleague
Congressman Cass Ballenger introduced the ESOP Promotion Act of
1990, which contained a section to permit ESOPs in S
corporations. Similar legislation was introduced in each
subsequent Congress, twice attracting over 100 co-sponsors.
Each time, eight to ten members of the Ways and Means Committee
were original co-sponsors of these pro-employee ownership
bills.
In 1996, our advocacy work began to payoff, as the Congress
adopted a provision of the Small Business Jobs Protection Act
of 1996, a law to permit an S corporations to sponsor an ESOP.
Immediately, however, all realized that the 1996 law was
fatally flawed. The major policy problem was the 1996 law was
going to tax S corporation income twice if it had an ESOP,
because it would have imposed the UBIT on the ESOP's share of
the S corporation's taxable income, and a tax on the
individuals receiving ESOP distributions.
Groups led by representatives of S corporation groups urged
the members of the tax committees to undo the double tax on the
ESOP's share of the S corporation's income.
And, at the same time, the ESOP community urged Congress to
provide S corporations the same tax benefits for promoting
employee ownership as available for C corporations, such as the
deferral of the capital gains tax on the proceeds of sales of
closely held stock to an ESOP under limited circumstances,
deductible dividends paid on ESOP stock in certain
circumstances, and the increase in the corporate tax deduction
for contributions to an ESOP up to 25% of payroll, plus the
interest on the loan used to acquire stock for the employees
through an ESOP.
So, as the work on the 1997 law known as the Taxpayer's
Relief Act began, these points were being made to
Congresspeople supportive of increasing employee ownership in
America.
First, in early summer 1997, this Committee adopted by
voice vote Congresswoman Johnson's amendment to clean up some
of the technical problems with the 1996 law.
Then the Senate Finance Committee had to decide--how to
encourage ESOPs in S corporations? Their decision was not to
use the C corporation ESOP tax benefits in an S corporation,
but to have a unique benefit, the deferral of tax on the ESOP's
share of the corporation's taxable income until distributions
to the employee owners.
In making this decision, the Senate staff people did review
a taxation scheme very similar to the one proposed in the
Administration's Fiscal Year 2000 budget. It involved paying
the UBIT on the ESOP's share of the S corporation's income, and
then later providing a tax credit or tax deduction. But this
scheme was rejected. The staff agreed that it was too
confusing. They felt that the system would never be clearly
understood, or work in the real world.
How ironic that now the Administration makes a similar
proposal, which was deemed too complex in 1997!
In any event, the result in 1997 was a decision not to have
the C corporation ESOP tax benefits available to an S
corporation ESOP but to have the ESOP share of the taxable
income of the S corporation subject to a deferred taxation when
the beneficial shareholders of the S corporation, the employees
got their money from the ESOP.
A key point in all of this decision making is the clear-cut
intent of the Senate to have an incentive for the creation and
operation of ESOPs in S corporations. In fact, the proposal was
scored as a near $400 million revenue drop over the 10 year
period of the revenue estimates for the 1997 Taxpayer's Tax
Relief Act.
When this approach was proposed by ESOP supporters in the
Senate, the ESOP community told key Congressional leaders that
this approach was unique, and felt it to be a powerful
incentive for the creation of 100% ESOP companies or near 100%
ESOP companies operating S corporations.
We were correct. Since the law became effective January 1,
1998, we estimate approximately 75 to 100 of our Association's
members have become 100% employee-owned S corporations through
an ESOP. Some of these companies increased their employee
ownership of their owner's share from less than 100% to 100%.
Clearly in our minds this was the intent--the incentive of
the law to increase the distribution of wealth in America.
Is this a good policy? If you support employee ownership,
the question becomes is it good employee ownership policy?
Yes, if Congress wishes to have an incentive for 100% or
near 100% employee ownership--a level of employee ownership
that is rare in America, less than 500 companies, but a level
that can be magical in creating an company culture where voices
are heard and votes do count--a company like Ewing & Thomas.
Why do large ESOPs, as measured by the size of the company
owned by the employees need an incentive that is different from
the C corporation ESOPs? Because the 100% ESOP company must
have significant cash values as it reaches maturity--5, 10, 15,
20, or more years of employee ownership in order to buy back
the stock from departing employees with large accounts in the
ESOP. We call this burden on ESOP companies our repurchase
obligation, or repurchase liability. Obviously, the bigger
share of the company owned by employees through the ESOP, and
the older the ESOP becomes, the more money the company has to
have to buy back stock from departing employee owners.
All too often we see fine examples of ESOP companies, where
employees are sharing substantially in the wealth they help
create, abandon employee ownership due to this repurchase
obligation issue, and the demands on cash. I cite AVIS and
reference Attachment 3.
The one level of tax on a 100% S corporation ESOP solves
this problem due to the fact that the cash saved may be used to
fund the repurchase of stock from departing employees.
Finally, I cite the objections of The ESOP Association to
the Administration's proposal.
Objection One: By being retroactive, by applying to
companies like mine that honestly relied on the law passed by
Congress, and signed the by the President just fourteen months
ago, the proposal pulls the rug out from under the employee
owners of my company and others like us.
Those in the Administration who came up with this proposal
might think we were naive to believe that the law was for the
benefit of companies like ours. Maybe they are laughing behind
their backs at us. We may be naive, and not sophisticated to
the cleaver nuances of how tax laws are made; but we do know
when we are being treated unfairly, and we don't like it.
Objection Two: It is not rational to reverse the 1997
decision to encourage more employee ownership only fourteen
months after the decision was made. As representatives of The
ESOP Association told key Congressional decisionmakers in 1997,
providing a deferral of the tax of the ESOP's share of the S
corporation's taxable income would be a significant incentive
to be a 100% ESOP company, like Ewing & Thomas believed. The
law has worked just as predicted. Why get rid of this
incentive?
Objection Three: The Administration's proposal is, in
essence, the same, impossible to administer scheme the
Congressional staff experts declared incredibly complex in
1997. My non-legal description of the proposal is as follows:
The S corporations with an ESOP loans the Federal government
money equal to the UBIT tax. Then, 5, 10, 15, 20, or even more
years down the road, the Federal government pays back the loan
in drips and drabs, in amounts related to distributions of ESOP
accounts that will not have any relationship whatsoever to the
amount of the UBIT paid in any one year.
Objection Four: The proposal, by permitting a tax deduction
for distributions from the ESOP against the current year UBIT
owed by the S corporation is an incentive for the corporations
to make distributions as rapidly as possible, or timed to
profitable years. Thus the proposal is an incentive that is
absolutely the opposite of good savings policy, where we want
to keep in the money in the savings systems for retirement
income security.
Objection Five: The Administration's proposal puts the S
corporation with an ESOP at a distinct disadvantage compared to
a C corporation ESOP. If the proposal is the law, the S
corporation ESOP, particularly those with 100% employee
ownership, pays more taxes than C corporations, and have none
of the special ESOP tax benefits, such as the ability of
certain sellers to an ESOP to deferred the capital gains tax,
deductible dividends paid on ESOP stock, and the higher
percentage of payroll that can be contributed to a leveraged
ESOP. These three are all available to the C corporation, but
not the S corporation.
This is a much bigger issue than the tax consequences of S
Corporation ESOPs. It is about your stand for employee
ownership in America. It is about your belief in increasing the
distribution of wealth in this country, about workers having a
voice, respect and dignity in the place that they work and
security for their retirement years.
The 100% S Corporation ESOP companies are the best this
country has to offer--we have done all the right things, for
all the right reasons--employee owners!
Members of this committee we ask for your protection from
this proposal. We are prepared to work with you and your staff
to assure the multitude of S Corporation companies can meet the
promise of employee ownership.
I urge you to allow us to work together to spread employee
ownership as a commonly accepted way of doing business as we
enter the next century.
Thank you for allowing this small company to be heard.
Chairman Archer. Ms. Thomas, that is what we are about, to
hear from people large and small and across the board. Thank
you for your testimony.
Mr. Hill, if you will identify yourself for the record, you
may proceed.
STATEMENT OF J. ELDRED HILL III, PRESIDENT, UNEMPLOYMENT
INSURANCE INSTITUTE, SHEPHERDSTOWN, WEST VIRGINIA
Mr. Hill. Yes, thank you, Mr. Chairman. My name is J.
Eldred Hill III. I am the president of the Unemployment
Insurance Institute. I thank you for this opportunity to
testify regarding tax proposals in the President's fiscal year
2000 budget, affecting the Nation's unemployment insurance
system.
The President's budget contains a proposal to accelerate
the collections of FUTA, Federal Unemployment Tax Act of 1939,
and State UI, Unemployment Insurance, taxes from quarterly to
monthly beginning in the year 2005. It would require every
employer whose FUTA liability in the immediately preceding year
was $1,100 or more to compute and pay both FUTA and State UI
taxes 12 times a year. Although this proposal in theory would
only affect businesses not classified as small under Federal
law, in practice, this proposal would also affect small
businesses which rely primarily on part-time workers, small
employers experiencing employee turnover beyond their control,
and small employers who provide summer jobs for youth.
This proposal, quite frankly, is a budget gimmick, which
would allow the administration to count two extra months of
FUTA collections as fiscal year 2005 revenue, producing a one-
time artificial budget gain of an estimated $1.2 billion.
Accelerated collections would not raise a nickel in new
revenue. Monthly collections would triple the paperwork and
other employer compliance costs forever. In addition, it would
triple the collection workload on the State employment security
agencies, increasing costs, and taking precious staff time away
from their primary responsibilities, of providing the
unemployed with benefits and jobs.
Mr. Chairman, unemployment contributes to a number of
social ills, including depression, alcohol and drug abuse,
domestic violence, repossessions, foreclosures, and evictions.
These real-world costs are not on a budget line. Yet under the
President's proposal, the Nation's unemployed could expect
reduced services as limited staff resources are used for more
frequent collections.
The President's budget also contains proposals which would
charge new fees to employers who request certification under
both the Work Opportunity Tax Credit, and the Welfare-to-Work
Tax Credit. Both of these Federal programs were designed to
encourage employers to hire targeted workers, and it would be
counterproductive to reduce those incentives.
We have heard a good bit today here about fees that are
included in the President's budget. Though these fees are
innocuous on the surface, certification costs are incidental to
these fees. The new fees are designed to be artificially high
and the additional revenue generated would be used for the
administration of the unemployment insurance system and the
employment service. These fees would be collected and spent at
the State level. The President's budget projects these fees to
generate $20 million per year, and upon enactment would cut
Federal appropriations for the administration of State UI and
ES programs by a corresponding $20 million.
These new fees are in effect a new FUTA surcharge. The
Nation's employers are already paying FUTA taxes which are more
than adequate to fund the administration of the UI and ES
systems. In 1997, Congress passed the Taxpayer Relief Act,
extending the unnecessary and so-called temporary 0.2 FUTA
surcharge for 9 years.
According to the President's budget, the Federal
administrative account, extended benefit account, and loan
account, will have combined statutory excesses of $5.68 billion
in fiscal year 2003, and $3.93 billion in fiscal year 2004.
Still, States on average see only 52 percent of dedicated FUTA
taxes returned for the administration of these programs.
Employers in 20 States also pay an additional State
administrative surcharge, which diverts revenues from the
benefit funds.
Mr. Chairman, in an era when we are engaged in public
debate over the budget surplus, it would be unfair for Congress
to allow employers to be further burdened with new, unneeded
FUTA surcharges or monthly collection.
Mr. Chairman, I appreciate this opportunity to appear
before the Committee. I would be happy to answer any questions
you or your colleagues may have. Thank you.
[The prepared statement follows:]
Statement of J. Eldred Hill III, President, Unemployment Insurance
Institute, Shepherdstown, West Virginia
Mr. Chairman and Members of the Committee:
Thank you for the opportunity to testify regarding the tax
proposals in the President's FY 2000 budget affecting the
nation's unemployment insurance system.
The President's FY 2000 budget contains a proposal to
accelerate collections of FUTA and state UI taxes from
quarterly to monthly beginning in 2005. It would require every
employer who's FUTA liability in the immediately preceding year
was $1,100 or more to compute and pay both FUTA and state UI
taxes 12 times a year. Although this proposal in theory would
only affect businesses not classified as ``small'' under
federal law; in practice this proposal would also affect small
businesses which rely primarily on part-time workers, small
employers experiencing employee turnover beyond their control,
and small employers who provide summer jobs for youth.
This proposal is a budget gimmick which would allow the
Administration to count 2 extra months of FUTA collections as
FY 2005 revenue, producing a one time artificial budget gain of
an estimated $1.2 billion. Accelerated collections would not
raise a nickel in new revenue.
Monthly collections would triple the paperwork and other
employer compliance costs forever. In addition it would triple
the collection workload on the State Employment Security
Agencies, increasing costs, and taking precious staff time away
from their primary responsibilities of providing the unemployed
with benefits and jobs. Unemployment contributes to a number of
social ills, including depression, alcohol and drug abuse,
domestic violence, repossessions, foreclosures, and evictions.
These real world costs are not on a budget line, yet under the
President's proposal, the nation's unemployed could expect
reduced services as limited staff resources are used for more
frequent collections.
The President's budget also contains proposals which would
charge new fees to employers who request certification under
the Work Opportunity Tax Credit and the Welfare-to-Work Tax
Credit. Both of these federal programs were designed to
encourage employers to hire targeted workers, and it would be
counterproductive to reduce those incentives. The proposal also
includes similar fees for employers of alien workers. Though
innocuous on the surface, certification costs are incidental to
these fees. The new fees are designed to be artificially high,
and the additional revenue generated would be used for
administration of unemployment insurance (UI) and the
employment service (ES). These fees would be collected and
spent at the state level. The President's budget projects these
fees to generate $20 million per year, and upon enactment would
cut federal appropriations for the administration of state UI
and ES programs by a corresponding $20 million.
These new ``fees'' are in effect a new FUTA surcharge. The
nation's employers are already paying FUTA taxes which are more
than adequate to fund the administration of the UI and ES
systems. In 1997 Congress passed The Taxpayer Relief Act
extending the unnecessary 0.2% FUTA Surcharge for nine years.
According to the President's budget, the federal administrative
account (ESAA), extended benefit account (EUCA), and loan
account (FUA) will have statutory excesses of $5.68 billion in
FY 2003 and $3.93 billion in FY 2004. Still, states on average
see only 52% of dedicated FUTA taxes returned for the
administration of these programs. Employers in 20 states also
pay an additional state administrative surcharge which diverts
revenues from benefit funds. Mr. Chairman, in an era when we
are engaged in public debate over the budget surplus, it would
be unfair for Congress to allow employers to be further
burdened with new unneeded FUTA charges or monthly taxation.
Mr. Chairman, I appreciate this opportunity to appear
before this committee. I would be happy to answer any questions
you or your colleagues might have.
Chairman Archer. Thank you, Mr. Hill.
I am told that our next witness is to be introduced by one
of our colleagues, the gentleman from Illinois, Mr.
Blagojevich.
Mr. Blagojevich. Thank you very much, Mr. Chairman. I will
be very brief.
A little over 10 years ago, Bill Bennett, who was then the
Secretary of Education under President Reagan, came to Chicago
and declared our school system the worst school system in the
country. A little over 10 years later, under the leadership of
our mayor, Mayor Daley, and under the leadership of our
president of the Chicago School Reform board of trustees, Gery
Chico, the Chicago public schools' success at school reform is
being held as a national model, and most recently was spoken of
by President Clinton in his State of the Union Address.
As a product of the public schools, I am proud today to
introduce the chief executive officer of the Chicago public
schools, Gery Chico, and let him tell this Committee about some
of the innovative things that the school board has performed in
our city and for our schools over the last 3 to 5 years. Gery?
Thank you, Mr. Chairman.
Chairman Archer. Thank you, Congressman Blagojevich.
Mr. Chico, you have already been identified for the record,
so you may proceed.
STATEMENT OF GERY CHICO, PRESIDENT, CHICAGO SCHOOL REFORM BOARD
OF TRUSTEES
Mr. Chico. Thank you, Mr. Chairman. I would like to thank
you for the opportunity to speak about an issue that is near
and dear to my heart and a lot of people in Chicago, and that
is the need to rebuild our school facilities. I would like to
thank Speaker Hastert and Congressman Rangel, who we had the
pleasure of meeting with this morning as a courtesy call to
explain our positions, and now to give the Committee our
position on this issue.
Since 1995, Chicago has committed nearly $2 billion from
local funds to improve our school facilities. We are doing our
part, but we think we need partners at the Federal level to
help us meet the continuing need, Mr. Chairman, which
conservatively is put at about another $1.5 billion just for
Chicago alone. The fact is, improving the learning environment
improves performance. A litany of studies shows that, although
I don't think you need studies to know that.
When kids are in overcrowded classrooms, or taking class in
hallways and basements, they figure school isn't important. In
1998, the report card on America's infrastructure, issued by
the American Society of Civil Engineers, Mr. Chairman, gave
schools an ``F'', being the only category of infrastructure
with an ``F'' rating. Roads, bridges, mass transit, aviation,
and others came in substantially higher. We can't afford to
send that message to our children.
In thinking about the proposals before the Committee I want
to emphasize what I think are four basic characteristics that
any plan that the Committee would adopt should have, so that we
can get the help we need. One, simplicity. Two, flexibility.
Three, the plan ought to be substantial. Four, we need
immediate help.
If it is not a simple plan, it creates a lot of paperwork
which eats up time and money. If it is not flexible, it will
dictate terms rather than support us, and that is not
appropriate in our view. If it is not substantial, it is really
not very relevant. There is an estimated $200 billion in school
infrastructure needs nationwide. We need a real commitment, not
token help. If it's not immediate, it is also not very relevant
to us because every year we delay, it deprives our children of
the education that we think they need and that we think that
they need today.
Before the Committee are two proposals. One plan has an
arbitrate component, that allows school districts to borrow
money and invest it for up to 4 years now instead of 2 years,
and use the extra interest earned toward school construction or
improvements. Our concerns are that this plan does not provide
enough money to make an impact, at least in Chicago's view, nor
does it provide the money right away.
In Chicago, we have issued four bond issues over the last 4
years to create that $2 billion. Only one of those four bond
issues would we have seen a positive arbitrage of one-tenth of
1 percent. In fact, the last bond issue that we saw just 2
weeks ago, we pay an interest rate of 5.17 percent and reinvest
at 4.85 percent, for negative arbitrage. It also doesn't work
for Chicago because we spend our money as soon as we get it,
Mr. Chairman. We can not afford the luxury of waiting 1 year, 2
years, or 3 years because people expect us to act and act
quickly.
The other plan advanced by the Clinton administration and
Vice President Gore and Congressman Rangel creates new school
modernization bonds, both of which rely on tax credits. It will
offer up to $25 billion in bonding authority to school
districts around the country. From our standpoint, this is a
solid plan for the reason that it provides us substantial
relief. In the case of Chicago, we figure that we could issue
$670 million in bonds and save $333 million in interest
payments. We think that is real help.
The Federal Government would even be more effective if they
would extend the payback period beyond the proposed 15 years in
the proposal before the Committee because the principle-only
payment for such a short term of 15 years is virtually the same
or close to the payments of principle and interest over 30
years.
The plan also calls for the Department of Education to sign
off on individual capital plans. We think, however, that the
Department's role should be limited to receiving descriptions
of capital plans and annual reports, and nothing more.
Unlike the school modernization bonds, the use of the
qualified zone academy bonds requires a substantial business
contribution. Unless Congress adjusts the proposal, to offer
business a significant incentive to make this investment, many
smaller local school districts won't be able to access the
program. For example, we are using this qualified academy zone
bond now for the second time. We have had to pull in five
surrounding districts to Chicago: Elgin, Aurora, DeKalb,
Mendota, and East St. Louis, to help them access this bond
issue, because otherwise they can't come up with the local
private sector match of 10 percent. It is just too much for
those districts.
We understand there is also a plan in front of the Senate
to enable private investors to fund school construction by
offering investors significant depreciation incentives along
with favorable tax-exempt financing. This concept works only if
the buildings remain free from real property taxation at the
local level. Congress should allow the school districts to
maintain title and allow the tax benefit to go to the private
investor if it goes down this road.
I have offered more detailed explanation of our
observations here in my written testimony. In the space of 5
minutes, I don't think we can--I won't revisit the
philosophical debate over whether the Federal Government has a
role to help us in education, but I will just repeat what I
said 6 weeks ago in front of Chairman Goodling's Committee.
That is, I think we need to make school construction a national
priority. We simply can't do it by ourselves any more. We have
been pretty aggressive about it at the local level. We really
need the Federal Government's help. I would like to thank the
Committee for hearing my testimony.
[The prepared statement follows:]
Statement of Gery Chico, President, Chicago School Reform Board of
Trustees
Mr. Chairman and Members of the Committee:
Thank you for the opportunity to address you on the issue
of how the federal government can play a role in rebuilding
America's schools.
I want to begin by thanking Speaker Denny Hastert who
recently visited our schools. We shared with him our progress
in improving performance and reforming a system once considered
one of the worst in the nation. Today, we've been called a
national model of reform.
I also want to thank Congressman Charles Rangel--who
created the Qualified Zone Academy Bonds.
Chicago was the first school district in the nation to use
the bonds. We're using the money to build the city's first
JROTC academy--at the site of the former home of the leading
African-American military regiment on Chicago's south side.
Thank you Congressman Rangel and the entire committee.
I also want to thank Congressman Rod Blagojevich for making
school construction an important issue. Although he's not on
the committee, he's been a strong voice for us.
Finally, I want to thank President Clinton and Vice-
President Gore for giving attention to this vitally important
issue.
Two years ago, the president came to Chicago and met Mayor
Daley and me and several others and we outlined the scope of
the infrastructure needs in our schools and the local
commitment we have made.
Since 1995, Chicago has committed close to $2 billion in
primarily local funding for 575 separate projects at 371
schools. That money has built 8 new schools and 48 additions or
annexes, adding 632 new classrooms to the district, which
serves 430,000 school children.
But more needs to be done, and Chicago cannot do it all
alone. We're doing our part, but we need partners at the
federal level to meet all the needs.
We've conservatively identified another $1.5 billion in
additional improvements needed before we can say that our
schools are truly the kinds of learning environments that we
know will make a difference.
The fact is, improving the learning environment improves
performance. When kids are in crumbling school buildings with
outdated equipment, they're getting the message that education
isn't important.
When they're in overcrowded classrooms or taking class in
hallways or basements because the classrooms are full--they
figure school isn't important.
We can't afford to send that message to our children. We're
entering a new century. Every forward-thinking industry knows
they can pack up and move anywhere on earth and conduct their
business.
If we want them to stay here and invest in America, we have
to give them a workforce that can deliver--in Chicago and in
schools throughout the nation.
The fact is, every school district needs help. Last year,
during the Rebuild America's Schools Campaign, we generated
83,000 letters of support from districts all across Illinois,
and they all said they needed federal help to rebuild their
schools.
In thinking about the plans under consideration, I want to
emphasize four basic characteristics of a good school
modernization funding plan: simple, flexible, substantial and
immediate.
If it's not simple it creates a lot of paperwork, which
eats up time and money and doesn't build or modernize schools.
If it's not flexible, it won't help everyone do what they
want to do; it will dictate rather than support--and that's not
appropriate.
If it's not substantial, it's irrelevant. There's an
estimated $200 billion in needs nationwide. We need a real
commitment--not a token gesture.
And if it's not immediate, it's also irrelevant. The
challenge is to do the right thing today--not years from now.
Every year our children move another grade. Every year we delay
deprives our children of the education they deserve--and need.
Before the committee are two proposals and I want to
briefly offer our observations and recommendations. Obviously,
we will work with you under any circumstances because the need
is so great.
One plan has an arbitrage component that essentially allows
school districts to borrow money as they currently do, but
invest that money for up to four years--instead of just two--
and then use the extra interest earned toward school
improvements.
Our concerns are that this ultimately does not provide
enough money to make an impact--nor does it provide any money
right away. In Chicago, only one of the four bond issues we
have done since 1996 had positive arbitrage and the earnings
were negligible--one-tenth of one percent per annum.
It also doesn't work for Chicago because we spend our money
as soon as we get it--and most other districts are in the same
position. So this arbitrage plan is neither substantial nor
immediate.
The other plan, advanced by the President, expands on the
QZAB program and creates new school modernization bonds, both
of which rely on tax credits. It will offer up to $25 billion
in bonding authority to school districts around the country.
From Chicago's standpoint, this is a good plan because it's
interest-free subsidy really adds up.
We estimate that the President's school modernization bond
program will allow Chicago to issue $676 million in bonds and
save us up to $333 million in interest payments. Now that's an
incentive and a form of assistance that can really make a
difference.
And the federal help would be even more effective if
Congress extended the payback period beyond the proposed 15
years to 20, 25, or even 30. Why? Because the principal-only
payment for 15 years is the same as, or very close to, the
payments of principal and interest over 30 years. As it is
currently written, the 15-year payback has almost the same
financial burden as if a school district borrowed the money
over 30 years with interest.
We also believe that the Department of Education's role
should be limited to receiving descriptions of capital plans
and annual reports. They should not sign off on individual
capital plans.
Unlike the school modernization bonds, the use of QZABs
will require substantial business contributions to schools.
Unless Congress adjusts the proposal to provide businesses with
a substantial incentive to make this investment, many local
school districts will be unable to access the program. In fact,
under this year's QZAB program, which requires a 10 percent
private contribution to the capital cost of projects, we are
partnering with five other schools districts in Illinois--
Mendota, DeKalb, Aurora, Elgin and East St. Louis--who probably
could not have structured a QZAB on their own because of
required private contribution. The circumstances probably will
be the same under the new business contribution requirement.
There is also a proposal in the Senate which would enable
private investors to use private activity bonds to fund school
construction. This proposal seeks to spur private investment in
school construction by offering investors significant
depreciation incentives along with favorable tax exempt
financing. This concept works only if the buildings remain free
from real property taxes.
To keep the buildings free from real property taxes,
Congress should allow the school district to maintain exclusive
title to its property but the tax law should impute a tax basis
to the private investor. This would enable the private investor
to depreciate the property but avoid a title transfer and real
property taxation that would undercut the depreciation tax
benefit and the usefulness of the private activity bond.
In the space of five minutes, I don't want to revisit the
philosophical debate over whether the federal government has
any role at all with respect to education. I will just repeat
what I said six weeks ago here in Washington when I testified
before the House Committee on Education and the Workforce.
America felt it was a national priority to build the
interstate highway system in the 1950's, but we've never made
the rebuilding of our schools a national priority. But at the
dawn of the new millennium, our schools are not merely a
national priority--they're a matter of national security and we
need to enhance and strengthen them.
Thank you Mr. Chairman and members of the Committee for
your time and consideration.
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Chairman Archer. Thank you, Mr. Chico.
Our next witness will be introduced by one of our own, Mr.
Houghton.
Mr. Houghton. Thank you very much, Mr. Chairman. Mr.
Bouchard does not come from sunny Florida. He comes from cold,
upstate New York. But we are delighted to have him here,
distinguished man, distinguished educator for over 39, almost
40 years. He has been superintendent and head of many
organizations, one of them being the National Rural Education
Association.
Thanks very much for being with us.
Chairman Archer. Mr. Bouchard, you have also been
identified for the record, so you may proceed.
STATEMENT OF RENE ``JAY'' BOUCHARD, DISTRICT SUPERINTENDENT,
STEUBEN-ALLEGANY COUNTIES, BATH, NEW YORK; CHIEF EXECUTIVE
OFFICER, STEUBEN-ALLEGANY BOARD OF COOPERATIVE EDUCATIONAL
SERVICES; MEMBER, EXECUTIVE COMMITTEE, AMERICAN ASSOCIATION OF
EDUCATIONAL SERVICE AGENCIES; AND MEMBER, EXECUTIVE COMMITTEE,
NATIONAL RURAL EDUCATION ASSOCIATION
Mr. Bouchard. Thank you, Mr. Chairman. I represent the
National Rural Education Association. I would like to speak
about the provision in the President's fiscal year 2000 budget
that would provide States and local districts desperately
needed help in modernizing America's public schools.
Unfortunately, rural schools often are nothing more than an
afterthought in the national debate on public education.
Nevertheless, I think there is a story to be told. For example,
one out of every two public schools in America is located in a
rural area or small town. Thirty-eight percent of America's
students go to school in rural areas. Forty-one percent of
public schoolteachers work in rural schools. Yet rural and
small town schools receive only 22 percent of the total funding
for K-12 education.
Last year, this Committee succinctly captured the challenge
facing the Nation's schools when it stated ``A great need
exists for construction and renovation of public schools if
American educational excellence is to be maintained.''
Nationwide, the GAO found that it would take $112 billion just
to make the necessary repairs on our schools, to ensure that
they are safe and healthy for our children. Another $73 billion
is needed to build additional schools and enlarging existing
schools to alleviate overcrowded conditions. The need for
access to the Internet and other technologies is particularly
acute in rural areas.
The $22 billion in zero-interest school modernization bonds
included in the administration's proposal would put more power
in the hands of States and local school districts. The
provision would allow bond buyers to receive Federal tax
credits in lieu of interest, thereby freeing up money the
districts would be paying for interest to be used for teaching
and learning.
We are pleased that Representative Charles Rangel of New
York, the Ranking Member of this Committee, who will introduce
the President's proposal in the House soon, has expressed a
willingness to consider giving a larger allocation to States,
potentially resulting in more funds being available to rural
schools. Representative Nancy Johnson of Connecticut, a Senior
Member on the Majority side of this Committee, will also soon
introduce her bill to provide tax credits on school
modernization bonds. With such bipartisan support, I strongly
urge this Committee to include such school modernization tax
credits in any tax bill considered this year.
Another proposal to assist school facilities is being
proposed by this Chairman, Chairman Archer, and included in
H.R. 2, the leadership's education package. This recommendation
would allow for a longer period of time an additional 2 years
in which earnings on bond proceeds can be kept by school
districts instead of being rebated to the Federal Government. I
would recommend though that because of the arbitrage rebate
relief proposal, it may benefit larger school districts, as Mr.
Chico talked about just recently. But it may be appropriate to
include it as an addition to the school modernization bonds in
the President's proposal. The Committee should also consider
raising the smaller-issuer exemption from $10 million to $25
million, which would provide additional benefits to rural
schools that issue bonds below this limit.
One other bill that has just been introduced, H.R. 996, by
Representative Etheridge, we heard from earlier here today,
also deserves this Committee's attention. This proposal would
provide another $7.2 billion in zero-interest bonds targeted to
States which have the fastest increases in population in school
enrollment.
The American people's attitude toward modernization, stated
in a recent survey, that 82 percent said that they support a
$22 billion 5-year spending proposal to rebuild America's
schools. Americans living in rural areas, 81 percent favor that
proposal. Numerous studies have documented the positive
correlation between student achievement and better building
conditions. A poll of the American Association of School
Administrators in April 1997 found that 94 percent of American
educators said computer technology had improved teaching and
learning. The Internet brings a vast library to our fingertips
in a timely and unencumbered manner.
Beyond the educational benefits that technology has to
offer modern schools, we ensure that students will be equipped
to compete equally and fairly in a job market that is relying
more heavily on proficiency in obtaining, synthesizing, and
presenting information.
Another example that I wanted to mention was Mr. Chico's
remark about the American Society of Civil Engineers, that gave
an ``F'' to education in regard to the study of the
infrastructure in this country. Yet while the Congress just
last year provided $216 billion for roads, bridges, and mass
transit through the highway bill, to date virtually no Federal
funds have been made available to improve school buildings.
Mr. Chairman, we appreciate your interest in rural
education, and the willingness of your Committee to address the
issue of public school construction and renovation. We hope
this Committee can actually expand on the President's proposal
as it prepares revenue legislation to assist rural communities
modernize their schools. Unless we give students equal access
to the tools necessary to succeed in the current marketplace,
we not only short change them, but we short change ourselves by
producing a citizenry unable to maintain our standard of living
as a community, and to compete in the global arena. Thank you.
[The prepared statement follows:]
Statement of Rene ``Jay'' Bouchard, District Superintendent, Steuben-
Allegany Counties, Bath, New York; Chief Executive Officer, Steuben-
Allegany Board of Cooperative Educational Services; Member, Executive
Committee, American Association of Education Services Agencies; and
Member, Executive Committee, National Rural Education Association
Mr. Chairman and Members of the Committee:
On behalf of the National Rural Education Association, I
want to thank you for the opportunity to address the Committee.
My name is Rene ``Jay'' Bouchard, and I would like to speak
about the provision in the President's Fiscal Year 2000 budget
that would provide states and local districts desperately
needed help in modernizing America's public schools.
Mr. Chairman, I come before you as someone who in one
professional capacity or another has been involved in public
education for 39 years. I have had the honor of serving as a
teacher, a vice-principal, and principal at the secondary
level. I have also served as a superintendent. Since 1982, I
have jointly held the positions of Chief Executive Officer for
the Steuben-Allegany Board of Cooperative Educational Services,
a confederation of 15 rural and small town school districts,
and Superintendent of the District of Steuben-Allegany
Counties.
I had the privilege of serving as president of the National
Rural Education Association, or NREA, from 1993 to 1994. I
currently sit on NREA's Executive Committee. I am also a member
of the Executive Committee of the American Association of
Educational Service Agencies.
I think it would be helpful to speak briefly about NREA.
The National Rural Education Association is the oldest
established national organization of its kind in the United
States. The Association traces its origins back to 1907.
Through the years, it has evolved into a strong and respected
organization of rural school administrators, teachers, board
members, regional service agency personnel, researchers,
business and industry representatives, and others interested in
maintaining the vitality of rural school systems across the
country.
THE NEEDS OF RURAL SCHOOLS
While president of NREA, I had the opportunity to travel
extensively throughout the United States and saw first-hand the
challenges that schools, administrators, students, and teachers
in rural areas and small towns face every day. These schools
are more likely than not to be underfunded, and their teachers,
when compared to their urban and suburban counterparts, receive
lower than average salaries and fewer benefits, have fewer
professional development opportunities, and have less access to
higher education.
Unfortunately, rural schools often are nothing more than an
afterthought in the national debate about public education.
Nevertheless, there is a story to be told. For example, one out
of every two public schools in America is located in a rural
area or small town. Thirty-eight percent of America's students
go to schools in rural areas. Forty-one percent of public
school teachers work in rural schools. Yet, rural and small
town schools receive only 22 percent of the total funding for
K-12 education.
Consequently, rural and small town educators must address
increasing expectations with diminishing resources. The school
modernization proposal in the President's budget proposal can
provide desperately needed assistance in the area of greatest
need--modernization of school buildings.
Last year, no less a distinguished body than this Committee
succinctly captured the challenge facing the nation's schools
when it stated: ``A great need exists for construction and
renovation of public schools if American educational excellence
is to be maintained.''
I could not have said it better myself.
The common perception among many outside the education
community is that the need for modern, safe schools that are
not overcrowded, and offer access to the Internet and other
education technology exists only in inner-city communities. The
truth of the matter, according to a landmark 1996 national
study by the General Accounting Office (GAO), ``School
Facilities: America's Schools Report Differing Conditions,'' is
that one out of two rural schools have at least one inadequate
structural and mechanical feature. These include roofs,
exterior walls, electrical systems, and heating, ventilation,
and air conditioning systems.
In addition, GAO found that 30.3 percent of rural schools,
serving more than 4.5 million students, had at least one
overall school building that was deemed inadequate.
The age and physical condition of our nation's schools also
hinders or prevents many from being retrofitted to accommodate
technology. According to the GAO report, the electrical systems
at nearly half of all schools are inadequate for full-scale
computer use.
Nationwide, GAO found that it would take $112 billion just
to make necessary repairs on our schools to ensure that they
are safe and healthy places for children to learn. On top of
these repair needs, because enrollment in our public schools is
at a record high level, and projected to grow every year for at
least the next decade, another $73 billion is needed to build
additional schools and enlarge existing schools to alleviate
overcrowded conditions.
The most recent figures from the National Center for
Education Statistics show that while we as a nation have made
substantial progress in connecting public classrooms to the
Internet, vast disparities remain between disadvantaged and
rural school districts and affluent ones. In addition,
according to a July 1998 report form the National
Telecommunications and Information Administration, rural
students (as well as urban and minority students) lack computer
access at home and must depend on schools or libraries for
access to technology.
The need for access to the Internet and other technologies
is particularly acute in rural areas. Because of tight budgets
and a limited ability to offer higher level and specialized
classes, rural schools are especially reliant on distance
learning technologies.
A case in point are the 15 school districts that comprise
the Steuben-Allegany Board of Cooperative Educational Services
that I oversee. Combined, these western New York districts,
which have consolidated many of their administrative and
curricular functions to achieve economies of scale, enroll
20,000 students. The districts are spread over 1,600 square
miles, an area that is slightly larger than the entire state of
Rhode Island.
Over 44 percent of the students in our schools are eligible
for the free and reduced price lunch program. That figure
climbs as high as 63 percent in some of our schools.
Given how widely dispersed is the area served by the
Steuben-Allegany Board of Cooperative Educational Services, the
ability to share resources electronically is crucial. In my
region, less than 15 percent of our students are in schools
with Internet access in their classrooms. Most of our schools
only have one or two single station connections to the Internet
in the entire school.
THE PRESIDENT'S SCHOOL MODERNIZATION PROPOSAL WOULD HELP RURAL SCHOOLS
The school modernization proposal in the President's budget
proposal would go a long way in helping us and others like us
to remedy this problem, repair and upgrade all the mechanical
systems of our buildings and better respond to environmental
hazards in our schools.
The $22 billion in zero interest school modernization bonds
included in the Administration's proposal would put more power
in the hands of states and local school districts and will not
create new federal bureaucracy. Decision making and management
prerogatives remain at the local level. By allowing local
communities to finance school construction or renovation with
the equivalent of interest-free bonds, the proposal presents
schools districts with a unique opportunity to renovate
existing buildings and build new schoolhouses.
The provision would allow bond buyers to receive federal
tax credits in lieu of interest, thereby freeing up money the
districts would be paying for interest to be used for teaching
and learning. Since over the 15-year repayment period of these
school modernization bonds interest payments typically
represent as much as 50 percent of the total repayment, the
savings to schools from this proposal will be substantial.
Fiscal relief to school districts such as mine will help
relieve pressure on property taxes, and thus make it easier to
convince our local voters to pass school bond referenda.
Combined with the $2.4 billion expansion of the existing
Qualified Zone Academy Bond (QZAB) Program, these two proposals
would generate nearly $25 billion in bonds at a cost to the
U.S. Treasury of $3.1 billion over five years, according to the
Joint Committee on Taxation. This is a national investment in
schools and in the work force for tomorrow's economy. I also
want to add that while the perception of QZABs is that these
bonds only benefit urban areas, any school district with at
least 35% of its children eligible for free or reduced-price
school lunch also qualifies.
New York State alone would be eligible for more than $2.7
billion in tax credit bonds.
The President's proposal calls for a 50-50 split in bonding
authority, with half of the allocation to the states and half
to the 100 school districts with the largest number of low-
income students. State agencies would assign the bonding
authority to districts, schools, or other governmental units
based on the family income level of the students to be served,
or other factors as they see fit. Most importantly for rural
schools is a requirement that the state give special
consideration to rural areas, as well as to high-growth areas.
Such a funding formula would greatly benefit rural schools.
Additionally, we are pleased that Representative Charles
Rangel of New York, the ranking member of this committee, who
will introduce the President's proposal in the House soon, has
expressed a willingness to consider giving a larger allocation
to states, potentially resulting in more funds being available
to rural schools. In addition, I am very pleased to note that
Representative Nancy Johnson of Connecticut, a senior member on
the majority side of this committee, will also soon introduce
her own bill to provide tax credits on school modernization
bonds. With such bipartisan support I strongly urge this
committee to include such school modernization tax credits in
any tax bill considered this year.
OTHER SCHOOL MODERNIZATION PROPOSALS
I also want to comment on another proposal to assist school
facilities proposed by Chairman Archer, and included in HR 2,
the leadership's education package. The Chairman recognized the
need for the federal government to assist school communities in
his proposal to change arbitrage rules. His recommendation will
allow for a longer period of time, an additional two years, in
which earnings on bond proceeds can be kept by school
districts, instead of being rebated to the federal government.
This is a positive proposal that will provide fiscal benefit to
some school districts.
However, for many rural districts this proposal will
generate little if any additional funds. For most rural
districts, if they do pass a bond, they will immediately put
those proceeds into the school construction or renovation. The
local voters who approve bonds expect projects to be initiated
and completed as quickly as possible. I should note that
districts with bonds of less than $10 million annually are
currently exempt from arbitrage rules, which represents the
majority of bonds issues by rural schools.
I would recommend though, that because the arbitrage rebate
relief proposal may benefit larger school districts, it may be
appropriate to include it as an addition to the school
modernization bonds in the President's proposal. The committee
should also consider raising the small issuer exemption from
$10 million to $25 million, which would provide some additional
benefit to rural schools that issue bonds below this limit.
One other bill that has just been introduced, HR 996 by
Rep. Etheridge of North Carolina, also deserves this
committee's attention. This proposal, intended as an addition
to the school modernization bonds in the President's budget,
would provide another $7.2 billion in zero interest bonds
targeted to states which have had the fastest increases in
population and school enrollment. The high growth states that
would be the greatest beneficiaries of these bonds include many
rural areas.
With the average school building in America greater than 50
years old, we cannot afford to wait any longer for the kind of
help the President's proposal would offer. Localities and
states, including New York, are addressing this pressing issue
as best they can, but they cannot go it alone. The President's
proposal provides the framework for the kind of local/state/
federal partnership necessary to address this national
emergency.
THE PUBLIC SUPPORTS FEDERAL HELP TO MODERNIZE PUBLIC SCHOOLS
The American people understand the connection between safe
and modern schools and student achievement. In fact, according
to the most comprehensive survey to date on American's
attitudes toward school modernization, 82 percent said they
support a $22 billion, five-year spending proposal to rebuild
America's schools. The survey, conducted on behalf of the
Rebuild America Coalition, by leading Republican pollster Frank
Luntz in January, found that Americans whether they live in the
inner city, the suburbs or rural areas, whether they are
affluent or low-income, whether they are black or white, men or
women, Republican or Democrat believe that modernizing
America's schools is a national priority.
Of those Americans living in rural areas, 81 percent
favored such a proposal. Twenty-six percent of rural Americans
said that public school buildings in their community were in
need of repair, replacement or modernization. Rural Americans
said the best reasons to modernize public schools were to
ensure a safe and healthy place for children to learn (46.1%)
and to provide more space to allow for smaller class sizes
(34.2%).
Numerous studies have documented the positive correlation
between student achievement and better building conditions. A
1996 study found an 11-point difference in academic achievement
between students in classrooms that are substandard and the
same demographic group of children in a first-class learning
environment. A poll issued by the American Association of
School Administrators in April 1997 found that 94 percent of
American educators said computer technology had improved
teaching and learning.
I have seen first-hand the difference technology can make
in the classroom. The range of resource materials available to
teachers and students on the Internet is staggering. The
Internet brings a vast library to our fingertips in a timely
and unencumbered manner. It provides students and teachers
alike access to timely, relevant, and interactive information
about the world around them and our past.
Children in rural communities as well as children in urban
and suburban areas should be educated in modern, well-equipped
schools, with small classes. Beyond the educational benefits
that technology has to offer, modern schools ensure that
students will be equipped to compete equally and fairly in a
job market that is relying more heavily on proficiency in
obtaining, synthesizing, and presenting information.
One last example of the desperate need for federal help to
modernize schools comes from the American Society of Civil
Engineers. Last year, this distinguished organization released
an analysis of the state of our nation's infrastructure. They
analyzed the condition of roads, bridges, wastewater treatment
systems, dams, hazardous waste sites, and solid waste disposal
sites. They found that public schools buildings are in worse
condition than any other part of our nation's infrastructure.
Yet, while the Congress just last year provided $216 billion
for roads, bridges and mass transit through the highway bill,
to date virtually no federal funds have been made available to
improve school buildings.
Mr. Chairman we appreciate your interest in rural education
and the willingness of your Committee to address the issue of
public school construction and renovation. It is crucial that
Congress enact the proposals such as the President's school
modernization plan. We hope this committee can actually expand
on the President's proposal as it prepares revenue legislation
to assist rural communities modernize their schools.
Unless we give students equal access to the tools necessary
to succeed in the current marketplace, we not only shortchange
them but we shortchange ourselves by producing a citizenry
unable to maintain our standard of living as a community and to
compete in the global arena.
Thank you.
Chairman Archer. Does any Member wish to inquire?
Mr. Doggett.
Mr. Doggett. Thank you very much.
Mr Chico, we hear so much about what is wrong with public
education from those who are determined to undermine it. It is
very good to hear some of the right things that are happening
in Chicago. I congratulate you on your success.
Mr. Chico. Thank you.
Mr. Doggett. If I understand your testimony, the arbitrage
proposal which has been advanced, will do very little for
continued improvement in the Chicago public schools?
Mr. Chico. That is correct.
Mr. Doggett. And given its cost, which I think is a little
less than $2 billion, if we had that $2 billion to apply in
some way to education, you would advise us to apply it
somewhere else rather than the arbitrage proposal?
Mr. Chico. I would say that between the Rangel and Clinton-
Gore proposal is about $3.7 billion. I just know for a fact
that we could actually access that money and put it to use.
Believe me, I don't come here with any bias. If I felt that we
could use the arbitrage provision and I ran the calculations
and saw if it generated any money for us over the last four
issues, I would say let's do it. But it does not.
Mr. Doggett. Is it your feeling that that situation is not
unique to the Chicago public schools, but that there are many
other districts with demands such that they have to apply their
bond moneys immediately that there are many other districts
around the country that likewise would not benefit
significantly from this proposal?
Mr. Chico. I believe that to be the case. I don't want to
speak for New York, but I spoke with the New York
representative before the meeting, and you have heard from the
small rural district association here, and you have heard from
Chicago. That is a pretty good snapshot, I believe.
Furthermore, I would ask the question, I mean who could
afford to hold onto their money for 4 years? I mean I have
never seen that luxury.
Mr. Doggett. So while this proposal might be presented as
benefiting all schools, just as every American has the right to
buy a Rolls Royce if they can afford it, some of our school
districts will not be able to afford to use this provision that
would be available to them under this arbitrage bill?
Mr. Chico. I think so.
Mr. Doggett. With reference to our rural schools, Mr.
Bouchard, in my State of Texas, some of our rural school
districts have got more oil wells than they do children. Then
some just a little bit down the highway who, because they have
only have rock and cedar trees, can't afford to buy air
conditioners for the classrooms. Are there problems that some
of our rural school districts around the country face because
they are property poor districts?
Mr. Bouchard. Absolutely. I come from an area in the Finger
Lakes region of New York that is the same as what you are
talking about, very, very, very poor. I have been in the inner
city of New York City, and I have seen more poverty in my area
than I have seen in New York City schools.
Mr. Doggett. Do you think that it is appropriate that as we
look at this whole school construction issue, that we focus on
at least if not addressing these inequities between property-
poor and property-rich districts, at least try not to
exacerbate them and make them worse by simply passing
legislation that only the richest can take advantage of?
Mr. Bouchard. Absolutely.
Mr. Doggett. Thank you very much. Thank you both, and the
entire panel.
Mrs. Thurman. Mr. Chairman.
Chairman Archer. Mrs. Thurman.
Mrs. Thurman. Dee, let me ask you just a couple of
questions. In reading your testimony and looking at some of the
language from the tax stuff that was given to us by the
administration, there is one area that has me a little
confused. There is something in there about retroactive tax
increases. But at the same time, it says that this proposal or
this initiative would actually take place the day this bill is
passed. Can you explain the retroactive issue for us?
Ms. Thomas. Yes. I think so. Again, it is not a simple
thing to understand. But I think effectively what happens is
that in this proposal is that there really isn't any effective
date. It talks about an effective date. What really happens is
there is not really an effective date.
The proposal goes on to say that we would be able to take
deduction for distributions and apply that against the UBIT.
Then it goes on to say that companies such as ours that have
already enacted the sub S ESOP, that we would have to--we
wouldn't be able to use that benefit. We would have to just
keep applying that until we had paid off what we have already
used. So for us, and for any like us, there is really no
effective date because it is going to be the same for all sub S
ESOPs. So that is the retroactive problem that we have.
Mrs. Thurman. And then the other issue, and I guess maybe
to the two colleagues that came with you as well, based on your
understanding, do you think you could remain as an ESOP and as
an independent company at this point?
Ms. Thomas. I think that it would be difficult for us.
Number one, this Committee needs to understand that Ewing &
Thomas functions in a world of a lot of federally regulated
Medicare money. There are a lot of changes that are occurring
that are really hitting on the independent practitioners, and
especially the small independent physical therapists. Not just
this issue, but some supervision issues and so the list goes
on. So that is not helping us. We are kind of in the squeeze
between that and now the sub S.
The sub S ESOP issue, with the proposal, there is so much,
I call it gobbley-goop, because it's very difficult for a
regular ordinary businessperson to understand. So that is going
to cost us administrative costs from a lawyer and evaluation
and administration firms. That is probably going to be over
what we already paying. Then we are looking at the possibility
of like a 40-percent tax, so we'll have that. Plus again, the
administrative fee. Then we have our repurchase liability that
we also have to continue to worry about.
So the proposal is going to be difficult for those of us
that made the election in good faith.
Mrs. Thurman. Thank you.
Mr. Marvin, I just want to say that I appreciate your being
here. I think the issues that you have raised as we go into the
next millennium are extremely important to this country. I am a
cosponsor--also I am one of the people on the efficiency on
energy. We really appreciate you all bringing these issues to
us, because they are very important into the future. Also, I
would say to our school districts, I have some large schools
districts and I have some rural districts, but I am also a
former teacher. So I understand. And a seventh and eighth
grade, not university.
Mr. Chico. You were on the frontlines.
Mrs. Thurman. I was right on the frontlines, and I actually
worked in a portable. So I can appreciate what you are saying
and certainly can appreciate from a standpoint of children
learning, and how important it is that they are in an
environment, if nothing else, to have the technical
advancements that are available in any kind of modernization
that we do. So we certainly appreciate the time you have taken.
Mr. Hill, we thank you for being here too.
Chairman Archer.
Mr. Collins.
Mr. Collins. Thank you, Mr. Chairman.
Mr. Chico, does Chicago School Reform board of trustees, is
that the Chicago----
Mr. Chico. School board.
Mr. Collins. School board?
Mr. Chico. What they did, Congressman, is we were in such
bad shape 4 years ago they virtually created an emergency act.
The Illinois legislature turned over the power for the control
of the schools to the Chicago mayor. They created this interim
board called the Reform Board of trustees, using the word
trustees to connote urgency.
Mr. Collins. OK. Well then you are actually the school
board?
Mr. Chico. We are the school board. We are the school
board.
Mr. Collins. So you are familiar with all the areas of the
cost of education?
Mr. Chico. Yes.
Mr. Collins. Versus just the cost of construction of
schools.
Mr. Chico. Yes, sir.
Mr. Collins. In relation to that, are you familiar or do
you have other areas of funding that are supposed to come from
the Federal level but don't come, and the lack of that causes
you to have to----
Mr. Chico. Yes.
Mr. Collins [continuing]. Cough up moneys in other areas
that prohibit you from using it for construction, such as the
IDEA?
Mr. Chico. Yes, sir. Special education. We receive about 8
percent from the Federal Government, and the Federal Government
has set a target for itself of providing 40 percent to the cost
of our special education.
Mr. Collins. Should the Congress come up with more funding
in that area, would it free up some funds for you to be able to
use for your school construction?
Mr. Chico. Yes, sir.
Mr. Collins. So if the bond issue, the bond provisions were
not put in place, there are other places you possibly could get
funds from then?
Mr. Chico. Absolutely. The money is money. What we would do
is if the Congress saw fit to increase the amounts sent to
school districts for special education, we would take that
money, take out the general dollars that we now put in from the
local level into special education, put that back into other
purposes like school construction.
Mr. Collins. Are there other areas that are mandates that
the Federal Government or the Congress puts on you that costs
you money that you could use for this same purpose if those
type of regulations were giving some relief to you?
Mr. Chico. There is probably a smattering of what you would
call unfunded mandates, Congressman. But none are as poignant
as the special education shortfall.
Mr. Collins. Oh I am sure there's not. That is a very
expensive item.
Mr. Chico. Yes.
Mr. Collins. But I am just thinking that the Congress, in
its attempt to oftentimes fund different areas, will put
mandates down and cause certain things that you have to do in
reporting and administrative costs too that cost a billion to
the operation versus the moneys you actually receive.
Mr. Chico. There is no doubt about it, Congressman. I will
give you a short story. When the Illinois legislature in 1995
created this emergency act to give the mayor responsibility for
the Chicago public schools, they also gave us flexibility to
use funds in different ways. So instead of mandating that there
is a particular formula for how to fund something, they put the
money in a general bloc, sent it to the Chicago public schools.
I think we have used it very effectively, because over a 15-
year period, they never had a balanced budget. For the last 4
years, we have had balanced budgets, and we hope to have them
until 2003 at least, when our labor agreement expires.
Mr. Collins. You said the State did this?
Mr. Chico. The State of Illinois. The Chicago Board of
Education is a separate municipal corporation established by
State statute. So the State is our ultimate authority.
Mr. Collins. Yes. So the State kind of block-granted down
to you the funds, and says you use it for education.
Mr. Chico. Yes.
Mr. Collins. Are you familiar with the fact that in the
last Congress, we passed something very similar, called Dollars
for the Classroom Act, that would have given you funds with the
flexibility to use them as you see need for the classroom?
Mr. Chico. I am not familiar with how much flexibility we
received as an individual school district. I understand that
the legislation was designed pretty much to give flexibility at
the State level. In turn, that was supposed to benefit us. We
are all for that in concept. Anything that allows us--we feel
we can pretty much solve a lot of our own problems, not all of
them, I mean here I think we have made a very good-faith effort
at raising $2 billion from local taxpayers, but unfortunately,
the nature of the need is still greater. That is why we are
looking to the Congress for help.
Mr. Collins. Yes. I fully understand because in the third
district of Georgia that I represent, we have some mayors that
are very fast growing. They are having growing pains, similar
to what you are having.
Thank you very much. I think you will see this Congress try
to give you some relief in several areas, such as mandates, and
also the area of the IDEA.
Mr. Chico. Thank you very much, Congressman.
Mr. Collins. Thank you. Thank you, Mr. Chairman.
Chairman Archer. Does any other Member wish to inquire?
Mr. Weller.
Mr. Weller. Thank you, Mr. Chairman. I am glad I got back
here in time.
I would like to direct my question to local school
superintendent from Illinois, Gery Chico. I see you met Mr.
Collins, who was directing some questions here. I particularly
want to thank you for acknowledging the bipartisan partnership
that worked, when we had a Republican Majority in the House and
a Republican Majority in the State senate, and of course a
Republican Governor, and they worked with Mayor Daley and got
rid of some dead wood and made some changes. The mayor is
taking advantage of that. Your team has done a good job of
bringing about some positive change.
Mr. Chico. Thank you, Congressman.
Mr. Weller. Its beneficiaries are the kids. So I salute you
and want to thank you for that. I also appreciate the
opportunities I have had as a Representative of Chicago to
visit your schools and see first-hand the good work that you
are doing.
Mr. Chico. You are always welcome.
Mr. Weller. When you and I have had conversations, you are
particularly, of course, interested in the school construction
bond initiatives that come before us. As Rod Blagojevich, my
former colleague in the assembly remembers, I was the sponsor
of a similar initiative when I was in the State legislature. So
I have always been a strong supporter, and I think recognize
the need to fix leaking roofs and need for new classrooms.
Just for the record though, in the State of Illinois, I
know in the State legislature and the Governor in the last
couple years have approved a school construction funding
initiative. How much is that, and how long is that in place
for?
Mr. Chico. It's $1.3 billion. It goes for about 5 years.
The unfortunate part of the problem is that the estimated need
for the State of Illinois is about $12 to $13 billion. One of
the other shortcomings we believe, Congressman, of the Illinois
mechanism is that 5 years trickles the money out to Chicago too
long. We would like to have the ability to borrow against that
longer stream and do the job today so that we don't have to
wait 4 years to get to the leaky roof and make it an entirely
new roof rather than a patch job.
Mr. Weller. OK. Again, I'm sorry, the dollar amount?
Mr. Chico. It's 1.3.
Mr. Weller. It's 1.3 over 5. Then the Chicago public
schools, your own school district, also has a school
construction initiative. What is the total on that?
Mr. Chico. Two billion.
Mr. Weller. So your share of the State?
Mr. Chico. Two fifty.
Mr. Weller. Two hundred and fifty million. So you have
essentially got almost $1.5 billion that will be essentially
yours coming from both the State initiative and then from the
local initiative?
Mr. Chico. It works out like this: $2 billion was raised
locally, and about $250 million from that $1.3 billion State
issue will come to Chicago also. So about $2.25.
Mr. Weller. That's $2.25 billion.
Mr. Chico. Total for Chicago.
Mr. Weller. Total. Then the QAZ, Qualified Academy Zone,
bonds that qualify, the zone academy bonds that were part of
the Balanced Budget Act and came as an initiative out of this
Committee, how are you using them within the Chicago public
schools?
Mr. Chico. I think we were the first in the country to
access the qualified academy zone bonds. Last year, the State
allocation was about $14.5 million. We were the only district
that stepped up and asked for the allocation, so we were given
the entire allocation. We took it and we renovated an old
United States armory and we created an ROTC high school for the
city at 38th and Calumet, along with an African-American
military museum right next to it.
This year, we are going for--we are working with five other
districts, plus Chicago, for the $15 million State allocation.
As I said in my testimony, Chicago will work with East St.
Louis, DeKalb, Aurora, Elgin, and Mendota, to share that $15
million pool. But what will happen here, Congressman, is
Chicago will do the brunt of the work and help raise the 10-
percent, private-sector match because that $1.5 million is a
lot of money to ask a rural town or a smaller town to go get.
Mr. Weller. Reclaiming my time. Is it a coincidence four of
those five school districts are in the district of the Speaker
of the House? [Laughter.]
Mr. Chico. No, not really, because I'll tell you what. If
we had our druthers--no, not necessarily. If we had our
druthers, we have actually reached out to other people, too,
around the State. These are the ones that have come forward
first. We would like to work with 40 or 50 districts.
Mr. Weller. Sure. I'm of course running out of time here.
Let me ask this, just on a philosophical standpoint. As we have
talked, and Mr. Collins brought this issue up, is we have
worked to give you greater flexibility and shift dollars back
to the States, and of course trying to get more dollars into
the classroom. Who would you rather apply to for the funds, the
Illinois State Board of Education or the Federal Department of
Education?
Mr. Chico. It depends who will give them to me quicker.
Mr. Weller. Well today, under today's circumstance, who has
less paperwork and who is the most responsive?
Mr. Chico. Congressman, in my testimony I said that I do
not believe the United States Department of Education should
sign off on our money. I said that we will be glad to observe a
reporting requirement. I think there ought to be some checks
and balances. But I do not believe we should make undue stops
for undue labor of review of a plan. I mean I think this is
fairly basic stuff. You are either fixing the building or
you're not fixing the building. You are building a new
classroom or you're not.
The State of Illinois has been very good. They have used
the Capital Development Board in Illinois. They have been a
very quick vehicle to transfer that money to the local
districts. So if our suggestion is heeded, then I think we will
be OK at the Federal level, too. But I don't think we should
create another organization for a very involved process to get
sign-off from at the Federal level.
Mr. Weller. Thank you. Thank you, Mr. Chairman. I see I am
out of time.
Chairman Archer. I was going to say, ``gentlemen,'' but we
have a wonderful lady on this panel too. My gratitude to all of
you for coming and giving us the benefit of your testimony
today. We have all learned a lot. We thank you, and we wish you
well.
There being no further business before the Committee, the
Committee will stand adjourned.
[Whereupon, at 5:12 p.m., the hearing was adjourned.]
[Submissions for the record follow:]
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 2000
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 five provisions included in the
Administration's budget. We urge the Committee to reject the
Administration's proposals to change the rules for bank-owned
life insurance, modify section 1374, tax the investment
earnings of section 501(c)(6) organizations, and eliminate
``corporate tax shelters.'' 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 two years
ago. 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 two years ago be broken by eliminating the
exception for employees, officers, and directors for taxable
years beginning after the date of enactment. 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 that permits an interest-paid
deduction for borrowings against policies covering key
employees would be repealed.)
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 obligations, 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 in agreement with the OCC position.)
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 and
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 fourth year in a row that legislation has been
proposed to limit the business use of life insurance. This is
the second year in a row that the Administration has asked
Congress to find a relationship between life insurance on
employees, officers, and directors that a corporation owns or
is the beneficiary of and general debt issued on the credit of
the corporation. The continuing attacks on corporate-owned life
insurance deprive taxpayers of certainty and, from the
Administration's point of view, are counterproductive.
Corporate taxpayers may feel compelled to purchase life
insurance to qualify for the current tax treatment before the
opportunity is lost. ACB urges the Committee to unequivocally
affirm that the current law treatment of corporate-owned life
insurance represents a sound compromise that should not be
disturbed.
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 member 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.
Three years ago the Chairs of the Ways and Means Committee
and its Subcommittee on Oversight 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 1998 was approximately
49.5 percent. Using this index to adjust the per capita limit,
it would now be approximately $1.87. The GDP price deflator for
residential fixed investment indicates 39.9 percent price
inflation, which would have increased the per capita limit to
approximately $1.75. (See Joint Committee on Taxation,
Description of Revenue Provisions Contained in the President's
Fiscal Year 2000 Budget Proposal (JCS-1-99), February 22, 1999)
More affordable low-income housing is currently needed.
``Despite the success of the Housing Credit in meeting
affordable rental housing needs, the apartments it helps
finance can barely keep pace with the nearly 100,000 low cost
apartments which were demolished, abandoned, or converted to
market use each year. Demand for Housing Credits currently
outstrips supply by more than three to one nationwide.
Increasing the cap as I propose would allow states to finance
approximately 27,000 more critically needed low-income
apartments each year using the Housing Credit, helping to meet
this growing need.'' (floor statement of Representative Nancy
Johnson, January 6, 1999). ``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). ``The Housing
Credit is the primary federal-state tool for producing
affordable rental housing all across the country. Since it was
established, state agencies have allocated over $3 billion in
Housing Credits to help finance nearly one million homes for
low income families, including 70,000 apartments in 1997. In my
own state of Connecticut, the Credit is responsible for helping
finance over 7,000 apartments for low income families,
including 650 apartments in 1997 (floor statement of
Representative Nancy Johnson, January 6, 1999).
Based on the foregoing, it is clear that it is time to
increase the LIHTC.
Repeal of Section 1374 for ``Large'' Corporations
Under the Administration's budget proposal, section 1374
would no longer apply to corporations that have a value of more
than $5 million. The repeal of section 1374 would apply to
Subchapter S elections that become effective after December 31,
1999. Section 1374 was enacted by the Tax Reform Act of 1986 in
order that taxpayers could not avoid the repeal of the General
Utilities rule (see General Utilities v. Helvering, 296 US 200
(1935)) that was one of the primary achievements of the 1986
Act. Under the General Utilities rule, a corporation could
avoid corporate level tax on appreciated property by
distributing such property to its shareholders. Section 1374
was enacted in lieu of the kind of liquidation tax now being
proposed by the Administration. Section 1374 provides that the
``built-in'' gain on appreciated assets held by a corporation
that makes a Subchapter S election will be triggered where the
assets are disposed of within 10 years of the election. Ten
years, though an essentially arbitrary period, is long enough
to indicate conclusively that the taxpayer did not have a tax
avoidance motive on these amounts for making the election.
The current Administration proposal first appeared in the
President's Seven-Year Balanced Budget Proposal, published in
December 7, 1995. It provides that a ``large'' regular
corporation--with a value of more than $5 million--electing to
become a Subchapter S corporation or merging into one will be
treated as if it were liquidated, followed by the contribution
of the assets its shareholders received in exchange for their
stock to the S corporation. The proposal would impose taxation
on any appreciated assets held by the corporation and would tax
the shareholders as if they had sold their stock and reinvested
the proceeds in the new Subchapter S entity.
Although as a general matter, enactment of the
Administration's proposal would probably make the Subchapter S
election too expensive for many existing corporations,
including commercial banks, the proposal would impose a
particular and prohibitive tax liability on the typical savings
institution or savings bank (thrift). In effect, Congress will
have made only a hollow gesture towards making Subchapter S
status available to thrifts.
Last year Congress advanced the ongoing process of
financial modernization by making it possible for thrifts to
change to commercial bank charters or to diversify their
lending activities to diminish risk created by concentrated
lending and to better serve their communities. This was
accomplished by requiring all thrifts to ``recapture'' into
taxable income their loan loss reserves accumulated after 1987,
except to the extent necessary to create an opening reserve
balance for those ``small'' thrifts permitted to remain on the
experience reserve method. The threat of subjecting the
remaining, pre-1988 reserve accumulation to recapture upon a
charter change or a diversification of the institution's loan
portfolio was dispelled. Recapture of the pre-1988 reserve will
still occur, however, where the thrift liquidates or otherwise
distributes the capital accumulated using the special thrift
subsidy reserve method that had been in existence since 1952
but that was repealed by Congress last year. Almost any
established thrift that is forced to recapture the capital
accumulated between 1952 and 1987 from the special thrift
reserve method would suffer a huge cut in its capital and a
likely regulatory capital shortfall, given the importance of
the previous deductions permitted under the method.
Although in Notice 97-18, published in the Internal Revenue
Bulletin 1997-10 on March 10, 1997, the Internal Revenue
Service distinguished the pre-1988 reserves of a thrift from
the experience reserves subject to recapture as a section
481(a) adjustment, there can be little doubt that the pre-1988
reserves satisfy the definition of a built-in gain in section
1374(d)(5) of the Internal Revenue Code.
ACB concurs with other commentators that the
Administration's proposal to repeal 1374 is not sound tax
policy. The taxation of excess passive income, as well as the
10-year holding period requirement to avoid the taxation of
built-in gains, limits the ability of corporations to avoid tax
by making a Subchapter S election. The proposed repeal of
section 1374 for large corporations would eliminate the
realization concept to such an extent that a corporation may be
unable to pay the required tax without an actual liquidation of
the assets of the business. This proposal would contravene one
of the principal purposes of the amendments to the Subchapter S
provisions made in 1982 and 1996--to increase the
attractiveness and availability of the Subchapter S election.
At a minimum, however, ACB strongly requests that, if the
Committee were to agree with the Administration on the need to
impose liquidation treatment on certain Subchapter S
conversions, an exception be created to avoid the recapture of
the pre-1988 loan loss reserves of thrifts. The very purpose of
the amendments to the reserve recapture rules made last year
was to limit the circumstances in which reserve recapture will
be imposed. It is inconsistent to create a new situation in
which recapture will be imposed. The Administration's proposal
will force many eligible thrifts to make the Subchapter S
election on a rush basis, rather than be effectively foreclosed
after the 1999 calendar year. The provision creates a trap for
the unwary thrift that could have a devastating impact on its
capital. This proposal will raise little, if any, revenue from
the thrift industry if their pre-1988 reserves are made subject
to recapture under it.
Investment Earnings of 501(c)(6) Organizations
Section 501(c)(6) of the Code creates an income tax
exemption tax for nonprofit business leagues, chambers of
commerce, and professional and trade associations. Such
organizations are not taxed on the revenues derived from
membership dues and exempt purpose activities. Income derived
from business activities unrelated to the tax-exempt purpose
is, however, taxed under section 511 of the Code at the regular
corporate rate, but an exclusion is provided for interest,
dividends, royalties, certain rental income, certain gains from
the disposition of property, and certain other income.
The Administration is proposing to tax the ``net investment
income'' of section 501(c)(6) organizations--i.e., the
interest, dividends, rents, royalties, and certain gains and
losses from the disposition of property, minus all directly
connected expenses. An exception would be provided for the
first $10,000 earned by an association from these sources, but
all investment income over the $10,000 floor will be subject to
the unrelated business income tax (UBIT).
The Treasury provides the following rationale for the
proposal:
The current-law exclusion from the UBIT for certain
investment income of a trade association allows the
organization's members to obtain an immediate deduction for
dues or similar payments to the organization in excess of the
amounts needed for current operations, while avoiding tax on a
proportionate share of the earnings from investing such surplus
amounts. If the trade association member instead had retained
its proportionate share of the surplus and itself had invested
that amount, the earnings thereon would have been taxed in the
year received by the member. Although in some instances
investment income earned tax-free by a trade association may be
used to reduce member payments in later years, and hence reduce
deductions claimed by members in such years, the member still
has gained a benefit under current law through tax deferral.
Thus, under current-law rules, trade association members may be
able to claim current deduction for future expenses. Even
assuming that dues and similar payments would be deductible by
the member if made in a later year, to the extent that
investment income is earned by the trade association in one
year and spent in a later year, the current-law exclusion
effectively provides the benefit of a deduction before the
expenditure actually is made. (U.S. Department of Treasury,
General Explanations of the Administration's Revenue Proposals,
(February, 1999), at p.60).
Based on this rationale, it is the Administration's view
that the UBIT should be used to eliminate the ability of
members of 501(c)(6) organizations to leverage their dues by
overpaying them in order to accumulate earnings on a tax-free
basis--regardless of the purpose for which these earnings are
accumulated. Assuming for the moment that this leveraging
actually occurs, it would be an expansion of the UBIT beyond
the purpose for which it was created and impose it on a
501(c)(6) organization's earnings used in furtherance of its
tax-exempt purpose. The UBIT was created to prevent tax-exempt
entities from competing unfairly with taxable businesses (e.g.,
the sort of competition that, nevertheless, exists between
credit unions and commercial banks and thrifts). The
legislative history makes clear that ``the problem at which the
tax on unrelated business income is directed here is primarily
that of unfair competition. The tax-free status of [section
501(c)] organizations enables them to use their profits tax-
free to expand operation, while their competitors expand only
with the profits remaining after taxes.'' (H.R. Rep. No. 81-
2319, 81st Cong., 2d Sess. 36-37 (1950) and S. Rep. No.81-2375,
81st Cong., 2d Sess. 28-29 (1950)). The same legislative
history also makes clear that investment earnings used to
advance the tax-exempt purpose are not to be subject to the
UBIT ``because they are `passive' in character and are not
likely to result in serious competition for taxable businesses
having similar income'' (H.R. Rep. No. 81-2139 at 36-38; S.
Rep. No. 81-2375 at 30-31).
The investment earnings of 501(c)(6) organizations are used
to fund research, educational, and charitable activities--in
short, all of the activities that serve the 501(c)(6)
organization's tax exempt purpose. The reasons for granting an
exemption for investment income from UBIT are as valid today as
they were fifty years ago. The Administration is able to point
to nothing that has changed since the creation of the UBIT such
that Congress should reverse the policy decision it made at
that time.
While the investment earnings of 501(c)(6) organizations
are in the end used directly to further their tax-exempt
functions, the maintenance of a capital reserve is a budgetary
necessity to provide for unanticipated costs and avoid a
financial crisis. Taxing these reserves will reduce the ability
of a 501(c)(6) organization to plan for the future performance
of its tax-exempt purpose. Dues income may fluctuate from one
year to the next and 501(c)(6) organizations do not have the
same access to the credit markets as regular corporations.
The implication of the Administration's rationale is that
501(c)(6) members are prepaying their dues because it is more
advantageous for the 501(c)(6) organization to accrue the
earnings on the excess dues payment. In effect, the tax-exempt
status of the 501(c)(6) organization can be used to create an
economic benefit for the members. This would certainly be news
to the members. In most cases the members of a 501(c)(6)
organization prefer to review annually the value of their
membership and would not be interested in prepaying dues. In
addition, the same need to assure future liquidity in their own
businesses would constrain an overpayment of dues.
In any case, the Administration's economic benefit theory
is fallacious. The reserves of a 501(c)(6) organization are
almost always invested in the most conservative instruments.
Very few members are likely to believe that they could not get
a better return on these funds in their own businesses and it
is likely that a failure to do so in their own businesses could
mean liquidation or unemployment. Moreover, a conscious attempt
to implement this economic theory would require a complex dues
formula to prevent some members from overpaying dues based on
their loss of investment opportunity relative to other members.
The Treasury concedes that a tax on the investment income
of a 501(c)(6) organization would require it to raise its
membership dues, with the result that the increased UBIT
revenue would be significantly offset by a deductible business
expense. It appears, however, that, in the view of Treasury,
matching the year of the UBIT and the dues deduction, in
addition to generating revenue by eliminating the ``float,'' is
theoretically preferable.
The failure of the Administration to include the investment
earnings of labor unions, which are tax-exempt under section
501(c)(5), in its proposal raises the issue of whether the
proposal is politically motivated. Labor unions generally
support Democrats; chambers of commerce, included in section
501(c)(6), generally favor Republicans. Both 501(c)(5) and
501(c)(6) organizations advance comparable goals and Congress
has, thus far, determined that both should receive similar tax
treatment. A Treasury official reportedly attempted to make a
distinction on the basis that union members generally claim the
standard deduction on their returns, while most members of
501(c)(6) organizations claim a business expense deduction. The
fact that someone chooses to take the standard deduction
because it produces a greater tax benefit than claiming an
employee business expense does not eliminate the comparability
of dues paid to 501(c)(5) and 501(c)(6) organizations.
Moreover, not all union members, such as those belonging to the
Screen Actors and Writers Guilds and the Airline Pilots
Association in many cases, take the standard deduction. Not all
members of 501(c)(6) organizations are able to deduct their
dues because of the limitation on the deductibility of employee
business expenses nor can they have their employers reimburse
them.
For all of the foregoing reasons ACB strongly urges the
Committee to reject the Administration's proposal to tax the
investment earnings of 501(c)(6) organizations.
Corporate Tax Shelters
The Administration has proposed a multifaceted and broad-
based attack to eliminate what it deems to be abusive ``tax
shelters.'' Unfortunately, the definitions used are so vague
and encompassing and the penalties prescribed are so draconian
that the enactment of these proposals would have a chilling
effect on many legitimate transactions. The individual
components of the Administration's tax shelter attack will be
discussed in the order presented in the budget proposal.
1. Modify substantial understatement rule for corporate tax
shelters.
The Administration is proposing to double the substantial
understatement penalty for corporate taxpayers from 20percent
to 40 percent for any item attributable to a ``corporate tax
shelter.'' A corporate tax shelter under the proposal would be
``any entity, plan, or arrangement (to be determined based on
all facts and circumstances)) in which a direct or indirect
corporate participant attempts to obtain a tax benefit in a tax
avoidance transaction.'' A ``tax benefit,'' according to the
proposal, would ``include a reduction, exclusion, avoidance, or
deferral of tax, or an increase in a refund, but would not
include a tax benefit clearly contemplated by the applicable
provision (taking into account the Congressional purpose for
such provision and the interaction of such provision with other
provisions of the Code).'' A ``tax avoidance transaction'' is
defined ``as any transaction in which the reasonably expected
pre-tax profit (determined on a present value basis, after
taking into account foreign taxes as expenses and transaction
costs) of the transaction is insignificant relative to the
reasonably expected net tax benefits ... In addition, a tax
avoidance transaction would be defined to cover certain
transactions involving the improper elimination or significant
reduction of tax on economic income.''
Simply presenting its definitions makes apparent how
troubling the proposal is. As is apparent from the definitions,
IRS agents would be empowered to recommend draconian penalties
on the basis of very subjective determinations. It is
disconcerting to think that the Treasury will be defining by
regulation such potentially broad terms as ``transaction,''
``reasonable expectation,'' and what is an ``improper
elimination or significant reduction of tax on economic
income'' in the context of ``tax avoidance transaction.''
Most troubling is the alternative definition of a tax
avoidance transaction. It could possibly include virtually any
transaction that an IRS agent chooses. In addition, it appears
that existing precedents and defenses otherwise available to
taxpayers to defend the legitimacy of a transaction may not be
available under this definition. To combine a definition of
such breadth and subjectivity as the alternative with a
doubling of the substantial underpayment penalty is to create
an enormous potential for IRS abuse. The threat of raising the
tax avoidance issue would give IRS agents enormous leverage to
force concessions on other items in dispute, apart from the
direct impact of the provision.
2. Deny certain tax benefits to persons avoiding income tax as
a result of tax-avoidance transactions.
The Administration is proposing to expand the scope of
section 269 of the Code by adding a provision authorizing the
disallowance of any deduction, credit, exclusion, or tax
benefit obtained in a tax avoidance transaction. Under current
law, section 269 provides that where a person gains control of
a corporation or a corporation acquires carryover basis
property and the principal purpose of the acquisition is the
evasion or avoidance of federal income tax by creating a
deduction, credit, or other tax benefit, the benefit may be
disallowed to the extent necessary to eliminate the evasion or
avoidance.
Once again, the Administration proposes the creation of
punitive provision whose breadth and scope is breathtaking.
Essentially, any corporate acquisition resulting in ``an
improper elimination or significant reduction of tax on
economic income'' could have any of the resulting tax benefits
denied by the IRS. According to the Administration, the IRS
should be given the statutory right to restructure any
corporate acquisition where, in the IRS view, the taxpayer has
obtained too much tax benefit.
3. Deny deductions for certain tax advice and impose an excise
tax on certain fees received.
Under current law, fees paid by corporations for tax advice
are deductible as an ordinary and necessary business expense.
The Administration is seeking to eliminate the deductibility of
fees paid by corporations for advice with respect to the
purchase and implementation of ``tax shelters'' or related to
``tax shelters.'' The proposal would also impose a 25 percent
excise tax on fees received with respect to corporate tax
shelter advice and related to implementing corporate tax
shelters (including underwriting fees). If a taxpayer claims a
deduction for a fee, whose deductibility is eliminated by this
proposal, that deduction would be subject to the substantial
underpayment penalty.
This is a singularly insidious proposal because it is
doubly punitive and because the chilling effects of the
ambiguities within the term ``tax shelter'' would impact both
the corporate client and its professional advisers. Many
legitimate transactions may not be done or may be done only
after very expensive intellectual agonizing and the imposition
of additional risk-based fees. This provision is another
indication of the Administration's overreaction to the current
marketing of aggressive tax advice by some tax advisers. The
Administration has chosen to terrorize corporate America with a
carpet bombing campaign to eliminate the threat of tax
shelters, instead of using the perfectly adequate weapons of
current law to surgically attack the problem.
4. Impose excise tax on certain rescission provisions and
provisions guaranteeing tax benefits.
The Administration would impose on corporations an excise
tax of 25 percent on the maximum payment under a recession or
insurance agreement entered into in connection with a corporate
tax shelter. The maximum payment would be the aggregate amount
the taxpayer would receive if the tax benefits of the corporate
tax shelter were denied. The Treasury report states that if,
for example, the taxpayer pays $100 for a guarantee of the tax
treatment of a transaction and the tax benefits are valued at
$10,000 under the guarantee, the taxpayer would owe an excise
tax of $2,500 automatically even if the IRS subsequently denies
only $5,000 of the tax benefits.
This is another purely punitive provision and it will also
have the effect of disrupting legitimate business transactions
and relationships. Ironically, it differs from the previous
proposals in that a punitive tax would be imposed in the
situation where a tax adviser is sufficiently confident that he
has provided sound tax advice that he is willing to stand
behind it with a guarantee.
It is the strongly held view of ACB that the foregoing
provisions could add significant cost and compliance burdens to
an already overly complex tax burden faced by our members. The
definitions are ambiguous and overly broad and ACB is concerned
that this approach may be intentional. ACB is concerned that
the Administration may intend these provisions to have a
chilling effect on aggressive tax planning at its inception.
Such an intention, if it were to exist, would amount to virtual
tax terrorism. The Administration already has an array of
effective Code provisions and court precedents to combat tax
shelters and we urge the Committee to reject these ill-
considered proposals.
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, Tax Counsel at ACB,
at 202-857-3125.
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 2000 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 Fiscal Year 2000 budget proposal
contains a number of provisions of interest to banking
institutions. Although we would welcome certain of those
provisions, we are once again deeply concerned with a number of
the Administration's revenue raising measures. Many of the
subject revenue provisions are, in fact, thinly disguised tax
increases rather than ``loophole closers.'' As a package, they
could inhibit job creation and inequitably penalize business.
The package may also lead to the reduction of employee and
retiree benefits provided by employers.
Our views on the most troubling provisions are set out
below.
REVENUE INCREASE MEASURES
Modify the Corporate-Owned Life Insurance Rules
The ABA strongly opposes the Administration's proposal to
modify the corporate-owned life insurance rules. We urge you
not to enact any further restrictions on the availability of
corporate owned life insurance arrangements. We believe that
the Administration's proposal will 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, and its continued use was effectively ratified
by the Tax Reform Act of 1997. In this connection, taxpayers
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.
Moreover, federal banking regulators recognize that
corporate-owned life insurance serves a necessary and useful
business purpose. Bank regulatory 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 subject provision would effectively eliminate the use
of corporate owned life insurance to offset escalating employee
and retiree benefit liabilities (such as health insurance,
survivor benefits, etc.). It would also penalize companies by
imposing a retroactive tax on those that have purchased such
insurance. Cutbacks in such programs may lead to the reduction
of benefits provided by employers. We urge you to, once again,
reject this revenue proposal.
S Corporations--Repeal Section 1374 for Large 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 create a
corporate level tax on BIG assets while also creating a
shareholder level tax with respect to their stock. The BIG tax
would apply to gains attributable to assets held on the first
day, negative adjustments due to accounting method change,
intangibles such as core deposits and excess servicing rights
and recapture of the bad debt reserve.
Financial institutions have only recently been allowed by
Congress to elect subchapter S status. Effectively, this
proposal would close the window of opportunity for them to
elect sub S by making the cost of conversion prohibitively
expensive for the majority of eligible banks, which we believe
is contrary to congressional intent. We urge you to reject the
Administration's proposal and to enact legislation that would
assist community banks in qualifying under the current rules.
Increased Information Reporting Penalties
The ABA strongly opposes the Administration's proposal to
increase penalties for failure to file information returns. The
Administration reasons that the current penalty provisions may
not be sufficient to encourage timely and accurate reporting.
We disagree. The banking industry prepares and files a
significant number of information returns annually in good
faith for the sole benefit of the Internal Revenue Service
(IRS). The suggestion that the Administration's proposal closes
``corporate loopholes'' presumes that corporations are
noncompliant, a conclusion for which there is no substantiating
evidence. Further, there is no evidence available to support
the assertion that the current penalty structure is inadequate.
Certainly, the proposed increase in penalty is unnecessary and
would not be sound tax policy. We urge you to once again reject
this revenue proposal.
Substantial Understatement Penalties
The ABA opposes the Administration's proposals to modify
the substantial understatement penalty. The proposed increases
would be overly broad and would penalize innocent mistakes and
inadvertent errors. The establishment of an inflexible standard
would effectively discourage legitimate ``plain vanilla''
business tax planning. We urge you to reject this revenue
proposal.
Eliminate Dividends-Received Deduction for Certain Preferred Stock/
Modify the Rules for Debt-Financed Portfolio Stock
The ABA strongly opposes the Administration's proposals to
deny the dividends-received deduction for non-qualified
preferred stock and to modify the standard for determining
whether portfolio stock is debt financed. The Administration
states that taxpayers have taken advantage of the dividends
received deduction for payments on instruments that
economically appear to be more akin to debt. We disagree. The
ABA, along with other members of the financial services
community, has steadfastly opposed all attempts to further
limit the dividends received deduction.
The dividends-received deduction currently reduced the
impact of the multiple level taxation of earnings from one
corporation paid to another and should not be considered a
``corporate loophole.'' Eliminating the deduction for certain
preferred stock would create a multiple level corporate tax
with respect to such stock. We urge you to oppose the
Administration's proposal.
The proposal to modify the rules for debt-financed
portfolio stock should also be rejected. In an attempt to
tighten the ``directly attributable'' standard, the
Administration proposes a pro rata formula that would be overly
inclusive and would effectively eliminate the dividends
received deduction for financial institutions.
Additionally, the subject proposals would also effectively
increase state tax liabilities for institutions that file
separate state tax returns with respect to subsidiaries
operating in certain states as the federal taxable income
amount is used in calculating state tax liabilities. We
strongly urge that these proposals be rejected.
Expand Reporting of Cancellation of Indebtedness Income
The Administration's budget proposes to require that
information reporting on discharges of indebtedness be done by
any entity involved in the business of lending money. The ABA
opposes this proposal, as it would increase the administrative
burdens and costs borne by credit card companies and other
financial institutions. We urge you to reject the
Administration's proposal.
Environmental Taxes
The ABA opposes the proposal to reinstate environmental
taxes. We believe the burden of payment of the taxes will fall
on current owners of certain properties (who may in many
instances be financial institutions) rather than the owners at
the time the damage occurred. It would, thus, impose a
retroactive tax on innocent third parties. In any event, such
taxes would be better considered as part of overall program
reform legislation. We urge you to reject the Administration's
proposal.
Require Current Accrual of Market Discount
The ABA opposes the Administration's proposal to require
current accrual of market discount by accrual method taxpayers.
This proposal would not only increase administrative complexity
but would raise taxes on business unnecessarily. We urge you to
reject the Administration's proposal.
Modify Treatment of Start-up and Organizational Expenses
The Administration's proposal would lengthen the
amortization period for start-up and organizational expenses in
excess of $55,000 from 5 to 15 years. Such change could have a
negative impact on the formation of small financial
institutions as well as financial services entities, which
typically involve start-up costs well in excess of the
threshold amount. We urge you to reject the Administration's
proposal.
Limit Tax Benefits for Lessors of Tax-Exempt Use Property
The ABA opposes the Administration's actions with respect
to tax-exempt use property. Recent IRS action in this area
would retroactively impact agreements that were entered into in
accordance with the requirements of the Internal Revenue Code.
Since this proposal is subject to congressional action, we
believe that any change to the current treatment of such
transactions should be prospective. We believe action by the
Service is not appropriate at this time.
Subject Investment Income of Trade Associations to Tax
The ABA strongly opposes the Administration's proposal to
tax the net investment income of trade associations. The
proposal would impose a tax on all passive income such as
interest, dividends, capital gains, rents, and royalties. It
would not only impact national organizations but smaller state
and local associations as well. In many instances, dues
payments represent a relatively small portion of an
association's income. Associations maintain surpluses to
protect against financial crises and to provide quality service
to members at an affordable cost. Indeed, it is used to further
the exempt purposes of the organization.
The Administration's proposal would impose an overly broad,
and ill conceived tax on well managed trade associations that
would directly affect their ability to continue to provide
services vital to their exempt purpose. We urge you to reject
the Administration's proposal.
Other Issues
The Administration's proposal contains a number of other
provisions, which will negatively impact many different types
of appropriate business activities. Some are overly broad,
which may have unintended consequences in the long and short
term. We strongly urge you to reject the following provisions.
Extend section 265 pro rata disallowance of tax-
exempt interest expense to all corporations
Modify treatment of ESOP as S corporation
shareholder
Impose excise tax on purchase of structured
settlements
Penalty increases with respect to corporate tax
shelters
Limit inappropriate tax benefits for lessors of
tax exempt use property
Require banks to accrue interest on short-term
obligations
Modify and clarify straddle rules
Tax issuance of tracking stock
Modify the structure of businesses indirectly
conducted by REITs
Modify the treatment of closely held REITs
Deny deduction for punitive damages
Treat certain foreign-source interest and
dividends equivalents as U.S.-effectively connected income
Recapture overall foreign losses when controlled
foreign corporation stock is disposed
Increase section 4973 excise tax on excess IRA
contributions
The impact of the above provisions will affect businesses
in various ways, depending upon their structures. Some of the
consequences are foreseeable; others are unforeseeable. One
result may be a restriction or change in products and services
provided to consumers. Another may be a restriction on the
ability of financial institutions to compete globally.
TAX INCENTIVE PROPOSALS
Educational Assistance
The ABA supports the permanent extension of tax incentives
for employer provided education. The banking and financial
service industries are experiencing dramatic technological
changes. This provision 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 used to recruit and retain vital
employees.
Research and Experimentation Tax Credit
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 and services in order to compete in an
increasingly sophisticated and global marketplace. The proposal
would extend sorely needed tax relief in this area.
Individual Retirement Accounts
The ABA fully supports efforts to expand the availability
of retirement savings. We are particularly pleased that the
concept of tax-advantaged retirement savings has garnered long-
standing bi-partisan support and that the Administration's plan
contains many significant proposals to encourage savings.
Low-income Housing Tax Credit
The ABA supports the proposal to raise the $1.25 per capita
cap to $1.75 per capita. This dollar value has not been
increased since it was first set in the 1986 Act. Raising the
cap would assist in the development of much needed affordable
rental housing in all areas of the country.
Qualified Zone Academy Bonds
The ABA supports the proposal to authorize the issuance of
additional qualified zone academy bonds and school
modernization bonds and to modify the tax credit bond program.
The proposed changes would facilitate the usage of such bonds
by financial institutions in impacted areas.
CONCLUSION
The ABA appreciates having this opportunity to present our
views on the revenue raising provisions contained in the
President's fiscal year 2000 budget proposal. We look forward
to working with you in the future on these most important
matters.
Statement of American Council of Life Insurance
The American Council of Life Insurance (ACLI) is strongly
opposed to the totally unwarranted $7 billion tax increase on
life insurance companies and products in the Administration's
Fiscal Year 2000 Budget Proposal. As 31 members of this
Committee have already recognized, these proposals would
seriously threaten the hopes of millions of Americans for a
financially secure retirement and jeopardize the financial
protection of families, businesses and family farms.
The Council is pleased to provide this statement
representing, for the first time in twenty years, a life
insurance industry fully united on all tax issues affecting our
industry. For many years we have been told by members of this
Committee that the industry's voice on tax issues is weakened
by the disagreements among the stock and mutual segments. Last
month, however, there was an historic change--the end of the
long-standing stock and mutual differences. With one voice now,
the Council declares that there is no justification for
provisions of the Code that separately tax stock and mutual
life companies. With one voice now, the Council opposes any
increase in taxes on any industry segment. With one voice now,
the Council demonstrates that our industry already pays more
than its fair share of taxes, and the Administration's
proposals are both totally unjustified and bad tax policy. We
are also pleased that the National Association of Life
Underwriters supports the Council in this statement.
The nearly 500 company members of the ACLI offer life
insurance, annuities, pensions, long term care insurance,
disability income insurance and other retirement and financial
protection products. Our members are deeply committed to
helping all Americans provide for a secure life and retirement.
Two of the proposals in the Fiscal Year 2000 Budget
Proposal would make annuities and life insurance more expensive
for individuals and families struggling to save for retirement
and protect against premature deaths. Annuities are the only
financial product that provides guarantees against outliving
one's income. Life insurance is the only product that gives
security to families should a breadwinner die prematurely.
Another proposal could wipe out a financial product that
protects businesses and allows them to provide employee
benefits, including retiree health benefits.
The proposals do not make sense, and represent a retreat by
the Administration from its stated goal of encouraging all
Americans to take more personal responsibility for their income
needs in retirement and at times of unexpected loss. They also
seem to reflect a failure to understand the important role life
insurance products play in the retirement and protection plans
of middle-income Americans. ACLI member companies strongly
support fixing Social Security first, but they are convinced
that it will be impossible to reach this goal in the absence of
a strong and vital private retirement and financial security
system. Tax proposals that weaken that system are misguided and
contradictory.
Contrary to the Administration's perception, life insurance
companies already pay federal taxes at a rate which is
significantly higher than the rate for all U.S. corporations.
Additional federal taxes would unfairly increase that already
high tax burden. A recently completed study by Coopers &
Lybrand shows that life insurers paid $54.4 billion in Federal
corporate income taxes from 1986-1995. The average effective
tax rate for U.S. life insurers over that ten year period was
31.9%, significantly higher than the 25.3% average effective
rate for all U.S. corporations. Moreover, the effective rate
rose sharply during the ten-year study period, from 23.9%
between 1986 and 1990, to 37.1% between 1991 and 1995, with the
imposition of the DAC tax in 1990 (described below).
The Administration Budget Proposal for Fiscal 2000 contains
many unwarranted tax increases on life insurance products,
policyholders and companies. The major increases include:
PROPOSAL TO INCREASE DAC TAX ON ANNUITIES AND LIFE INSURANCE
In addition to paying regular corporate income taxes, life
insurers must pay a tax based on gross premiums from the sales
of their products, including life insurance and annuities. This
tax is known as the DAC tax. This new tax was imposed in 1990
to serve as a proxy for the amount of expenses life companies
incur to put life and annuity policies on their books. Under
the DAC tax, these expenses are no longer tax deductible in the
year paid; rather the deduction is spread over a ten year
period. (The acronym DAC stands for deferred acquisition
costs.) The DAC tax is an arbitrary addition to corporate
income tax calculated as a percentage of the net premiums
attributable to each type of policy. It was not logically
defensible in 1990, and is not now. The Administration proposes
to triple the DAC tax on annuities, nearly double the tax on
individual whole life insurance, raise the tax on group whole
life six-fold and also increase other DAC taxes.
ACLI RESPONSE:
An Increase in the DAC Tax on Annuities and Life
Insurance Would Make Important Protection and Retirement
Savings Products More Expensive. Today Americans are living
longer than ever before and our aging population is putting
more pressure on already-strained government entitlement
programs. Consequently, individuals must take more
responsibility for their own retirement income and protection
needs. Adding taxes based on the premiums companies receive for
retirement and protection products will lead directly to higher
prices and undermine Americans' private retirement and
protection efforts.
The Administration Proposal Represents a Thinly
Disguised Tax Increase on Policyholders and an Attack on Inside
Build-up. The proposed DAC tax increase falls principally on
annuities and whole life insurance, both individual and group.
These are the products that allow policyholders to accumulate
earnings to fund the costs of insurance in the later, more
expensive years of the policy. The inside build-up is taxed if
cash is withdrawn from the policy. This tax treatment
represents sound social and tax policy designed to encourage
individuals to purchase these important retirement and
protection products. The increase in the DAC tax on annuities
and whole life insurance is an attempt to tax indirectly the
policyholders' inside build-up on these products, contrary to
sound tax policy. The tax will certainly have that effect on
policyholders through increased costs and lower returns.
The Tax System Prior to Enactment of the 1990 DAC
Tax Already Deferred Life Insurers' Deductions for Acquisition
Costs through Reduced Reserve Deductions. It is Inappropriate
to Further Extend this Unfair ``Double Deferral'' Scheme. In
1984, Congress reduced companies' reserve deductions by a
formula that effectively defers deductions for policy
acquisition costs. Thus, the DAC tax was unnecessary in 1990
and should not be increased in the 21st century. No insurance
accounting system (GAAP or state regulatory) requires both the
use of low reserves and deferral of deductions for policy
acquisition expenses. Treasury specifically cites the GAAP
system as a model for requiring deferred deductions for
acquisition costs, but ignores the fact that GAAP does not also
require reduced reserve deductions.
PROPOSAL TO TAX POLICYHOLDERS SURPLUS ACCOUNTS
Prior to the Tax Reform Act of 1984, shareholder-owned life
insurance companies established policyholders surplus accounts
(PSAs), reflecting a portion of their operating gains that were
not subject to tax. PSA amounts would be taxed only if such
amounts were deemed distributed to shareholders or the company
ceased being a life insurance company. In 1984, Congress
completely rewrote the structure of taxation of life insurance
companies to tax them on a comprehensive income basis. As part
of that thorough rewrite, Congress decided to eliminate further
additions to PSAs. Congress also concluded that the shareholder
distribution trigger for taxing PSAs would be maintained. The
Administration now proposes to force life companies to include
these tax accounts in income and pay tax on the PSA over a ten
year period.
ACLI RESPONSE:
The Administration Proposal Is a Retroactive Tax
and a Violation of Fair Tax Treatment. To reach back for tax
revenues on long-past operating results, some from nearly 40
years ago, is wrong. Congress addressed the tax treatment of
policyholders surplus accounts 15 years ago. In fact, the
Committee Reports to the 1984 Tax Reform Act specifically
provide that life insurance companies ``will not be taxed on
previously deferred amounts unless they are treated as
distributed to shareholders or subtracted from the
policyholders surplus account under rules comparable to those
provided under the 1959 Act.'' Such arbitrary efforts to
retroactively change the tax rules applicable to old operations
reveals a desperate revenue grab by Treasury.
The Administration Proposal Inappropriately
Resurrects Tax Code Deadwood. The policyholders surplus account
(Section 815 of the tax code) is merely a tax accounting
mechanism or record in the practical operations of life
insurance companies. There are no special untaxed assets set
aside in a vault available to pay this unanticipated tax. In
fact, the accountants have concluded that under state statutory
and GAAP accounting rules that govern shareholder-owned life
insurance companies, Section 815 accounts would very rarely, if
ever, be triggered, and, if so, would be triggered only by
activities under the control of the taxpayer. Thus, statutory
and GAAP accounting conclude that the potential tax liability
under Section 815 should be disregarded for accounting
purposes. No one could conceive that Treasury would resurrect
this deadwood. Only now, when Treasury needs to fill out its
budget, is the deadwood brought to life.
The Administration Proposal Creates Immediate Full
Loss of Shareholder Value, in Addition to Tax Hit. Should this
proposal become law, shareholder-owned life insurance companies
would be hit first when forced to pay tax over a ten-year
period out of the earnings and assets that would otherwise be
used to do business and protect policyholders. The companies
would also be forced to record immediately the new, full tax
liability on their public accounting reports to shareholders.
This creates an immediate loss to shareholders of the entire
amount of the new tax, not just the first year payment.
The Administration Reasoning Relating the PSAs to
Specific Policies is Specious. There is not now, and never has
been, any relationship between liabilities under specific
policies and additions to PSAs that took place prior to 1984.
Thus, Treasury is disingenuous when it suggests that taxing
PSAs now would cause no harm to policyholders from a past era.
What the new tax will do is affect the return to current
policyholders since this is a tax that must be paid from
current operations.
PROPOSAL TO TAX BUSINESS LIFE INSURANCE
In 1996, Congress eliminated the deductibility of interest
paid on loans borrowed directly against business life insurance
(policy loans), except in very limited circumstances involving
grandfathered policies and policies covering key individuals.
In 1997, Congress further limited deductions for interest on
unrelated business borrowing if the business owns life
insurance. This most recent tax penalty does not apply to
contracts covering employees, officers, directors and 20-
percent owners. The Administration now proposes to place an
additional tax on companies that borrow for any purpose if
those companies also own life insurance, including key employee
insurance. The proposal would also increase taxes on companies
that borrow directly against life insurance policies covering
key employees. This proposal would destroy the carefully
crafted limitations created in the 1996 and 1997 legislation by
eliminating most key persons as defined in the 1996 Act and
eliminating employees, officers and directors from the 1997 Act
provisions.
ACLI RESPONSE:
Further changes in the tax treatment of business life
insurance are unnecessary and would unfairly disrupt the
fundamental protection and benefit plans of many businesses.
Far from a ``tax shelter'' as Treasury contends, business life
insurance is a product that protects businesses, especially
small businesses, and allows all businesses to provide employee
benefits, including retiree health benefits. The proposal would
eliminate the use of business life insurance in providing those
protections and benefits.
The Proposal Is Anti-Business Expansion. Under the
proposal, the mere ownership of a whole life insurance policy
on the president of a company could result in additional tax to
that company. This additional tax would be imposed against
loans that bear no relation to any borrowing from the life
insurance policy, but rather would result from normal business
borrowing for expansion and similar fundamental purposes. There
is no good reason why the mere ownership of a policy on the
employees, directors or officers of the firm should result in a
tax penalty on unrelated borrowing. The businesses affected by
this proposal will have to choose between protecting themselves
against the premature death of a valued employee, officer or
director, and borrowing to increase their business. This forced
choice between valid, unrelated business needs is bad tax and
economic policy.
Key Person Direct Borrowing Exception Is
Important. In 1996, Congress reviewed the taxation of policy
loans borrowed directly from life insurance policies. As a
result of this review, substantial restrictions were placed on
this borrowing, limiting it to coverage on a small number of
key employees. The present proposal ignores this review and
crafts new and more draconian limitations. There is no
rationale for changing from the 1996 legislation to the current
proposal. The key person exception is especially important to
allow small businesses access to their limited assets.
Mere Ownership Of A Policy On An Employee, Officer
Or Director Should Not Result In A Tax Penalty. In 1997,
Congress reviewed the taxation of borrowing unrelated to life
insurance policies where the business also happened to own life
insurance. As a result of this review, a tax penalty was
imposed on companies that have loans unrelated to the life
insurance policy if the policy covers customers, debtors and
other similar insureds. Coverage of employees, officers,
directors and 20-percent owners was specifically exempt from
this penalty. There is no rationale for changing from the 1997
legislation to the current proposal under which policies on
employees, officers and directors can result in a tax penalty.
Protection of valuable workplace human capital assets is
crucial to business and should not be penalized.
Protecting Against Loss Of Valuable Employees Is
Fundamental To Business Operations. Just as businesses rely on
insurance to protect against the loss of property, they need
life insurance to minimize the economic costs of losing other
valuable assets, such as employees. This is especially
important with respect to small businesses, the survival and
success of which often rest with their key employees. Without
access to permanent life insurance at a reasonable cost,
companies may not have the capital necessary to keep operations
afloat after the loss of such assets. The proposal can well
make that cost in excess of what a business can afford.
Businesses Need Employee Coverage To Fund Retiree
Benefits. Corporations frequently use life insurance as a
source of funds for various employee benefits, such as retiree
health care. Permanent life insurance helps make these benefits
affordable. Loss of interest deductions on unrelated borrowing
is an inappropriate tax penalty that will force these companies
to reduce employee and retiree benefits funded through business
life insurance.
The Administration ``Arbitrage'' Reasoning is
Specious and Masks an Unwarranted Attempt to Tax Inside Build-
Up. Any further tax changes to business life insurance target
the current treatment of inside build-up on permanent life
insurance. The effect of denying general interest deductions by
reference to the cash value of life insurance is to tax the
cash value build-up in the permanent policy. Allowing general
business interest deductions to accompany mere ownership of
life insurance cash values does not represent tax arbitrage and
is fully consistent with general tax and social policy. For
example, a business that uses commercial real estate as
collateral for a loan does not lose the deduction of loan
interest even though the property's value consists of
appreciation and even though the tax on that appreciation is
deferred until the property is sold. Additionally, the rate of
tax on any gain is the lower capital gains rate. Similarly,
other business tax benefits, such as the research and
development tax credit, do not result in a loss of interest
deductions when a firm borrows for normal business purposes.
The Administration's arbitrage reasoning is plainly
inappropriate because if applied to an individual it would
cause the loss of home mortgage interest deductions when a
taxpayer also owns permanent life insurance.
Statement of American Insurance Association
INTRODUCTION
The American Insurance Association (AIA) is a national
trade association representing more than 300 major insurance
companies that provide all lines of property and casualty (P&C)
insurance nationwide and globally.
AIA appreciates having this opportunity to comment on the
revenue proposals in the Administration's' fiscal year 2000
budget. AIA's concerns with these proposals can be grouped into
three categories, as follows:
P&C insurer-targeted proposal (i.e., increasing
the ``proration'' of tax exempt interest and certain dividends
received by P&C insurers from 15% to 25%);
Broader proposals opposed by AIA (i.e.,
reinstating Superfund excise taxes and corporate environmental
income tax (EIT); requiring the current accrual of market
discount; denying a deduction for punitive damages; increasing
information reporting penalties; taxing the investment income
of section 501(c)(6) trade associations); and
Tax changes supported by AIA (i.e., extending the
active financing income exception; imposing the excise tax on
structured settlements).
These comments principally address the adverse impacts of
the ``proration'' proposal, which is targeted at P&C insurers
(and, indirectly, the exempt bond market in which they
participate). However, AIA feels no less strongly about its
positions, described below, on extending the active financing
income exception, which otherwise will sunset this year, and
reinstating Superfund taxes.
In addition, AIA feels strongly, from an association
perspective, that it is time to put to rest for good the
proposal to tax the investment income of trade associations,
which was rejected by Congress in 1987.
P&C INSURER-TARGETED PROPOSAL
Proration of Tax Exempt Interest and Dividends Received
As part of its fundamental overhaul of the tax rules
governing P&C insurers, Congress in 1986 adopted the
``proration'' rule, effectively taxing a portion of P&C
insurers' exempt interest and dividend income.\1\ Congress
fixed this portion at the 15% level to generate additional
taxable income from P&C insurers, while maintaining such
insurers as viable investors in the market for municipal
bonds.\2\ This purpose was reaffirmed, in effect, when Congress
excluded insurers from a proposal in 1997 to disallow an
interest expense deduction with respect to a pro rata portion
of municipal bond earnings.\3\
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\1\ P&C insurers are major holders of tax-exempt municipal bonds.
In 1997, P&C insurers held some $180 billion (almost 14%) of the total
$1.3 trillion of outstanding exempt bonds.
\2\ These bonds--a vital source of capital for state and local
governments--are used to finance new public school construction, build
bridges, roads, and water and sewer systems, airports, and for a
variety of other traditional public uses.
\3\ The exemption is included in the pro rata interest disallowance
rule included in the Administration's fiscal year 2000 budget.
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Last year, the Administration unsuccessfully sought to
double the tax on exempt interest received by P&C insurers.
Treasury's stated rationale was that P&C insurers should be
treated more like other financial intermediaries, whose ability
to purchase municipal bonds already had been, as Treasury
stated, ``severely curtailed or eliminated.'' The
Administration, presumably persuaded last year that 30%
proration would have unacceptable impacts on the municipal bond
market, now proposes instead to hike P&C insurer proration to
25%. This proposal would be effective with respect to
investments acquired on or after the date of first committee
action.
Last year, AIA surveyed its membership to assess the
impacts of adopting the Administration's proration proposal.
Respondents to the survey, comprising almost 20% of total P&C
insurance industry premium volume and collectively holding
almost $39 billion of municipal bonds, confirmed that they
would buy fewer municipal bonds if the proposal was adopted,
unless municipal bond yields increased sufficiently.\4\ This
would, in turn, increase the costs of borrowing for state and
local issuers and the tax burden on state and local taxpayers,
with no discernible tax policy or public policy benefits.
Indeed, it was estimated last year that 75% of the total
additional taxes raised by the proration proposal would have
been borne by state and local governments, and ultimately
taxpayers, in the form of increased municipal bond yields.\5\
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\4\ A P&C insurer must match its investments with its liabilities,
so that the increased yield that such an insurer would need to invest
in municipal bonds under 25% proration, typically would not be realized
by changing the duration of the insurer's investment portfolio.
\5\ Municipal Market Comment, Friedlander & Mosley (Salomon Smith
Barney, February 6, 1998).
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It is obvious that a P&C insurer will not invest in a
municipal bond unless the investment yields a greater after-tax
return than a taxable bond. As a matter of arithmetic, this
``breakeven'' ratio, now 68.6%, would rise to 71.2% (relative
to U.S. Treasury securities) if the 25% proration proposal were
adopted. This already is perilously close to the typical market
yield spreads between exempt and taxable bonds, particularly in
the typical ``P&C maturity range'' (i.e., 10 to 20 years
maturity). As a practical matter, however, a P&C insurer will
invest in a municipal bond only when this yield ratio is
sufficiently in excess of this breakeven ratio to take account
of the significant risk premium that the municipal bond
carries. This risk premium arises from a number of liquidity,
tax and business risks, including the following:
Alternative investments. Even now, the municipal
bond market is illiquid relative to the markets for higher-
yielding, taxable P&C investments.
Capital gains rates. Reduced individual capital
gains rates have increased the attractiveness of equities for
these investors, further narrowing liquidity in the exempt bond
market.
``Grandfathered'' bonds. P&C insurers would be
reluctant to sell current exempt bond holdings,
``grandfathered'' under the proration proposal, significantly
narrowing liquidity in the exempt market.
Alternative buyers. Current tax rules make it
uneconomic, in general, for a P&C to invest in municipal bonds
at the shorter end of the maturity curve. If a P&C insurer's
costs increase in the P&C maturity range, where support from
retail investors and mutual funds is only occasional, it is
unclear that there would be any alternative market in this
range.
Regular tax rates. Corporate tax rates have
fluctuated widely over the past 10 to 15 years. The possibility
of reduced marginal tax rates is a significant risk factor for
a P&C insurer investing in a municipal bond in the P&C maturity
range.
Shifting proration rules. A P&C investor cannot
ignore the risk that the market will perceive the 25% proration
proposal as the latest in a series of continuing attempts to
erode the value of exempt interest, demanding an additional
risk premium across all sectors of the exempt market.
Tax restructuring. A P&C insurer purchasing a
municipal bond in the P&C maturity range, even today, cannot
ignore the risk that fundamental tax restructuring (e.g., a
flat tax, or national sales tax replacing the federal income
tax) might eliminate any tax incentive to hold such bonds.
Alternative minimum tax (AMT). For a P&C insurer,
adverse loss experience, including a single major catastrophic
event (e.g., Hurricane Andrew, the Northridge Earthquake), can
readily and dramatically change assumptions about underwriting
results. Where adverse underwriting results give rise to
liability for the AMT, a P&C insurer faces a significant
penalty on tax-exempt interest.\6\
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\6\ Exempt interest is now taxed to a P&C insurer at an effective
rate of 15.75%, well above the 5.25% effective tax rate under the
regular tax. While AMT credits may mitigate this penalty, they do not
eliminate it.
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State tax. Most states do not subject P&C insurers
to state income tax. Such insurers are subject instead to a
premium tax, which is a gross receipts tax on total direct
premiums received by the insurer. P&C insurers investing in
municipal bonds, in general, will realize reduced yields with
no tax benefit at the state level.
These risk factors increase significantly above the
``arithmetic breakeven ratio'' the market yield ratio that a
P&C investor must demand to purchase a municipal bond. As a
result, if proration increases, a P&C insurer would invest in a
municipal bond in the P&C maturity range only if yields
increased significantly (e.g., by an estimated 10 to 15 basis
points, under 30% proration \7\).
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\7\ Municipal Market Comment, Friedlander & Mosley (Salomon Smith
Barney, February 13, 1998).
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Even a small increase in the interest cost to municipal
finance would substantially increase the aggregate financial
costs to state and local governments of critical debt-financed
public works projects. Last year, the Bond Market Association
estimated that, if 30% proration had been in effect in 1997,
when some $207 billion in tax exempt securities were issued, it
would have cost issuers $2 to $3 billion over the life of their
issues (assuming an average 15-year maturity).
The proration proposal also would increase the taxation of
certain dividends received by a P&C insurer. This would reduce
financing options for U.S. companies, increase the costs of
capital, and reduce liquidity in domestic capital markets. For
these reasons, Congress has wisely rejected other proposals in
recent years to increase the taxation of dividends received.
The remaining tax burden of increased proration would be
borne by the P&C insurance industry and its policyholders.
There is no justification for singling-out this industry,
already bearing its fair share of the federal income tax
burden, for another tax hike. The 1986 and 1990 tax acts
imposed on P&C insurers a number of fundamental, targeted tax
law changes that significantly increased this industry's
federal tax burden. Studies of the 1986 changes, including
Treasury's own study, consistently reflect that the P&C
industry has substantially exceeded Congress' revenue
expectations. Other changes, including the taxation of
municipal bond interest under the AMT, which became more severe
in 1990, and the limitation in 1997 of the net operating loss
carryback period, further disproportionately burden P&C
insurers.
BROADER TAX PROPOSALS
Superfund Taxes
The Administration proposes to reinstate the Superfund
taxes that expired on December 31, 1995. However, the
authorization for the Superfund hazardous waste cleanup
program, which the taxes were intended to finance, expired at
the end of 1994, and the Administration has continued to block
all Congressional attempts to reauthorize and reform the
program. AIA would support the reinstatement of the taxes only
as part of comprehensive Superfund reform legislation, and only
if revenues from these taxes are used for hazardous waste
cleanup, and not to fund unrelated programs.
Market Discount
The Administration proposes to require the current accrual
of market discount on debt instruments. The proposal would be
effective for debt instruments acquired on or after the date of
enactment. P&C insurers must invest in debt securities and
equities to back loss reserves needed to meet obligations to
policyholders. AIA opposes this proposal because it would
impose additional costs and complexity \8\ on P&C insurers and
their policyholders. Significantly, the proposal would be
retroactive, in effect, because it would apply to bonds
``acquired'' (rather than ``issued'') after enactment, thereby
diminishing the value of a market discount bond in the existing
portfolio of an affected P&C insurer.
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\8\ The complexity of the provision also is a concern reflected in
the Description of Revenue Provisions Contained in the President's
Fiscal Year 2000 Budget A Proposal, prepared by the staff of the Joint
Committee on Taxation, at 207 (February 22, 1999).
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Punitive Damages
The Administration proposes to deny a deduction in all
cases where punitive damages are paid or incurred by the
taxpayer. In cases where the liability is covered by insurance,
the Administration proposes that the damages must be included
in the income of the insured and the insurer must report such
amounts to the insured and the IRS.
The Administration's proposal appears to assume that
punitive damages are generally covered by insurance. As a
general rule, however, punitive damages are not (and, in many
states, cannot be) covered by insurance.
In the typical civil litigation case, where insurance may
cover a settlement payment but not a punitive damages award,
this proposal would provide an incentive for a commercial
insured to settle, even at a higher amount, in order to avoid
the possibility of a punitive damage award. By driving up the
cost of settlements, the proposal would increase the costs of
insurance.
In the (unusual) case, where punitive damages are covered
by insurance, the proposal would impose a new information
reporting burden on P&C insurers, who are still struggling
(with no regulatory guidance) with the burdens and
uncertainties arising under the requirement, adopted in 1997,
to report ``gross proceeds'' payments to attorneys.
Information Reporting Penalties
The Administration proposes to increase the penalties for
failures to correctly file certain information returns from $50
per return to the greater of $50 or 5% of the amount required
to be reported (subject to certain exceptions). As applied to
the millions of Forms 1099-MISC that individual P&C insurers
must file for payments to third-party service providers (e.g.,
auto body repair shops), with whom they typically have no
account relationship and no prior dealings, this proposal would
impose additional costs with minimal compliance benefits.
Moreover, as applied to ``gross proceeds'' attorney reporting
required under the 1997 tax act, imposing this penalty as a
percentage of the amount required to be reported (much of
which, typically, will be a nontaxable claims payment) would
disproportionately burden P&C insurers.\9\
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\9\ Id. at 323.
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Investment Income Tax on Trade Associations
The Administration proposes to subject the investment
income of trade associations to the unrelated business income
tax (UBIT). For several reasons, AIA feels that this proposal,
wisely rejected by the Congress in 1987, should be firmly
repudiated this year.
If this proposal is adopted, affected trade
associations would need to increase member dues to pay the new
tax \10\ or reduce member services. The proposal would subject
to this Hobson's Choice--inexplicably and inequitably--exempt
trade associations that lobby, like AIA, but not other exempt
organizations that lobby.
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\10\ This would increase the tax deduction taken by members for
dues payments, and reduce any revenue raised by the proposal. In this
regard, Treasury estimates that this proposal would raise $1.44 billion
over five years, while the Joint Committee on Taxation estimates that
it would raise $700 million over the same period.
---------------------------------------------------------------------------
The purpose of UBIT is to avoid unfair competition
with respect to for-profit businesses. The taxation of a trade
association's passive investment income in no way addresses any
issue of competitiveness, however, nor has Treasury even
suggested that it does.
A tax exempt trade association's investment income
does not, and cannot, result in private inurement to any
private shareholder or individual. Rather, this income is
allocated to the association's operating budget, furthering its
exempt purposes (i.e., improving the business conditions of a
particular line of business).
For a trade association, which cannot access the
capital or credit markets, investment income can serve as a
vital buffer against instability during economic downturns. The
proposed tax, which would erode this buffer, would perversely
penalize associations for taking this prudent step.
TAX CHANGES SUPPORTED BY AIA
Active Financing Income Exception
The Administration's budget proposals provide for the extension of
six expiring provisions, but omit the active financing income exception
to subpart F of the Internal Revenue Code, which expires at the end of
1999. This provision, which helps to level the playing field with
respect to foreign multinational and local country competitors in
global markets, is essential to the competitiveness of U.S. insurers
seeking to enter or expand in those markets. It also is essential to
the equitable tax treatment of U.S. financial services industries
relative to other U.S. industries.
AIA endorses H.R. 681, which would achieve a permanent, stable tax
regime in this area. AIA agrees with comments on this issue filed with
the Committee (and joined in by AIA) by The Coalition of Services
Industries. At a minimum, this provision should be extended along with
other extensions of expiring provisions in the budget bill.
Structured Settlements
The Administration proposes to impose a 40% excise tax on persons
acquiring a payment stream (i.e., factoring) a structured settlement.
This proposal is similar to bills sponsored this year and last by Rep.
Shaw. The staff of the Joint Committee on Taxation has aptly described
the value of this proposal, as follows:
The proposal responds to the social concern that injured
persons may not be adequately protected financially in
transactions in which a long-term payment stream is exchanged
for a lump sum. Transfer of the payment stream under a
structured settlement arrangement arguably subverts the purpose
of the structured settlement provisions of the Code to promote
periodic payments for injured persons.\11\
---------------------------------------------------------------------------
\11\ Id. at 329.
AIA agrees that this proposal will help to maintain the
integrity of the structured settlement process.
CONCLUSIONS
AIA respectfully urges the Committee to reject the
Administration's budget proposals to:
increase the taxation of otherwise tax-exempt
income and certain dividends received,
reinstate Superfund excise taxes and the corporate
EIT,
require the current accrual of market discount on
bonds,
disallow a deduction for punitive damages,
increase information reporting penalties, and
tax the investment income of trade associations.
AIA also urges the Committee to extend the active financing
income exception under subpart F of the Code, and to adopt the
budget proposal to impose an excise tax on the ``factoring'' of
structured settlements.
AIA remains ready to assist the Committee in any way
possible to achieve these goals.
Statement of American Network of Community Options and Resources
(ANCOR), Annandale, Virginia
This testimony outlines the comments and suggestions of the
American Network of Community Options and Resources (``ANCOR'')
on the Administration's proposal to simplify the foster child
definition under the earned income tax credit (``EITC'').
Formed in 1970 to improve the quality of life of persons
with disabilities and their families by coordinating the
efforts of concerned providers of private support services,
ANCOR is comprised of more than 650 organizations from across
the United States together providing community supports to more
than 150,000 individuals with disabilities.
ANCOR supports the underlying goals of the Administration's
EITC proposal to clarify the scope of current tax law as it
applies to foster families. However, ANCOR also strongly
recommends that the proposal be drafted to reflect a proposed
amendment to Section 131 of the Internal Revenue Code of 1986,
as amended (the ``Code''). This amendment would eliminate
inequities and uncertainties of current law and uniformly allow
foster care providers to exclude from income the foster care
payments they receive from a governmental source. ANCOR
believes that amending Section 131 in this manner would (i)
support State and local government efforts to reduce
bureaucracy and costs, (ii) simplify the tax treatment of
foster care payments, and (iii) encourage much-needed foster
care providers to participate in foster care programs.
Description of Current Law and Administration's Proposal
I. Current law.
Section 32 of the Code allows a taxpayer to claim the EITC
if he or she lives with a child or grandchild for more than
half the year. In addition, a taxpayer may claim the EITC if he
or she lives with a ``foster child.'' ``Foster child'' is
defined as an individual who lives with the taxpayer for the
entire year and for whom the taxpayer cares as such taxpayer's
own child. To qualify for the EITC, the individual must be (i)
younger than 19 years of age if not a full time student, (ii)
younger than 24 years of age if a full time student, or (iii)
any age if permanently and totally disabled. Section 32 does
not require that a foster child for whom a family takes the
EITC be placed in the household by any particular type of
foster care agency.
II. Administration's proposal.
For purposes of qualifying for the EITC under Section 32,
the Administration proposes defining ``foster child'' to
include, inter alia, children (or disabled individuals) placed
in the taxpayer's home by an agency of a State, one of its
political subdivisions, or tax-exempt child placement agency
licensed by a State. This language tracks the language in
Section 131, another Code provision relating to taxation of
foster families.
Analysis of the Administration's Proposal
I. The Administration's proposal would help clarify who
qualifies for the EITC under Code Section 32.
We believe that clarifying who qualifies as a foster child
or individual as suggested by the Administration will help
prevent the unintentional mistakes of countless taxpayers who
now question whether their situations meet the qualifications
of Section 32. Additionally, such clarifying changes would
provide qualifying foster care providers with an adequate
guarantee of their eligibility to take the EITC. Clarity would
also help reduce the expense qualifying foster care providers
often incur when they are forced to prove that they have
claimed the EITC lawfully. Any such clarifying amendments,
however, should parallel those proposed for Section 131, as
explained below.
II. Congress should further clarify the tax treatment of foster
care payments by amending Code Section 131.
Defining the term ``foster child'' as it applies to the
EITC is only a first step in simplifying the complicated tax
rubric associated with the provision of foster care services.
Additional changes should be made to Section 131 of the Code,
which creates a dichotomy in the tax treatment of foster care
providers for individuals under 19 years of age and those who
provide treatment to individuals over 19 years of age. These
Section 131 changes should also be applied to the treatment of
a ``foster child'' under Section 32.
For children under 19 years old, Section 131 of the Code
currently permits foster care providers to exclude foster care
payments from taxable income when a government entity or
charitable tax-exempt organization directly places the
individual and makes the foster care payments. For individuals
19 years of age or older, Section 131 excludes foster care
payments from taxable income only when a government entity
makes the placement and the payment. Thus, the excludability of
foster care payments, even though such payments are derived
from government funds, is linked to the type of agency that
places the individual with a foster care provider.
This inflexible and dated treatment of taxpayers who
provide services to children and special needs individuals has
become more evident as foster care placement has developed as a
preferred means of service provision to many individuals. In
addition to the benefits this form of service produces for
special needs individuals, foster homes have proven their
efficacy for these individuals when compared to institutional
services and are a growing choice of State and local
governments. Governmental entities have found that foster care
provides better service to certain special needs individuals
and is less expensive and onerous for them to maintain. This
type of residential alternative also adds to the available
stock of community housing and expands the availability of
qualified individuals to provide support to both adults and
children with disabilities.
A realization that foster care placement is the best
solution in certain circumstances, added with a desire to
reduce government involvement in the day-to-day placement and
service decisions, has resulted in governmental agencies
becoming more reliant on private agencies to arrange foster
care services for both children and adults. The private sector
continues to play an important and growing role on behalf of
government by arranging for and supervising these homes through
licensing or certification by State or local governments.
Congress should amend Section 131 to allow all foster care
providers the ability to exclude from income foster care
payments received from a governmental source regardless of
whether a governmental entity placed the foster child, as long
as a governmental entity has either certified or licensed the
placement agency. Amending Section 131 in such a way would not
only support the efforts of State and local governments to
address the needs of their communities more effectively, but
would also simplify the treatment of foster care payments and
reduce the administrative burden of the Internal Revenue
Service (``IRS'').
A. Current law fails to support the decisions of State and
local governments.--Governmental entities are becoming
increasingly reliant on private agencies to place both children
and special needs adults in foster care. In particular,
governmental entities have found that foster care for special
needs adults reduces the expense that is usually incurred when
maintaining group homes and institutional settings.
Additionally, State and local governments often use outside
entities to make case-specific decisions (such as
identification of those individuals who would benefit from
foster care and those foster care families with whom such
individuals should be placed) as a means of reducing
bureaucracy in an already trying situation. Current law,
however, fails to provide the same tax treatment to those
foster care families identified by private entities acting
under a license or certification with States, counties and
municipalities as is provided to foster care families that are
identified directly by the State. Disparate treatment exists
despite the fact that from the governmental entities'
perspectives, the activities are the same. As a result of the
difference in treatment, State and local governments are
discouraged from contracting with private agencies to make
placement decisions. The tax code should support State and
local governments that decide to cut costs, reduce bureaucracy
and support the special needs individuals in their communities
through expanding their foster care programs.
B. Current law is confusing to taxpayers and to the IRS.--
As illustrated by Table 1, incongruent treatment of foster care
providers has created a complex system of determining when
providers can exclude their foster care payments from income.
Table 1--Excludability of Foster Care Payments from Income Under Section 131
----------------------------------------------------------------------------------------------------------------
Age of Foster Care
Placement Agency Payor Individual Payment Excludable?
----------------------------------------------------------------------------------------------------------------
State or political subdivision...... State or political <19 years.............. Yes
subdivision.
State or political subdivision...... State or political 19 years.... Yes
subdivision.
State or political subdivision...... 501(c)(3)............... <19 years.............. Yes
State or political subdivision...... 501(c)(3)............... 19 years.... No
State or political subdivision...... Not 501(c)(3)........... <19 years.............. No
State or political subdivision...... Not 501(c)(3)........... 19 years.... No
Licensed 501(c)(3).................. State or political <19 years.............. Yes
subdivision.
Licensed 501(c)(3).................. State or political 19 years.... No
subdivision.
Licensed 501(c)(3).................. 501(c)(3)............... <19 years.............. Yes
Licensed 501(c)(3).................. 501(c)(3)............... 19 years.... No
Licensed 501(c)(3).................. Not 501(c)(3)........... <19 years.............. No
Licensed 501(c)(3).................. Not 501(c)(3)........... 19 years.... No
Not 501(c)(3)....................... State or political <19 years.............. No
subdivision.
Not 501(c)(3)....................... State or political 19 years.... No
subdivision.
Not 501(c)(3)....................... 501(c)(3)............... <19 years.............. No
Not 501(c)(3)....................... 501(c)(3)............... 19 years.... No
Not 501(c)(3)....................... Not 501(c)(3)........... <19 years.............. No
Not 501(c)(3)....................... Not 501(c)(3)........... 19 years.... No
----------------------------------------------------------------------------------------------------------------
The confusion presented by current law was exemplified by
the recent decision in Micorescu v. Commissioner, T.C. Memo
1998-398. In Micorescu, the Tax Court held that an Oregon
family providing foster care services to adults in the family's
home could not exclude from income payments received from the
private agency that placed the foster individuals with the
family. The court reasoned that because the adult foster
individuals were placed with the family by a private agency
rather than by the State or an agency of the State, the foster
individuals were not ``qualified foster individuals'' within
the meaning of Section 131. The court reached this conclusion
even though the organization that placed the adults in the
family's home both contracted with and received funds from the
State of Oregon. Equal treatment of all foster care families
(i) who receive payments from an agency that operates under a
license or certification by a government entity or (ii) who
receive payments directly from a government entity would reduce
the confusion that currently exists. Foster families, like the
family involved in the Micorescu case, would know with
certainty whether they could exclude their income.
Taxpayers are not alone in their confusion. Section 131 has
proven so confusing, in fact, that IRS officials and
experienced certified public accountants and tax attorneys also
have difficulty ascertaining when a payment is excludable. Our
members can site various examples of situations in which foster
care providers have been told informally by an IRS official
and/or an experienced tax advisor that their foster care
payments were to be excluded from taxable income, when in fact
those payments were not excludable. Amending Section 131 would,
therefore, prevent not only the confusion taxpayers and their
tax advisors have over whether foster care payments are
excludable, but also the confusion experienced by the IRS
officials that are charged with administering the law.
C. Current treatment of foster care payments discourages
much-needed foster care families from participating in foster
care programs.--Current law discourages families from becoming
foster care providers, even though these rules allow families
to offset taxable foster care payments (paid by non-qualified
agencies) by treating expenditures made on behalf of a foster
individual as a business expense deductions. Such deductions
are permitted only if the families maintain detailed expense
records. Accordingly, otherwise willing foster care families
are discouraged from accepting individuals placed by non-
qualified agencies because such providers are forced to endure
the time and inconvenience associated with keeping extensive
records. In addition, the confusion created by Section 131's
complex rules discourages many potential foster care families
from participating in these programs. The result is a smaller
pool of available, qualified and willing foster care providers
and a growing pool of special needs individuals for whom group
housing or institutional living is inappropriate. Amending
Section 131 as suggested would help address the increasing
demand for foster care providers.
D. Legislation introduced this year would remedy these
problems.--Bills were introduced in the Senate (S.670) and in
the House (H.R. 1194) that propose to eliminate the illogical
differences in the tax treatment of payments received by foster
care providers. These bills would simplify the current rules
under Section 131 for foster care payments. Under the
legislation, foster care providers would avoid onerous record
keeping by excluding from income any foster care payment
received regardless of the age of the foster care individual
and the type of entity that placed the individual, as long as
foster care payments are funded by governmental monies and the
placement agency licensed or certified by a State or local
government to make payments.
Conclusion
The Administration's proposal clarifies when a taxpayer,
who is caring for a foster individual, may take the EITC and
thus reduces taxpayer confusion and unintentional mistakes. The
Administration's proposal is but one needed step, however,
toward removing confusion created by the complicated rubric
associated with the taxation of foster care payments.
Therefore, we additionally recommend amending Section 131 of
the Internal Revenue Code so that all governmental payments
received by foster care providers be treated the same. This
change should also be reflected in any change affecting the
definition of ``foster child'' in Section 32. If enacted,
current law's confusing and unfair tax rules would no longer
discourage much-needed foster care families from participating
in foster care programs. Amending Section 131 and Section 32 in
this fashion also will support State and local governments in
their efforts to reduce bureaucracy and cut costs, provide more
alternatives to institutionalization and simplify tax
administration.
February 23, 1999
The Honorable Bill Archer
Chairman, Committee on Ways and Means
1102 Longworth House Office Building
Washington, D.C. 20515-6348
The Honorable Charles Rangel
Ranking Member, Committee on Ways and Means
1106 Longworth House Office Building
Washington, D.C. 20515-6348
Dear Chairman Archer and Ranking Member Rangel:
We are writing to express our opposition to a provision in the
Administration's FY 2000 budget proposal that would accelerate, from
quarterly to monthly, the collection of most federal and state
unemployment insurance (UI) taxes beginning in 2005. A similar proposal
was put forth in the Administration's FY 1999 Budget and was rejected
by Congress.
Imposing monthly collection of federal and state UI taxes is a
burdensome device that accelerates the collection of these taxes to
generate 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 state unemployment insurance
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.
This proposal is even more objectionable than some other tax speed-
up gimmicks considered in the past. For example, a proposal to move an
excise tax deposit date forward by one month into an earlier fiscal
year may make little policy sense, but it would not necessarily create
major additional administrative burdens. The UI speed-up proposal,
however, would result directly in significant and continuing costs to
taxpayers and to state governments--tripling the number of required UI
tax collection filings from 8 to 24 per affected employer each year.
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. Even many smaller businesses
that add or replace employees or hire seasonal workers would not
qualify for the exemption, however, since new FUTA liability accrues
with each new hire, including replacement employees. This deposit
acceleration rule makes no sense for businesses large or small, and an
exemption for certain small businesses does nothing to improve this
fundamentally flawed concept.
We are all strongly supportive of UI reform that simplifies the
system and reduces the burden on employers and the costs of
administration to the federal and state governments. Adopting the
Administration's UI collection speed-up proposal, however, would take
the system in exactly the opposite direction, creating even greater
burdens than those which exist under the current system.
We urge you to reject the Administration's UI collection speed-up
proposal and focus instead on proposals that would make meaningful
system-wide reforms. Thank you for your consideration of our views on
this important issue. Please do not hesitate to let us know if we can
provide additional assistance.
Sincerely,
American Payroll Association
American Society for Payroll
Management
American Trucking Association
National Association of
Manufacturers
National Federation of Independent
Business
National Retail Federation
Service Bureau Consortium, Inc.
Society for Human Resource
Management
U.S. Chamber of Commerce
UWC, Inc.
cc: Members of the Committee on Ways and Means
Statement of American Petroleum Institute
Introduction
This testimony is submitted by the American Petroleum
Institute (API) for the March 10, 1999 Ways and Means hearing
on the tax provisions in the Administration's fy 2000 budget
proposal. API represents approximately 400 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 suffering through its
worst times in recent memory. The collapse of world oil prices
that began in late 1997 continued and worsened through 1998.
While there has been some modest recovery in prices in recent
weeks, many analysts view this recovery as transitory, and see
little firm basis for sustained recovery in market conditions
for several years. It is especially troubling that at this time
when the industry is already reeling, the Administration has
come forward with proposals that would increase taxes on oil
and gas companies by as much as $6 billion over the next five
years. Congress can help to ensure that no additional harm is
done to this industry by rejecting the Administration's
proposal to increase taxes on the foreign source income of oil
and gas companies, and the proposals to reinstate the Superfund
taxes and the Oil Spill tax.
Background
By the end of 1998, as a result of reduced worldwide demand
and excess production, U.S. wellhead crude oil prices had
fallen to their lowest inflation-adjusted levels since the
Great Depression. At year's end the average U.S. wellhead price
was less than $8 per barrel, barely half the $15.06 average for
the same month one year earlier. For the year, the annual
average wellhead price was an estimated $10.85 per barrel, down
by more than a third from $17.24 in 1997.
Domestic oil exploration and development activity suffered
dramatically from the lower oil prices. The total number of
operating rigs in the U.S. fell 44% from February 98 to
February 99. The decline for oil rigs was 69% and for gas rigs
28%. Oil and gas companies' current upstream spending plans for
1999 for the U.S. have been cut by 20 percent, according to a
recent survey conducted by Salomon Smith Barney. U.S. companies
have been forced to delay or outright cancel projects in other
regions of the world, as well.
Industry employment has suffered. Bureau of Labor
Statistics data show that from October 1998 to February 1999
the oil and gas extraction industry, including field service
companies, lost 26,000 jobs. That 4 month loss was 6,000 more
jobs than were lost during the entire year from October 1997 to
October 1998. The most recent decline reduced the number of
upstream jobs in the U.S. to about 291,000--60 percent less
than the peak in early 1982 of 754,000 jobs.
For petroleum refiners lower crude oil prices generally
have not yielded higher refinery profit rates. Gasoline prices
for 1998, adjusted for inflation, were the lowest observed
since 1920. Regular gasoline prices dropped to 96 cents per
gallon by year-end. They averaged about $1.06 per gallon for
the year. The low product prices have come on the heels of
major operating cost increases resulting from compliance with
numerous government regulations, especially regulations aimed
at environmental improvement. In 1997 (the latest year
available), the refining sector spent slightly over $4 billion
on U.S. environmental expenditures.
Administration Proposals
Our testimony will address the following proposals:
modify rules relating to foreign oil and gas
extraction income;
reinstate excise taxes and the corporate
environmental tax deposited in the Hazardous Substance
Superfund Trust Fund;
reinstate the oil spill excise tax;
corporate tax shelters;
Harbor Maintenance Tax Converted to User Fee; and
tax investment income of trade associations
RULES RELATING TO FOREIGN OIL AND GAS EXTRACTION INCOME
President Clinton's budget proposal includes the following
provisions:
In situations where taxpayers are subject to a
foreign income tax and also receive an economic benefit from
the foreign country, taxpayers would be able to claim a credit
for such taxes under Code Section 901 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.
Effective for taxable years beginning after
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 foreign oil and gas extraction income (FOGEI) and
foreign oil related income (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.)
This proposal, aimed directly at the foreign operations 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.
If U.S. oil and gas concerns are 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. 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.
With non-OPEC development being cut back, and OPEC market
share once again rising, a key concern of federal policy should
be that of maintaining the global supply diversity that has
been the keystone of improved energy security for the past two
decades. The principal tool for promotion of that diversity is
active participation by U.S. firms in the development of these
new frontiers. At a time when those operations are especially
vulnerable, federal policy should be geared to enhancing the
competitiveness of U.S. firms operating abroad, not reducing it
with new tax burdens.
The foreign tax credit (FTC) principle of avoiding double
taxation represents the foundation of U.S. taxation of foreign
source income. The Administration's budget proposal would
destroy this foundation on a selective basis for foreign oil
and gas income only, in direct conflict with long established
tax policy and with U.S. trade policy of global integration,
embraced by both Democratic and Republican Administrations.
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
is intended to prevent 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'').
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 multiplying the tentative U.S. tax on
worldwide income by the ratio of foreign source income to
worldwide taxable 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 not less
than 9 ``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.
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 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 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.
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 finalized 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 and 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).
The Proposal Disallows FTCs Of Dual Capacity Taxpayers where
the Host Country Has No Generally Applicable Income Tax
If a host country had an income tax on FOGI (i.e., FOGEI or
FORI), but no generally applicable income tax, the proposal
would disallow 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.
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 income tax 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 which
may not be ready for an income tax, as for post-industrial
nations which may turn to a transaction tax, 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.
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.
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.
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. The source of FOGI was
determined by nature millions of years ago. FORI is generally
derived from the country where the processing or marketing of
oil occurs which presupposes substantial investment in
nonmovable assets. Moreover, Treasury has issued detailed
regulations addressing this sourcing issue. Also, unless any
FORI is earned in the extraction or consumption country, it is
very likely taxed currently, before distribution, as subpart F
income even though it is definitely not passive income.
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 a 1998
analysis by 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
carryback/carryover period for foreign tax credits, and the
repeal of section 907.
The Administration's fy 1999 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.
REINSTATMENT OF EXPIRED SUPERFUND TAXES
The Administration's proposal would reinstate the Superfund
excise taxes on petroleum and certain chemicals as well as the
Corporate Environmental Tax through October 1, 2009. API
strongly opposes this proposal.
It is generally agreed that the CERCLA program, otherwise
known as Superfund, has matured to the point that most of the
sites on the National Priorities List (NPL) are in some phase
of cleanup. Problems, however, remain in the structure of the
current program. The program should undergo comprehensive
legislative reform and should sunset at the completion of
cleanups of the CERCLA sites currently on the NPL. Issues that
the reform legislation should address include: liability,
remedy selection, and natural resource damage assessments. A
restructured and improved Superfund program can and should be
funded through general revenues.
Superfund sites are a broad societal problem. Revenues
raised to remediate these sites should be broadly based rather
than unfairly burdening a few specific industries. EPA has
found wastes from all types of businesses and government
agencies at hazardous waste sites. The entire economy benefited
in the pre-1980 era from the lower cost of handling waste
attributable to standards that were acceptable at the time. To
place responsibility for the additional costs resulting from
retroactive Superfund cleanup standards on the shoulders of a
very few industries when previous economic benefits were widely
shared is patently unfair.
The petroleum industry is estimated to be responsible for
less than 10 percent of the contamination at Superfund sites
but has historically paid over 50 percent of the Superfund
taxes. This inequity should be rectified. Congress should
substantially reform the program and fund the program through
general revenues or other broad-based funding sources.
REINSTATMENT OF 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, 2009,
and increasing the trust fund limitation (the ``cap'') from $1
billion to $5 billion. API strongly opposes the proposal.
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 are being accomplished without any need
for additional revenues. Congress should reject this proposal.
CORPORATE TAX SHELTERS
In a sweeping attack on corporate tax planning, the
Administration has proposed sixteen provisions purported to
deal with corporate tax shelters. These proposals are overly
broad and would bring within their scope many corporate
transactions that are clearly permitted under existing law.
Moreover, their ambiguity would leave taxpayers uncertain as to
the tax consequences of their activities and would lead to
increased controversy and litigation. Business taxpayers must
be able to rely on the tax code and existing income tax
regulations in order to carry on their business activities.
Treasury's proposed rules could cost the economy more in lost
business activity than they produce in taxing previously
``sheltered'' income.
HARBOR MAINTENANCE EXCISE TAX CONVERTED TO COST-BASED USER FEE
The Administration's budget contains a placeholder for
revenue from a new Harbor Services User Fee and Harbor Services
Fund. This fee would raise nearly $1 billion in new taxes,
almost twice what is needed for maintenance dredging. The
Administration delayed sending the proposal to the 105th
Congress because of the intense and uniform opposition from
ports, shippers, carriers and labor. Despite this opposition,
the Administration has provided few details about how the new
user fee would be structured and has not sought stakeholder
input since last September.
API strongly supports the use of such funds for channel
maintenance and dredge disposal. We object to the
Administration's proposal to use these funds for port
construction and other services. The Administration should
earmark these funds to address the growing demand for harbor
maintenance and dredging. Moreover, we urge Congress to pass
H.R. 111 and create an off-budget trust fund for the Harbor
Services Fund. Finally, API urges Congress to take the lead in
seeking stakeholder input and developing a fair and equitable
means of generating the needed revenue.
SUBJECT INVESTMENT INCOME OF TRADE ASSOCIATIONS TO TAX
The Administration's proposal would subject to tax the net
investment income in excess of $10,000 of trade associations
and other organizations described in section 501(c)(6). API
opposes this provision that is estimated to increase taxes on
trade associations and other similar not-for-profit
organizations by $1.4 billion. We agree with the Tax Council
and other groups that subjecting trade association investment
income to the unrelated business income tax (UBIT) conflicts
with the current-law purpose of imposing UBIT on associations
and other tax-exempt organizations to prevent such
organizations from competing unfairly against for-profit
businesses. The Administration's proposal mischaracterizes the
benefit that trade association members receive from such
earnings. Without such earnings, members of these associations
would have to pay larger tax-deductible dues. There is no tax
abuse. Congress should reject this proposal.
Statement of the American Public Power Association
The American Public Power Association (APPA) is pleased to
present this statement on the electric restructuring tax
proposal included in the president's FY 2000 budget. APPA is
the national service organization representing the interests of
more than 2,000 municipal and other state and locally owned
utilities throughout the United States. Collectively, public
power utilities deliver electric energy to one of every seven
U.S. electric consumers (about 40 million people), serving some
of the nation's largest cities. However, the majority of APPA's
member systems are located in small and medium-sized
communities in every state except Hawaii.
APPA appreciates the opportunity to comment on the
Administration's proposal on tax-exempt bonds for electric
facilities of public power entities. The proposal deals with an
issue of extreme importance to the more than 2,000 community-
owned electric providers, the bondholders of the over $75
billion in outstanding tax-exempt bonds and the communities
that rely on low cost, reliable electric power. This is an
issue that has developed as a result of wholesale and retail
electricity competition, and needs legislative attention as
soon as possible.
Changing Circumstances:
Many states have begun to establish retail electricity
markets, abolishing the traditional regulated monopoly regime
and replacing it with one in which all consumers have a choice
of electricity suppliers. Nearly twenty states have adopted
such legislation or regulation to open up to competition. These
state laws can not be effective unless Congress removes certain
tax barriers to retail competition. One such barrier is the
existing ``private use'' test on the over $75 billion in
outstanding tax-exempt bonds used to build and maintain
electric generation, transmission and distribution facilities.
In addition, consumers need desperately for Congress to clarify
existing tax law to encourage an efficient and fair electric
marketplace.
This state trend to promote retail electric competition
follows action by Congress in 1992 to increase competition at
the wholesale level, by empowering the Federal Energy
Regulatory Commission (FERC) to compel all transmission owners,
including public power systems, to allow third parties
equaitable access to their transmission lines. If municipal
electric utilities open their transmission systems to wholesale
competition, they face violating the private use restrictions
on their existing tax-exempt bonds, thus creating an enormous
disincentive for public power systems to embrace both retail
and wholesale electricity competition.
Municipal electric utilities that have issued tax-exempt
bonds to finance their facilities under the old regulated
monopoly framework face tough and potentially costly options
for operating in the new restructured legal environment. If
municipal utilities enter the competitive arena and violate the
private use restrictions, tax-exempt bond financing on their
affected facilities utilized by private parties becomes
retroactively taxable, leading to immediate bondholder
lawsuits. Or, in the alternative, municipal utilities may
decide to compete and refinance their facilities with taxable
bonds, causing an increase in financing costs. In either case,
existing customers will have to pay higher electricity prices
due to the accommodation to regulatory changes that no one
foresaw at the time of the original financings. On the other
hand, if public power systems choose not to compete, they will
inevitably lose customers, resulting in the remaining customers
paying higher costs for the underutilized infrastructure.
Administration's Proposal--A Step in the Right Direction
We commend the Administration's legislative proposal to
eliminate federal tax code barriers to electricity competition
facing public power. Most importantly, the Administration's tax
proposal lifts the existing private use test on outstanding
tax-exempt bonds and eliminates a disincentive for public power
systems to participate in wholesale and retail electricity
competition. In addition, this provision also protects existing
bondholders from the possible retroactive taxability of their
bonds. Lastly, the Administration's bill preserves public power
systems' ability to issue tax-free bonds for local distribution
facilities, which is defined as 69kv or lower.
Unfortunately, the proposal is in effect, a federal mandate
that prohibits all community owned utilities from building or
maintaining transmission and generation facilities, on a tax-
exempt basis. Most small municipalities do not have outstanding
tax-exempt bonds and would therefore endure a significant
penalty to resolve a problem that does not currently apply to
them. Moreover, this prohibition applies even if the
transmission or generation facilities are dedicated to
municipal functions providing public benefits to its community.
APPA believes this aspect of the Administration's proposal is
extremely severe, hindering many smaller community owned
electric systems from utilizing tax-exempt debt for important
infrastructure needs, and exercising their rights of local
control. With regard to transmission, energy policy is moving
us to a system in which all consumers will benefit if building
certain portions of the transmission gird is done on a tax-
exempt basis, thus lowering costs for all consumers.
In summary, the Administration's tax proposal moves us in
the right direction, in that it protects the existing tax-
exempt debt of public power communities, but on a prospective
going forward basis it is unnecessarily severe for many
communities that have no outstanding bonds and would prefer to
preserve their existing authority over financing of electric
generation and transmission facilities.
APPA is pleased that the Administration is sensitive to
these concerns and would like to work together with members of
Congress and public power communities to address this concern.
In fact, on February 4th, Energy Secretary Bill Richardson
wrote to APPA and acknowledged some differences in their
approach and said he believed ``these differences can be
resolved. It is absolutely essential that Congress address this
issue quickly so as not to further impede the progress of
competitive programs,'' Secretary Richardson said. (See
attached DOE letter dated February 4, 1999.)
A Fair, Bipartisan Compromise is Advanced--The Bond Fairness and
Protection Act of 1999, H.R. 721/S. 386
A proposal that embraces local control and local choices
has been advanced in Congress. The Bond Fairness and Protection
Act of 1999 is much better suited to deal with the diversity in
the marketplace, while protecting the fundamental rights of
state and local government, and providing transition relief to
the outstanding tax-exempt bonds.
More specifically, the Bond Fairness and Protection Act, a
bill introduced in the Senate as S. 386 by Senators Slade
Gorton (R-WA) and Robert Kerrey (D-NE) and in the House as H.R.
721 by Representatives J.D. Hayworth (R-AZ) and Robert Matsui
(D-CA), is a compromise solution to the private use problem. If
enacted, the Gorton-Kerrey/Hayworth-Matsui bill will accomplish
two objectives: 1) clarify existing tax laws and regulations
regarding the private use rules so that they will work in a new
competitive marketplace; and 2) provide encouragement for
public power utilities to open their transmission or
distribution systems, thereby providing more choice to all
consumers.
Under the bill, publicly owned utilities would have two
options: 1) They could continue to operate under a clarified
version of the existing tax laws and private use regulations;
or 2) If relief from private use restrictions were needed,
municipal utilities could opt for a full grandfathering of
their outstanding tax-exempt debt, but they would have to
exercise an ``irrevocable termination election,'' permanently
eliminating their ability to issue tax-exempt debt to build any
new generating facilities. Such an election would not affect
transmission and distribution facilities which unlike
generation will continue to operate as regulated monopolies.
This removes the disincentive for municipal electric systems to
participate in competitive markets without providing a
competitive advantage to either public power or private
utilities.
Because the bill provides publicly owned utilities the
flexibility to participate in competitive markets without
jeopardizing the tax-exempt status of their bonds while
requiring a significant trade-off to some private utilities'
concerns, it has attracted the support of a number of
organizations. The list includes: The National League of
Cities, The National Association of Counties, The Governors
Public Power Alliance, The International City/County Managers
Association, The Government Finance Officers Association, The
California Independent Energy Producers, Enron, the National
Consumers' League, Public Citizen, and The Natural Resources
Defense Council and some individual investor-owned utilities. A
number of investor owned utilities either support or are
neutral on the bill, and many are seeking small clarifications
to help promote competition in general.
Conclusion:
A fully competitive retail electricity market will include
a variety of electrical suppliers, many of which are for-
profit, taxable entities and others like public power systems,
that are not-for profit state and local agencies. Each type of
market participant faces barriers to participate in future
competitive markets. Municipal financing concerns are one
barrier that must be addressed as part of a balanced approach
to a fair and open marketplace. The Administration's tax
provision is a step in the right direction, but, Congress
should embrace efforts to preserve local communities' choices
and instead enact H.R 721/S. 386, a bipartisan compromise that
makes political and economic sense.
We appreciate the opportunity to present our statement, and
look forward to working with the Ways and Means members and
staff as the budget debate progresses.
[Attachment is being retained in the Committee files.]
Associated Builders and Contractors, Inc.
Rosslyn, Virginia 22209
March 24, 1999
The Honorable Bill Archer
Chairman, Ways and Means Committee
U.S. House of Representatives
Washington, DC 20515
Dear Mr. Chairman:
On behalf of Associated Builders and Contractors (ABC) and its more
than 20,000 member firms, I would like to respectfully submit the
following comments for the record of the hearing of March 10, 1999
entitled ``Revenue Provisions in President's Fiscal Year 2000 Budget.''
President Clinton's FY 2000 budget proposes a significant tax
increase on Associations that are tax exempt under section 501 (c) (6)
of the Internal Revenue Code. Under the administration's proposal,
trade associations that have net ``investment'' income in excess of
$10,000 for any taxable year would be subject to the unrelated business
income tax (UBIT), for the portion over $10,000. This would adversely
affect ABC's tax liability, as well as the tax liability of our
chapters that may have ``investment'' income over $10,000. ABC strongly
opposes this proposal, which would significantly impact ABC's financial
status.
ABC's ``investment'' income is not generated by any activity in
competition with tax-paying businesses. Congress recognized in the
``unrelated business tax'' (UBIT) rules, that Section 501 (c)(6) tax-
exempt groups were not competing with for-profit entities or being
unfairly advantaged by the receipt of tax-exempt income from certain
``passive'' sources such as interest, dividends, capital gains and
royalties. ABC and other associations' income from these sources are
used to further its exempt purposes, including education, improving
industry safety, and training, and for community involvement. For
example, ABC might be forced to curtail its ongoing non-profit efforts
to attract and train young people for a lucrative career in the
construction industry.
Additionally, it is important to recognize that keeping this
``investment'' and ``passive'' income free from taxation enables ABC
and other 501 (c)(6) associations to maintain modest surplus funds from
year to year in order maintain stability during economic downturns.
The Administration's proposal appears to assume that 501 (c)(6)
associations like ABC are effectively over-charging their members for
dues, and their members expect to realize investment gains from those
overpayments. This is absurd logic, which shows a patent
misunderstanding of the structure and operation of tax-exempt
organizations. In fact, dues payments do not make up the larger portion
of an average association's annual revenue.
For the aforementioned reasons, ABC would like to express its
strong opposition to the Administration's proposal to tax 501 (c)(6)
investment income. Thank you for considering ABC's comments.
Sincerely,
Christopher T. Salp
Washington Representative
Association for Play Therapy
Fresno, CA 93703
March 9, 1999
Hon. Bill Archer, Chair
Committee on Ways and Means
United States House of Representatives
1102 Longworth Office Building
Washington, DC 20515
Re: Opposition to Taxing Association Savings
Dear Chair Archer:
During its February 27 meeting in Baltimore, MD, the Board of
Directors of the International Association for Play Therapy, Inc.
unanimously elected to oppose the Administration budget proposal to
raise $1.4 billion over the next five years by taxing interest and
dividends in excess of $10,000 earned annually by non-profit
organizations.
Our private 501c(6) association and its 3,300 volunteer member
mental health professionals have since 1982 researched and promoted the
therapeutic benefits of play and play therapy on behalf of children and
others. We have diligently and responsibly built an emergency reserve
fund, the earnings from which may eventually finance research and other
programs that further satisfy our mission statement. Because
competition for grants, sponsorships, and other forms of non-dues
revenues is fierce, it is critical that we and other associations
continue to enjoy this fundraising option and that interest earned from
our savings not be taxed.
Please advise me if you will oppose this proposal. Your leadership
and assistance are critical and sincerely appreciated. Thank you very
much.
Cordially,
William M. Burns
Executive Director
cc: Chair Rise VanFleet, Ph.D.
Statement of Association of International Automobile Manufacturers,
Inc., Arlington, Virginia
The Association of International Automobile Manufacturers,
Inc. (``AIAM'') respectfully submits this statement for the
Committee on Ways & Means March 10, 1999 hearing record
regarding the Revenue Provisions in the President's Budget for
Fiscal Year 2000. AIAM is a trade association that represents
companies which sell passenger cars and light trucks in the
United States that are manufactured both here and abroad.\1\
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\1\ AIAM is the trade association representing the U.S.
subsidiaries of international automobile companies doing business in
the United States. Member companies distribute passenger cars, light
trucks, and multipurpose passenger vehicles in the U.S. Nearly two-
thirds of these vehicles are manufactured in the New American Plants
established by AIAM companies in the past decade.
International automakers support American jobs in manufacturing,
supplier industries, ports, distribution centers, headquarters, R & D
centers and automobile dealerships. AIAM also represents manufacturers
of tires and other original equipment with production facilities in the
U.S. and abroad.
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AIAM members import and produce in U.S. manufacturing
facilities light vehicles for sale in the U.S. Automobile
manufacturers have invested millions of dollars into the
research and development of environmentally superior vehicles,
yet the demand for these autos remain at remarkably low levels.
Nearly every automaker in the world has begun development of
advanced propulsion technology vehicles. For example, motor
vehicles like Honda's EV Plus, Nissan's Altra, and Toyota's
Prius are currently offered (or will be shortly) for sale in
the U.S. market by these innovative automobile manufacturers.
While AIAM reserves judgement on the details of the
Administration's Fiscal Year 2000 Budget proposal to provide a
tax credit for advanced technology vehicles, AIAM endorses the
underlying market-based principles of the proposal. Should the
Committee desire any assistance in the development of this tax
incentive, AIAM stands ready to be involved in the process.
While automakers continue to make strides in environmental
technology, there is a lack of consumer demand for new premium
priced advanced technology vehicles. Creating market-driven
incentives to entice consumers towards the purchase of
environmentally superior vehicles is necessary if we are going
to achieve the environmental gains we all desire. AIAM believes
credits will encourage the purchase of new environmentally
superior vehicles.
There currently are two design principles that AIAM member
companies agree should be included in a tax incentive program.
Incentives should capitalize on the power and efficiency of the
retail market; and should be easy for consumers to use.
Incentives should capitalize on the power and efficiency of the retail
market
The retail vehicle market is a ready institution for
bringing incentives directly to bear on the people who may want
to buy fuel efficient vehicles at the moment they are making
that choice. The market, being a constant factor in purchasing
decisions, will deliver economic incentives and results with
virtually no delay or administrative cost.
An unsatisfactory alternative to a market-driven design
would be a new command-and-control regime of regulations
between manufacturers and government. By all experience, the
erection and operation of another regulatory apparatus would be
slow, expensive, nonadaptive, and adversarial. It could not be
structured in any way to deal with potential buyers as they
decide whether to choose fuel-efficient vehicles.
It is AIAM's opinion that a market-based approach to energy
conservation is superior in effectiveness to regulation. Market
incentives encourage energy conservation and the costs on
society is far less than those imposed by command-and-control
regulations.
Incentives should be easy for consumers to use
For this type of policy to succeed through tax incentives,
the incentives should be easy for consumers to use.
To be most effective in selling fuel-efficient vehicles,
the availability and value of the credit should be certain and
palpable at the buyer's moment of decision.
To achieve the program's objectives, the credit should be
available whether the potential buyer is an individual or
business; rich, poor, or middle-income; is a minimum tax payer
or not; is considering a foreign-or domestic-manufactured
vehicle, and other distinguishing characteristics.
AIAM believes that a manufacturers' rebate-style incentive
at point of purchase is the most effective type of credit. This
type of approach would provide an immediate and enticing
incentive for the purchase of an advanced technology vehicle.
This could be accomplished by designing the credit so that it
goes directly to the manufacturer. The manufacturer, in turn,
would pass the incentive along to the customer at the time of
purchase, thereby creating an immediate incentive to purchase
the qualifying vehicle.
Conclusion
The Administration has taken a constructive step by
promulgating the concepts of tax incentive programs for the
purchase of qualifying fuel efficient vehicles. Building a
basis for market-driven consumer incentive policy is important
in creating a demand for advanced technology vehicles in the
United States that have the potential to deliver environmental
and energy-saving benefits. AIAM would be pleased to provide
the Committee whatever further information on this issue the
Committee would find useful.
Statement of Bond Market Association
The Bond Market Association is pleased to present this
statement on tax proposals in the president's FY 2000 budget.
The Bond Market Association represents approximately 200
securities firms and banks that underwrite, trade and sell debt
securities, both domestically and internationally. We take an
active interest in tax policy that affects the ability of
corporations, state and local governments and the federal
government to access the capital markets to finance investment.
Indeed, capital investment is the engine that powers long-term
economic growth, and the federal tax code can have a profound
effect on the cost of capital investment. It is in our interest
and, we believe, the nation's interest to foster a tax system
that encourages capital investment and makes capital available
as efficiently as possible.
Perhaps the most important thing Congress has done in
recent years to facilitate capital investment has been to
pursue policies which helped to eliminate the federal budget
deficit. For decades, the deficit served as a drain on the pool
of funds available to finance new investment. Every dollar of
overspending was a dollar not available to build roads,
schools, factories, housing and other capital assets that
contribute to economic growth and improve living standards.
This committee, under Chairman Archer's leadership, played a
vital role in crafting policies that have eliminated the
deficit and freed up economic resources for productive use. At
the same time, this committee has managed to resist ill-
conceived tax increases on capital formation and has even
supported proposals designed to expand access to the capital
markets, such as last year's increase in tax-exempt private-
activity bond volume caps. For that, we commend you.
The president's budget contains a number of proposals that
would affect the capital markets. Unfortunately, many of these
proposals are recycled versions of the same tax increases that
Congress has rejected for years. As we have in the past, we
strongly oppose these tax increases on savings and investment.
Other proposals, although well-intentioned, would likely not
provide the level of assistance they are intended to.
Tax Increase Proposals
Increase proration percentage for property and casualty
companies
The Association commented extensively on a variation of
this proposal in our statement to the committee in February
1998.\1\ Although the administration has tempered the proposal
slightly in its current budget, it would still represent a
significant tax increase on ``tax-exempt'' interest earned by
property and casualty (P&C) insurance companies.
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\1\ Statement of The Bond Market Association, Submitted to the
House Committee on Ways and Means, on Certain Revenue Provisions in the
Administration's FY 1999 Budget, February 25, 1998.
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P&Cs are an extremely important source of demand for
municipal securities. In a market dominated by individual
investors--approximately 64 percent of outstanding municipal
bonds are held by individuals or their proxies, money-market
and mutual funds--P&Cs play a vital role in maintaining market
stability by providing a steady source of demand. If not for
the active participation of P&Cs in the municipal bond market,
state and local borrowing rates would be much higher than they
are.
So-called ``tax-exempt'' interest earned by P&Cs on
municipal bond transactions is not truly tax-exempt. P&Cs are
permitted a deduction for contributions to loss reserves.
However, this deduction is reduced by an amount equal to 15
percent of their ``proration income,'' which includes tax-
exempt bond interest. P&Cs lose 15 cents of an otherwise
allowable deduction for every dollar of tax-exempt interest
they earn. This loss of deduction is tantamount to a direct tax
of 5.25 percent on their municipal bond interest income.
The administration has proposed raising the loss reserve
deduction disallowance from 15 percent of proration income to
25 percent. This would increase the implicit tax rate on
municipal bond interest earned by P&Cs from 5.25 percent to
8.75 percent, an increase of 67 percent. (In its FY 1999
budget, the administration proposed a full doubling of the
proration tax.) Describing the administration's proposal as a
tax increase on P&Cs, however, disguises its true effect. In
reality, the burden of this proposed tax increase would fall
almost entirely on state and local government bond issuers, not
on P&Cs. 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. 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. Of course, higher borrowing costs simply
discourage new investment in schools, roads, airports, sewer
systems, parks and the many other infrastructure projects that
are financed with tax-exempt bonds. The staff of the Joint
Committee on taxation was absolutely correct in its analysis:
[P&C] insurers are large holders of tax-exempt bonds. A
reduction in demand for these securities by the [P&C] insurers
may lead to an increase in borrowing costs for state and local
governments. Even a small increase in the interest cost to tax-
exempt finance could create a substantial increase in the
aggregate financial cost of debt-financed public works projects
to state and local governments.\2\
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\2\ Staff of the Joint Committee on Taxation, ``Description of
Revenue Provisions in the President's FY 2000 Budget Proposal'' (JCS-1-
99), February 22, 1999, pgs. 275-276.
Moreover, the administration has offered little justification for
this proposed tax increase. The Treasury Department states only that a
5.25 percent P&C tax on municipal bond interest is too low because it
``still allows [P&Cs] to fund a substantial portion of their deductible
reserves with tax-exempt or tax-deferred income.'' \3\ This argument
fails to draw any parallel between interest earned on municipal bonds
and deductions for contributions to loss reserves. The relationship
between municipal bond interest and loss reserve deductions is no
closer than that between municipal bond interest and any deductible
expense, such as that for wages and salaries. The administration also
fails to justify the apparent arbitrary proration percentage level
contained in its proposal. Why is a 25-percent proration level more
appropriate than a 15-percent level? Why in its FY 1999 budget did the
administration propose a 30-percent level, but this year's proposal is
for a 25-percent level? Both questions are unanswered, and both suggest
that the administration's proposal is less an adjustment of tax policy
to address changing circumstances and more a pure tax increase proposed
solely as a revenue-raiser with little tax policy justification.
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\3\ Department of the Treasury, ``General Explanations of the
Administration's Revenue Proposals, February 1999, page 159.
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Disallow Interest on Debt Allocable to Tax-exempt Obligations
A second proposed tax increase in the administration's budget is
also ostensibly targeted at corporations. However, like the
``proration'' issue discussed above, this tax increase would be borne
by state and local government bond issuers who would pay higher
interest rates on their borrowing. This proposal would apply the
current-law ``pro rata'' interest expense disallowance that applies to
financial institutions to all financial intermediaries.
Currently, all taxpayers, including all corporations, are
prohibited from deducting interest expenses associated with purchasing
or carrying tax-exempt bonds. Most corporations, including some
financial intermediaries, are required to demonstrate that any tax-
exempt bond holdings were not financed with the proceeds of borrowing--
the so-called ``tracing rule.'' Most corporations are relieved of this
burden if their tax-exempt bond holdings do not exceed two percent of
their total assets--the so-called ``two-percent de minimis rule.''
Securities firms and banks, however, are subject to stricter treatment;
they automatically lose a pro rata portion of their interest expense
deduction if they earn any tax-exempt interest. In applying the
disallowance, securities firms are permitted to disregard interest
expense that is clearly traceable to activities unrelated to municipal
bonds. The administration's proposal would apply the pro rata
disallowance provision currently applicable to banks to all ``financial
intermediaries,'' including securities firms, finance and leasing
companies, and certain government-sponsored corporations. The proposal
would affect various segments of the municipal bond market differently.
For securities firms, the proposal would apply the current-law pro
rata disallowance to a larger portion of a firm's total interest
expense deduction, even to interest which is clearly and demonstrably
unrelated to holding municipal bonds. A large portion of a securities
firm's borrowing is for specific purposes. Securities firms use
repurchase agreements--a form of secured borrowing--to finance
overnight holdings of Treasury securities bought in the normal course
of market-making activity. Or, in another example, firms incur margin
loans for stock purchases. In both these examples, the interest expense
associated with the borrowing is clearly related to activity unrelated
to buying or holding municipal bonds, and so is disregarded in applying
the pro rata disallowance of interest expense. In both these examples
as well as others, under the administration's proposal, this interest
expense would be subject to the disallowance. Securities firms' after-
tax costs of carrying municipal bonds would increase.
Securities firms buy and sell municipal bonds in the normal course
of doing business. As underwriters, they buy newly issued securities
and resell them to investors. When investors seek to sell bonds before
their maturity, securities firms quote prices and buy municipal bonds
on the secondary market. As a result of the administration's proposal,
the after-tax cost of holding municipal bonds in the normal course of
business would increase because every time a securities firm bought a
bond, it would face a higher after-tax ``cost of carry.'' Firms would
be less willing, at least on the margin, to take positions in municipal
securities being bought and sold by investors and would consequently
bid prices less aggressively. In the end, virtually all the additional
tax liability faced by securities firms would ultimately be borne by
bond issuers and investors in the forms of higher issuance and
transaction costs.
The administration's proposal would affect other market sectors, as
well. The proposal would remove government-sponsored corporations from
the markets for tax-exempt housing and student loan bonds by repealing
the two-percent de minimis rule for these investors. Organizations such
as Fannie Mae and Freddie Mac are major buyers of bonds issued for low-
and middle-income owner-occupied and multi-family rental housing.
Sallie Mae buys tax-exempt student loan bonds. These investors keep
financing costs low for worthwhile state and local housing and student
loan programs, and their loss from the market would make it more
difficult and more expensive for states and localities to provide these
services. Finally, the proposal would dramatically raise costs for
firms that finance equipment leases for states and localities. These
costs would be passed onto state and local governments in the form of
higher leasing costs. Hardest hit would be smaller governments, since
they have a more difficult time accessing the conventional capital
markets and tend to depend more on leasing as a form of long-term
financing.
The administration argues that current law permits securities
dealers and other financial intermediaries ``to reduce their tax
liability inappropriately through double federal tax benefits of
interest expense deduction and tax-exempt interest, notwithstanding
that they operate similarly to banks.'' This statement is simply not
true. Current law could not be more direct. It is not legal for any
corporation to deduct the interest expense associated with holding tax-
exempt bonds. It is true that not all corporations are bound to the pro
rata disallowance of interest expense deductions as banks are.
Equalizing treatment between banks and non-banks, however, could just
as easily entail the application of the tracing and two-percent de
minimis rules to banks as the application of the pro rata disallowance
to non-banks. The administration also argues that ``the treatment of
banks should be applicable to other taxpayers engaged in the business
of financial intermediation, such as securities dealers.'' And further,
``it is difficult to trace funds within the institution and nearly
impossible to assess the taxpayer's purpose in accepting deposits or
making other borrowings.'' Both these statements are very misleading.
In fact, banks and securities firms are both subject to nearly
identical rules under current law. Both are already subject to the pro
rata disallowance of interest expense deductions. Securities firms are
simply able, in applying the disallowance, to disregard certain
interest expense that clearly is traceable. Moreover, of The Bond
Market Association's numerous commercial bank members, we are aware of
none that have complained about unfair treatment under current law or
who have called for anything similar to the administration's proposal.
Require Current Accrual of Market Discount by Accrual Method Taxpayers
Under current law, market discount occurs when taxpayers buy bonds
at a discount to face value (par). Market discount, the difference
between a bond's purchase price and its face value, is generally
treated as ordinary interest income. The only exception is that tax
liability is incurred not annually, but when the bond is sold or
redeemed. The administration has proposed that accrual taxpayers would
be required to recognize the accrual of market discount--and pay taxes
on that accrual--annually.
Much of the problem with the administration's proposed treatment of
market discount stems from its mistreatment under current law. On the
basis of good tax policy and for purposes of tax symmetry, market
discount really should be treated as a capital gain rather than as
ordinary income. After all, market discount occurs when, as a result of
a decline in market prices, a bond is sold in the secondary market at a
price lower than its original issue price (or, in the case of a bond
with original issue discount, its adjusted issue price). In such a
case, the seller of the bond would incur a capital loss. The buyer of
the bond, however, would recognize ordinary income. Such treatment is,
at the very least, unfair. This asymmetry is mitigated, however, by the
fact that like a capital gain, taxpayers are not required to recognize
market discount income until a bond is sold or redeemed. The capital-
gain nature of market discount is highlighted in the case of distressed
debt. In this case, when an investor buys a bond at a deeply discounted
price due to credit deterioration of the issuer and then realizes a
gain due to improvements in the issuer's credit condition, the gain is
much more in the character of a capital gain than of interest income.
The administration recognizes this point in its explanation of its
proposal.\4\
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\4\ Ibid., Page 121.
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The administration has proposed that accrual taxpayers be required
to recognize the accrual of market discount as it occurs and to incur
tax liability on market discount annually. As a result, the proposal
would exacerbate problems and inconsistencies associated with current-
law treatment of market discount.
First, the proposal would introduce significant complexity to the
treatment of market discount. As the JCT staff recognizes, when the
existing market discount provisions were adopted in 1984, Congress
purposefully established the current scheme of treatment--incurring tax
liability only when a bond is sold or redeemed--in recognition that
annual accrual treatment would be too complex.\5\ The problem of
complexity is compounded, as the JCT staff also recognizes, when a bond
carries both original-issue discount and market discount. The
complexity of the market discount rules were highlighted in 1993, when
the treatment of market discount on municipal bonds was changed from
capital gain to ordinary income. This provision caused significant
confusion among municipal bond investors.
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\5\ Staff of the Joint Committee on Taxation, Page 207.
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Second, the administration's proposal would reduce the
attractiveness of bonds trading at a discount to investors who are
accrual taxpayers. Unfortunately, the tax treatment of market discount
becomes an increasing concern to investors at times of market
uncertainty, when bond prices are declining as a result of rising
interest rates and when, as a result, market liquidity is hampered.
Imposing additional, negative tax consequences on buyers of discounted
debt instruments would simply fuel the illiquidity fire. This problem
is compounded in times of persistent and severe declines in bond
prices. It would be possible in these conditions for certain investors
to pay tax annually on the accrual of market discount when, because the
value of the bond fails to increase as fast as the discount accrues,
little no real cash income is ever actually earned. In such severe
cases, an investor would be forced to recognize the accrual of market
discount as ordinary income, even though that income was actually
absorbed in a capital loss. Although this mistreatment exists under
current law, it would be exacerbated if accrual taxpayers are forced to
recognize market discount annually.
Defer interest deduction and original issue discount on certain
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.'' \6\ However,
performance does not bear 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.
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\6\ Department of the Treasury, page 127.
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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.'' \7\
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.
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\7\ Ibid., page 132.
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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.
New Budget Initiatives
Provide Tax Credits for Holders of Qualified School
Modernization Bonds and Qualified Zone Academy Bonds and
Provide Tax Credits for Holders of Better America Bonds
The administration has proposed policy initiatives
significantly expanding the use of ``tax credit bonds.'' Under
this new financing structure, states and localities would be
able to issue qualified debt securities for targeted projects,
including the construction and rehabilitation of public primary
and secondary school facilities and for certain environmental
uses. Investors in the bonds earn federal income tax credits,
presumably in lieu of interest payments by the issuers.
Qualified Zone Academy Bonds.--In 1997, Congress passed and
the President signed H.R. 2014 (P.L. 105-34), a budget
reconciliation bill which included the Taxpayer Relief Act of
1997. Section 226 of the bill provides tax credits for holders
of ``Qualified Zone Academy Bonds'' (QZABs). QZABs are bonds
which may be issued by state and local governments to finance
rehabilitation projects for public primary and secondary
schools located in empowerment zones or enterprise communities
or where at least 35 percent of students qualify for subsidized
lunches under the National School Lunch Act. QZABs represent
the first use of ``tax credit bonds'' to provide assistance for
a designated public policy goal.
Although the goals of the QZAB program are laudable, the
structure of the QZAB provision has seriously hindered its
usefulness to school districts. Although some problems with the
program are inherent in the tax credit bond structure, there
are several notable problems with QZABs in particular.
The program is very small.--The Taxpayer Relief Act
authorized only $400 million of QZAB issuance per year for two
years. This $400 million amount is allocated among all the
states, so any one state receives a relatively small
allocation. In 1999, for example, the District of Columbia is
permitted to issue a total of only $1.2 million of QZABs. The
small size and short term of the program causes several
problems. First, it is difficult for bond issuers, attorneys,
underwriters, investors and others associated with capital
market transactions to commit resources to developing expertise
on a new and unknown financing vehicle when very little
issuance will be permitted to take place. Second, the small
issuance volume ensures that there will be no significant
secondary market for QZABs. A lack of market liquidity
discourages investors and raises costs for issuers.
The program requires ``private business contributions.''--
In order to qualify for QZAB financing, a school district must
secure a ``private business contribution'' to the project being
financed. The contribution must comprise at least 10 percent of
the proceeds of the QZAB issue. The contribution can take the
form of property or services. In practice, it has been
prohibitively difficult for school districts to secure private
business contributions needed to qualify for QZAB financing.
The credit rate is reset monthly.--The tax credit rate--the
rate that determines the amount of tax credit earned by holders
of QZABs--is set by the Treasury department monthly. This reset
period is too infrequent to allow for efficient pricing and
issuance of QZABs. Market interest rates change daily, even
hourly, so a monthly reset period virtually ensures that the
current credit will bear little relation to current market
yields. Moreover, the credit rate is set at 110 percent of the
``applicable federal rate'' (AFR). This rate, however, does not
necessarily reflect the actual rate of return that investors
would demand in order to buy QZABs at a price that would leave
the issuer with a no-cost source of capital.
Investors are limited.--Only three classes of investors are
permitted to earn federal income tax credits by holding QZABs,
banks, insurance companies and ``corporations actively engaged
in the business of lending money.'' Individual investors, a
potentially strong source of demand for tax-preferred
investments, are excluded as QZAB investors.
New construction is not eligible.--The QZAB program
provides assistance only for the rehabilitation of existing
school facilities. Construction of new schools is not eligible
for QZAB financing. School districts whose capital investment
plans include primarily the construction of new schools are not
helped significantly by the program.
These problems, along with other issues related to tax
credit bonds generally (see below), have crippled the QZAB
program. To date, only three QZAB transactions have taken
place. Moreover, the two publicly offered issues sold at a
discounted price. In other words, in neither case did the
school district receive a zero-percent interest rate, as the
QZAB program is intended to provide. In both cases, issuers had
to offer significant original issue discount, in addition to
the federal tax credits, in order to attract investors.
New Initiatives
In its FY200 budget, the administration has proposed a
significant expansion of tax credit bonds for school
construction and rehabilitation and environmental purposes.
First, in recognition of the severe limitation that the
``private business contribution'' imposes on the QZAB program,
the administration has proposed a tax credit for corporations
that provide contributions to qualified zone academies located
in empowerment zones and enterprise communities equal to 50
percent of the value of the contribution. Each empowerment zone
would be able to allocate $4 million in credits and each
enterprise community would be allowed to designate $2 million
of credits. This proposal may make it easier to attract private
business contributions for QZAB-financed projects.
Second, the administration has proposed expanding the QZAB
program. Under the administration's proposal, eligible school
districts could issue $1 billion of QZABs in 2000 and $1.4
billion in 2001. The program would be expanded to include
school construction as well as rehabilitation. Eligibility
requirements for QZAB projects, including the private business
contribution, would remain the same. The QZAB structure would
be changed to bring it into line with other proposed tax credit
bond programs. (See below.)
Third, the administration has proposed new tax credit bond
programs for school construction and renovation, Qualified
School Modernization Bonds (QSMBs), and for greenspace
preservation and other environmental uses, Better America Bonds
(BABs). Although the QSMB and BAB proposals attempt to remedy
some of the problems with QZABs, they would also impose new
requirements on states and localities that do not apply under
the QZAB program. The administration's proposal stipulates that
the Education Department would be required to approve the
school modernization plan of any state or school district that
used QSMBs. The Environmental Protection Agency (EPA) would be
required to approve all projects funded with BABs.
The QZAB program provides a simple allocation formula based
on state populations of individuals living below the poverty
line. The proposed QSMB program, although much larger than the
QZAB program, imposes more stringent allocations. The
administration proposes $11 billion of QSMB issuance per year
in 2000 and 2001. Half of this volume would be allocated to the
100 school districts with the largest number of children living
below poverty. The Education Department would also be able to
designate an additional 25 school districts which ``are in
particular need of assistance.'' The other half would be
allocated among the states based on funding currently received
under the Education Department's Title I grant program. Other
allocations would be reserved for U.S. possessions and for
schools funded by the Bureau of Indian Affairs. BABs would
presumably be allocated by the EPA competitively on a project-
by-project basis.
The Proposed New Structure for Tax Credit Bonds
In its FY 2000 budget, the administration proposes a new
structure for all tax credit bonds. This new structure would
apply to QZABs issued after December 31, 1999, QSMBs and BABs.
In general, the structure is designed so that investors would
buy tax credit bonds at face value--with no original issue
discount--and with no pledge of interest payments by the
issuer. If it works as designed, all of an investor's return
would be earned in the form of the tax credit. The issuer is
supposed to receive a zero-percent cost of capital.
Under the proposal, any taxpayer could claim a credit
associated with holding a tax credit bond. Bondholders would
become eligible to claim the credit annually on the anniversary
date of a bond's issuance. Tax credits would be treated as
taxable interest and would be included in a taxpayer's gross
income calculation. The maximum term of a tax credit bond would
be 15 years. Credits would be non-refundable, but could be
carried forward for up to five years. The credit rate would be
set daily rather than monthly, as under the current QZAB
program. The credit rate would be based on prevailing market
yields in the corporate bond market. An issuer selling tax
credit bonds would use the tax credit rate published by the
Treasury Department on the day prior to the day the bonds are
sold.
Tax Credit Bonds and the Capital Markets
Although the administration's proposed new structure for
tax credit bonds is an improvement over the structure used in
the current QZAB program, from a market perspective, there are
flaws inherent in any tax credit bond which would result in
significant inefficiencies. Perhaps the most significant
involves the timing of tax credits and the nature of the
investment return sought by bond investors.
With a traditional bond that pays cash interest, the yield
calculation used by investors to price the value of a bond
assumes that investors will receive interest payments according
to a specified schedule and that investors will have the
opportunity to reinvest those payments immediately. In the
standard yield or price calculation, there is no time when any
portion of an investor's return is not generating income. In
contrast, the value of a tax credit under any of the proposed
tax credit bond proposals is largely dependent on timing and on
the tax situation of a particular investor. Under the
administration's proposal, an investor earns the ability to
take an annual credit on the anniversary date of a bond's
issuance. However, the credit becomes economically valuable to
the investor only when it has the effect of reducing a tax
payment, and that occurs only on a day when an investor is
required to make a federal tax payment. For some investors, tax
payment dates occur only once per year. In the likely
occurrence that the anniversary date does not coincide with a
tax payment date, the investor incurs a period of time when the
credit has no significant economic value. Because no money has
changed hands, it is not possible for the investor to
``reinvest'' the credit as he or she could with a cash interest
payment. The investor loses the reinvestment income that
normally begins accruing on an interest payment date.
The situation worsens in years when a tax credit bond
investor has no tax liability whatsoever. Under the
administration's proposal, tax credits may be carried forward
for up to five years. However, if an investor has no tax
liability in a given year and is forced to carry the credit
forward, the period of time during which the credit provides no
economic value is extended even further. Again, until an
investor is able to earn true economic value from the credit
through a reduction in a tax payment, the reinvestment
potential normally associated with interest payments is lost.
This substantially erodes the value of the investment. These
timing problems make it exceedingly difficult to efficiently
price the value of a tax credit bond and introduces
inefficiencies to the structure. Indeed, the value of the bond
differs from investor to investor, depending on their tax
circumstances.
A second problem associated with the tax credit bond
proposal involves the overall size of the program. The overall
volume of tax credit bond issuance would increase substantially
under the administration's various proposals. Taken together,
the QZAB, QSMB and BAB proposals would authorize the issuance
of nearly $29 billion of tax credit bonds over five years. In
the context of the capital markets overall, however, this is a
relatively small volume of issuance, especially given the
novelty of the financing structure. In contrast, in 1998 alone,
states and localities issued $286 billion of traditional
municipal bonds. The relatively small size of the tax credit
bond market would ensure that little secondary market trading
took place. Tax credit bonds would be illiquid instruments. As
a result, investors would demand a liquidity premium--a higher
rate of return--from bond issuers.
A third problem with tax credit bonds relates to the timing
and value of the credit rate. The administration has proposed
to set the credit rate on a daily basis using prevailing market
yields in the corporate bond market. Tax credit bond issuers
would use the previous day's credit rate when pricing and
selling their bonds. However, market interest rates change from
day to day and even from minute to minute. It is unlikely that
the interest rates used on Monday to set the credit rate would
still prevail on Tuesday, when an issuer came to market with a
bond issue. If rates have risen, issuers would have to make up
the difference by offering a discounted price on their bonds.
Market professionals have also expressed concerns about the
credit rate itself and the attractiveness to investors of tax
credit bonds with credit rates based on corporate bond yields.
Because they would be priced and sold to investors based on
corporate bond rates of return, they would compete for capital
with corporate bonds themselves and similar taxable
investments. However, because they are tax-preferred
investments, tax credit bonds would be of little value to tax-
exempt or tax-deferred investors such as pension funds,
retirement accounts and foreigners, groups of investors which
are very active in the U.S. taxable bond markets. The only
investor groups to whom tax-credit bonds would be attractive
are domestic individuals and corporations, largely banks and
insurance companies, since they are most active in the capital
markets as investors.
For individual investors, tax-credit bonds would compete
with tax-exempt municipal bonds and taxable corporate bonds.
For many individual investors, municipal bonds provide a more
attractive after-tax rate of return than corporate and similar
taxable bonds. This stands whether the taxable investment pays
cash interest or offers a tax credit at a rate based on
prevailing corporate bond rates of return. It is unlikely that
investors for whom tax-exempt municipal bonds provide a
superior after-tax rate of return to corporate bonds would be
attracted to tax credit bonds with yields based on the
corporate market. Banks and insurance companies, who are active
in the corporate bond market, would potentially find the credit
rate appealing. However, the timing issues outlined above would
make tax credit bonds with interest rates based on corporate
bond yields less attractive than corporate bonds themselves. In
short, it is likely that the pool of potential investors in tax
credit bonds would be severely limited, given that tax-credit
bonds would compete against corporate bonds themselves and
similar taxable investments.
A fourth and final problem associated with the
administration's proposals involves the degree to which federal
agencies are required to approve projects before they qualify
for tax credit bond financing. This approach runs counter to
the flexibility and freedom enjoyed by states and localities in
planning, financing and executing their construction projects.
It is virtually unheard of for a local school district to seek
federal approval before proceeding with a construction project.
Injecting a high degree of federal control in the financing
process would discourage school districts from taking advantage
of the tax credit bond programs.
In sum, given the problems associated with tax credit bonds
outlined above, it is highly unlikely that any state or local
government would obtain a zero-percent cost of capital through
a tax credit bond. Given the inefficiencies built into the tax
credit bond structure, states and localities would invariably
be forced to sell bonds at a discount to attract investor
interest. The difference between the sale price of tax credit
bonds and their face value would represent interest cost to the
issuer in the form of original issue discount.
An Alternative--Tax-exempt Financing
Tax-exempt bonds are the single most important source of
financing for state and local investment in public school
infrastructure. Over the past decade or so, tax-exempt bonds
have financed approximately 90 percent of the nation's
investment in public schools. Tax-exempt bonds are efficient,
well-understood, popular among investors, and have an
established market infrastructure with a several-hundred-year
history beginning in colonial times. Moreover, tax-exempt bonds
provide an important source of federal assistance from the
federal government to states and localities. Because the
federal government foregoes the tax revenue on interest earned
by investors on qualified municipal bonds, investors demand a
much lower rate of interest than they otherwise would. States
and localities benefit through a lower cost of capital.
Tax-exempt bonds are not plagued by any of the problems
that would affect the success of tax credit bonds. Because they
pay cash interest, municipal bonds are not affected by the
timing issues that would erode the value of tax credit bonds.
Because it is a large and established market with a broad base
of investors, secondary market trading is relatively active and
liquid. Interest rates are set efficiently according to market-
based rates of return, and issuers do not need any form of
federal approval to tap the capital markets.
As beneficial as tax-exempt bonds are in helping school
districts finance construction and rehabilitation, the federal
tax code contains a number of restrictions on the issuance and
use of tax-exempt bonds that prevent school districts from
using municipal bonds to their full potential. Congress has
considered and is considering several targeted changes to
improve the ability of school districts to use tax-exempt bonds
to finance school construction. These proposals would address
restrictions related to private use, arbitrage, refinancings
and restrictions on investing in school bonds. They would
provide meaningful assistance to school districts by lowering
the cost of financing for school construction projects. The
proposals would result in more schools being built and repaired
and would, in some cases, accelerate construction projects that
are on school districts' capital investment plans.
On February 4, Chairman Archer announced his support for an
initiative to extend from two years to four the construction
spend-down exemption from arbitrage rebate rules for school
bonds. In announcing this initiative, Chairman Archer correctly
recognized that addressing existing impediments to the broader
use of tax-exempt bonds for school construction would go a long
way towards encouraging and assisting local school districts to
build more schools faster. We fully support Chairman Archer's
proposal and we urge Congress to enact it quickly. We also urge
Congress to consider, as an alternative or supplement to tax-
credit bonds, other targeted changes to municipal bond rules
for school bonds to spur public school construction and
rehabilitation.
Summary
Government fiscal policy, especially tax policy, can have a
profound effect on the ability of governments and corporations
to undertake capital investment. Tax increase proposals as
seemingly arcane, technical and focused as ``increasing the
proration percentage for property and casualty companies'' or
``disallowing interest on debt allocable to tax-exempt
obligations'' 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 tax
increase proposals outlined above would have the opposite
effect. We urge you to oppose these provisions.
We agree with the administration's goals in other areas. We
agree, for example, that tax incentives designed to assist and
encourage school districts to build and rehabilitate public
schools are appropriate. Unfortunately, it appears that the
administration's tax credit bond initiatives would fail to
achieve the goal of providing state and local governments with
a zero-interest source of capital. We urge Congress to explore
alternative ways to expand traditional municipal bond financing
for school construction and rehabilitation.
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.
Statement of Business Insurance Coalition
AIG Life Companies (U.S.)
American Council of Life Insurance
American General Corporation
America's Community Bankers
Association for Advanced Life Underwriting
Business Use Insurance Committee
Clarke/Bardes, Inc.
Harris, Crouch, Long, Scott & Miller, Inc.
Massachusetts Mutual Life Insurance Company
MetLife
National Association of Life Underwriters
New York Life Insurance Company
Pacific Life
Security Life of Denver Insurance
Southland Insurance Company
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 2000 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. The Administration
has again proposed--as it did last year--a heavy tax on life
insurance held by businesses that would strongly discourage the
vast majority of employers from utilizing this important
product. We urge Members of the Ways and Means Committee to
reject it once again.
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 upon the death of a business owner, to buy
out heirs of a deceased owner or to meet payroll and other
ongoing expenses when an income-producing worker dies.
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 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 2000 budget proposal would severely
impact all of the aforementioned business uses of life
insurance. Under the proposal, any business with general
business debt unrelated to insurance would lose part of its
deduction for interest paid on that debt simply because the
business owns, or is the beneficiary of, permanent life
insurance. The business' interest deduction would be reduced by
an amount related to the net unborrowed cash values in such
policies (except for those covering the lives of 20 percent
owners). This would impose an indirect tax on accumulating cash
values of the insurance--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.
Last year, the Administration made the same proposal, which
seeks to overturn current law developed after three years of
Congressional examination into appropriate business uses of
life insurance. It again asks Congress to reconsider its 1996
and 1997 determinations 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 an 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 in connection with employee and retiree
benefits. It would hurt employees by unduly restricting the
benefits companies can provide to key workers. It would hurt
businesses by making it more difficult 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, which the retroactive
application of the Administration's new tax on existing
policies would be certain to trigger. 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 used 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. If the Administration's logic were
applied to individual taxpayers, homeowners would lose their
ability to deduct interest on their home mortgage loans because
they also own permanent life insurance.
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.
The Administration's Characterization of Business Insurance as a Tax
Shelter is Nonsense
The tax attributes of life insurance are clearly defined by
the Internal Revenue Code, of which they have been a part for
many years. Those attributes have been the object of study by
Congress from time to time and refinement of some of the
ancillary rules. The fundamental tax attributes have remained
unchanged, however, and they are well understood.
As noted above, life insurance has long been used by
businesses to assure business continuation, provide employee
benefits, and attract and retain key employees. These business
uses of life insurance are also well known. Indeed, they have
been examined exhaustively by the Congress in each of the last
three years.
In 1996, Congress examined business life insurance and made
adjustments with respect to policy loans. It did so again in
1997, when it imposed limitations on life insurance covering
the lives of non-employees. Both times, Congress left alone
traditional uses of life insurance by businesses. In 1998,
Congress again examined business life insurance, this time
rejecting the very proposal the Administration again makes this
year to impose a new tax on all forms of cash value life
insurance held by business by denying a deduction for interest
on unrelated debt.
It is therefore surprising that the Administration now
seeks to characterize business insurance as a tax shelter. At
the heart of the Administration's tax shelter proposals is the
concept of a ``tax avoidance transaction.'' Mere ownership of
life insurance, the tax attributes of which are longstanding
and well known, plainly cannot be such a transaction.
More specifically, the Administration makes it clear in its
tax shelter proposals that a tax shelter does not include any
``tax benefit clearly contemplated by the applicable
provision.'' Department of the Treasury, General Explanation of
the Administration's Revenue Proposals at 96 (February 1999).
The tax attributes of life insurance are not only clearly
contemplated and well understood--they were precisely the
attributes examined at length by Congress in 1996, 1997 and
1998.
The Administration's proposal is to impose a new tax on
traditional business uses of life insurance, and nothing more.
It should be considered--and rejected--on its merits, and not
based on the Administration's incongruous and entirely
inappropriate characterization of life insurance as a ``tax
shelter.''
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 be able to 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.
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 less than
two years ago--and then to change them again 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 2000 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 again
reject the Administration's proposal to impose new taxes on
business-use.
Statement of Business Roundtable
I am Thomas Usher, chief executive officer of USX
Corporation and chairman of the Taxation Task Force of The
Business Roundtable. I am testifying in writing to the views of
The Business Roundtable on tax legislation for 1999. The
members of The Business Roundtable are chief executive officers
of leading corporations with a combined workforce of more than
10 million employees in the United States.
In the United States, corporations employ more people, pay
more wages, fund more research, invest in more plant and
equipment, and support more employee benefits than any other
type of business. We also pay more federal income tax.
Therefore, one of our main public policy interests is how taxes
are affecting corporations in their central economic role as
engines pulling the national economy.
From that perspective, we urge Congress to reduce the
corporate income tax. Corporate funds that are not diverted to
taxes can go into building the economy and underwriting
prosperity in future years. The old saying is true: the time to
invest is when you have it. The condition of the federal
budget, itself a beneficiary of economic growth, makes a
corporate tax reduction feasible.
Lowering the corporate income tax rate would be the most
effective form of corporate tax reduction. It would affect all
types of corporations. It would put funds into play to compete
for economic projects that have the best prospects for creating
value and stimulating growth. The alternative is for the
government to pick business winners based on politics and thus
dilute the beneficial impact of a business tax reduction.
The top corporate income tax rate is 35 percent. It is in
the 30's today rather than the 20's as the result of tax reform
politics in 1986 and not for any reason of tax or economic
policy. The original tax reform ideal was to broaden the tax
base and lower tax rates so that the net change was revenue
neutral. If Congress had applied this principle to the
corporate income tax in the Tax Reform Act of 1986, the top
corporate tax rate would have been 26 or 27 percent. But to
obtain support for tax reform in 1986, the government enacted
more than a 20 percent corporate tax increase so that it could
cut individuals' taxes in the same amount.
Other broad improvements to the federal corporate income
tax would allow businesses to create additional value. These
improvements include simplification of tax rules governing
international business; a permanent tax credit to encourage
research and experimentation so that the credit functions more
effectively, as all commentators on the subject have observed;
and alternative minimum tax relief so that heavy-investing
companies are not penalized and capital can flow into job-
producing uses rather than prepayment of income tax.
Constructive measures like cutting corporate tax rates and
simplifying international tax rules stand in stark contrast to
the Administration's proposals to increase taxes on business.
Corporations are singled out in certain proposals that have
soundbite appeal but only magnify the worst tendencies of the
tax system to complicate, confuse, and retard economic growth.
Each of these revenue-raising proposals regarding global
operations, exports, corporate tax planning, tracking stock,
and punitive damages is objectionable on its own and should be
rejected. Together these proposals represent an additional tax
burden on American business that is anticompetitive in the
global marketplace.
We would have thought it axiomatic that U.S. tax policy
should not handicap U.S. enterprises in the international
contest for business. But the Administration's proposals would
have a particularly harsh impact on international operations.
They could be employed by IRS agents to deny foreign tax
credits and interest deductions where corporate structures are
debt-financed. They would add significantly to the tax burden
of U.S. multinationals and make it impossible for them to
operate with certainty regarding the tax treatment of their
global operations. The proposal to repeal the ``export sales
source rule'' would increase taxes sharply on U.S. companies
that export goods overseas.
The Administration's proposal to tax the issuance of
tracking stock is unprecedented. Such a tax would constitute
the only direct tax on the issuance of common stock. Companies
use tracking stock for compelling business reasons: to raise
capital efficiently to grow or acquire businesses, to attract
and retain employees, and to satisfy investor demands. The
imposition of a tax on the issuance of tracking stock would
constrict new business technology investment, disrupt financial
markets, cost jobs, and require massive financial re-
engineering for some companies.
In the name of attacking ``corporate tax shelters'' the
Administration would give IRS auditors unprecedented authority
to impose taxes and penalties on almost any business
transaction where tax-planning considerations may have played a
role. These proposals could affect a wide range of legitimate
business transactions undertaken in the ordinary course of
business. The proposals would compromise the rights of
taxpayers to pay no more than the minimum amount they owe under
the tax laws and overlook the ample tools the government
already possesses to address abuses of the tax system. The
proposals are even more surprising coming so soon after the
Administration itself found it necessary to rein in undesirable
practices of IRS agents and reform the IRS.
It is accepted in tax theory and in the actual practice of
our global competitors to allow business deductions against
income. Yet the Administration proposes to deny deductions for
punitive damages paid by corporations upon judgment by a court
or upon settlement of a claim. It is particularly unfair given
our litigious society and given that the federal government has
failed to enact any meaningful tort reform.
Finally, we would not have expected the Administration to
propose a $20 billion corporate income tax increase over the
same 5-year period that federal budget surpluses will amass to
$953 billion.
Who will look to the bigger picture? We respectfully urge
this Committee, this House of Representatives, and this
Congress to close the book on fragmentary and narrow-gauged tax
measures, like many of those in the Administration's budget,
and to consider more visionary policies that promote the
general economic welfare of this nation as it engages in the
global contest for income and prosperity.
Thank you for considering our views.
Statement of Central & South West Corporation, Dallas, Texas
Mr. Chairman and Members of the Committee, we thank you for
the opportunity to submit this statement on behalf of Central &
South West Corporation of Dallas, Texas on the importance of
extending the wind energy production tax credit (PTC) until the
year 2004.
Central and South West Corporation (CSW) is an investor-
owned electric utility holding company based in Dallas, Texas.
CSW owns and operates four electric utilities in the United
States: Central Power and Light Company, Public Service Company
of Oklahoma, Southwestern Electric Power Company, and West
Texas Utilities Company. These companies serve 1.7 million
customers in an area covering 152,000 square miles of Texas,
Oklahoma, Louisiana, and Arkansas.
CSW also owns a regional electricity company in the United
Kingdom, SEEBOARD plc, which serves 2 million customers in
Southeast England. CSW engages in international energy,
telecommunications and energy services businesses through
nonutility subsidiaries including CSW Energy, CSW
International, C3 Communications, EnerShop, and CSW Energy
Services. CSW is currently in the process of seeking regulatory
approval for a merger with American Electric Power Company,
based in Columbus, Ohio, and expects the merger to be completed
sometime in the 4th quarter of 1999.
CSW has been active in the research and development of wind
energy for six years, and was named as the American Wind Energy
Association's Utility of the Year in 1996. CSW owns and
operates the first wind farm built as part of the U. S.
Department of Energy's Turbine Verification Program in which
state-of-the-art, U.S.-manufactured wind turbine technology is
being tested. In addition, a 75 MW wind farm is currently being
built near the west Texas community of McCamey in order to
serve the customers of three CSW subsidiaries--West Texas
Utilities Company, Central Power and Light Company, and
Southwestern Electric Power Company.
We want to commend Representative Bill Thomas, and all of
the cosponsors of H.R. 750, and Senators Grassley, Jeffords and
Conrad and all of the cosponsors of S. 414, for their
leadership in supporting legislation to extend the wind energy
PTC until the year 2004. H.R. 750 and S. 414 both have broad,
bipartisan support. H.R. 750 was introduced with sixty (60)
original cosponsors, including nineteen (19) members of this
committee. H.R. 750 is now supported by 86 cosponsors including
23 of the members, a majority, of this committee.
We also want to commend President Clinton for including,
and funding, a five-year extension of the wind energy PTC in
the Administration's FY 2000 Budget.
We hope the Congress will take swift action to extend the
wind energy PTC by enacting the provisions of H.R. 750--S. 414
before the expiration of the current PTC on June 30, 1999.
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
June 30, 1999. The current credit will expire on June 30, 1999.
II. WHY DO WE NEED A WIND ENERGY PTC?
A. The Wind Energy PTC is Helping to Drive Costs Down, Making Wind
Energy a Viable and Efficient Source of Renewable Power
The efficiency of wind generated electric energy has
increased dramatically since the early to mid-1980's. The
machine technology of the 1980's was in its early stages and
costs of wind energy during this time period exceeded 25 cents
per kilowatt-hour. Since that time, however, the wind industry
has succeeded in reducing wind energy production costs by a
remarkable 80% to the current cost of about 4.5 cents/kilowatt-
hour. The 1.5 cent/kilowatt-hour credit enables the industry to
compete with other generating sources currently being sold at
3.0 cents/kilowatt-hour.
The industry expects that its costs will continue to
decline as wind turbine technology and manufacturing economies
of scale increase in efficiency. Through further machine
development and manufacturing efficiencies, the wind energy
industry anticipates the cost of wind energy will be further
reduced to 3 cents/kilowatt-hour or lower by the year 2004,
which will enable it to fully compete on its own in the
marketplace.
The most significant factor contributing to the dramatic
reduction in U.S. wind energy production costs over the years--
since the 1980's--has been the dramatic improvement in machine
efficiency. Since the 1980's, the industry has developed three
generations of new and improved machines, with each generation
of design improving upon its predecessor. As a result, reduced
costs of production of new wind turbines, blade designs,
computer controls, and extended machine component life have
been achieved. Proven machine technology has evolved from the
50-kilowatt machines of the 1980's to the 750-kilowatt machines
of today that have the capacity to satisfy the energy demands
of as many as 150 to 200 homes annually. Moreover, a new 1500-
kilowatt machine is currently undergoing the last phases of
development and testing that will further improve the
technology's efficiency and further reduce wind power costs to
about 4 cents per kilowatt-hour.
The wind industry anticipates that wind energy production
costs will continue to decline in the future, and is confident
that the next two generations of wind turbine design--estimated
to be available by the year 2004--will sufficiently lower the
technology costs to allow the industry to fully compete in the
United States on its own merits with fossil-fueled generation.
The five-year extension of the wind energy production tax
credit will bridge the gap for the domestic industry until it
is fully able to stand on its own by the year 2004.
B. Wind Power will Play an Important Role in a Deregulated Electrical
Market
The electrical generation market is going through
significant 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 country. These projects are currently generating 1,761
megawatts of wind power in the following states: Texas, New
York, Minnesota, Iowa, 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 significant 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, as measured
by annual energy potential in the billions of kWhs in
environment and land use exclusions for wind class sites of 3
and higher, include:
1. North Dakota................... 1,210
2. Texas.......................... 1,190
3. Kansas......................... 1,070
4. South Dakota................... 1,030
5. Montana........................ 1,020
6. Nebraska....................... 868
7. Wyoming........................ 747
8. Oklahoma....................... 725
9. Minnesota...................... 657
10. Iowa........................... 551
11. Colorado....................... 481
12. New Mexico..................... 435
13. Idaho.......................... 73
14. Michigan....................... 65
15. New York....................... 62
16. Illinois....................... 61
17. California..................... 59
18. Wisconsin...................... 58
19. Maine.......................... 56
20. Missouri \1\................... 52
Source: An Assessment of the Available Windy Land Area and Wind Energy
Potential in the Contiguous United States, Pacific Northwest
Laboratory, 1991.
Sixteen states, including our home state of Texas, have
greater wind energy potential than California where, to date,
the vast majority of wind development has taken place.
a. Wind Power Projects can Serve as a Supplemental Source of
Income for Farmers
As discussed above, the increasing sophistication of wind
energy technology has opened up new regions of the country to
wind energy production. One area of the country that has been
opened up to wind power production over the last few years is
the Farm Belt. Since wind power projects and farming are fully
compatible--a wind power plant can operate on land that is
being farmed with little or no displacement of crops or
livestock--wind power projects are now be sited on land in the
Farm Belt that is also being used for crop and/or livestock
production. The land rent paid by wind project developers is a
valuable source of additional income for farmers. For example,
a new wind plant soon to go on line in Clear Lake, Iowa will
pay rent to fourteen different landowners who will be
supplementing their income by leasing their land for the
operation of the plant without disrupting their ongoing farming
operations. This is a win-win situation for both farmers and
consumers in Iowa.
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.
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
four months, June 30, 1999, wind energy developers and
investors are unable to plan any new wind power projects. The
immediate extension of the wind energy PTC is therefore
critical to the continued development and evolution 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 efficiently 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 is
an environmentally-friendly energy source that can aid in the
reduction of greenhouse gas emissions. The economic
opportunities of the wind energy market are significant, both
domestically and internationally. As such, we urge Congress to
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.
Thank you for providing us with this opportunity to present
our views on the extension of the wind energy PTC.
Statement of Coalition for the Fair Taxation of Business Transactions
\1\
The Coalition for the Fair Taxation of Business
Transactions (the ``Coalition'') is composed of U.S. companies
representing a broad cross-section of industries. The Coalition
is opposed to the broad-based ``corporate tax shelter''
provisions in the Administration's budget because of their
detrimental impact on legitimate business transactions. The
Coalition is particularly concerned with the broad delegation
of authority provided to IRS agents under these proposals,
which we believe reverses some of the reforms of the IRS
Restructuring and Reform Act, passed just last year.
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\1\ This testimony was prepared by Arthur Andersen on behalf of the
Coalition for the Fair Taxation of Business Transactions.
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Introduction
The Administration's Fiscal Year 2000 Budget contains
several proposals addressing so-called ``corporate tax
shelters.'' The proposals fall into two general categories. The
first is a set of broad-based proposals that could result in
multiple penalties for any corporation that engages in a
transaction that results in any reduction of taxes. The second
is a set of specific proposals targeted at specific
transactions that Treasury and the IRS view as abusive or
inappropriate. These proposals, especially the set of broad-
based proposals, appear to be driven by a perception on the
part of Treasury and the IRS of a substantial increase in
``corporate tax shelter'' activity in recent years and that
such activity has caused a serious erosion in the corporate tax
base.
As a general matter, the Coalition does not believe that
there has been a substantial erosion of the corporate tax base.
Statistics recently released by the Congressional Budget Office
(CBO) \2\ demonstrate that, rather than falling, corporate
income tax receipts have been steadily rising in recent years.
Further, CBO and the Office of Management and Budget (``OMB'')
both project that revenues from corporate income taxes will
continue to rise over the next 10 years. In fact, the average
tax rate paid by corporations is approximately 32.5 percent and
is projected by CBO to rise to 33.6 percent in 2000. In
addition, according to CBO, corporate income tax receipts grew
3.5 percent for fiscal year 1998, while taxable corporate
profits grew at a slower rate of only 2.3 percent. In light of
the average corporate tax rate remaining relatively constant,
there does not appear to be any compelling reason for a radical
set of new proposals addressing ``corporate tax shelters.''
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\2\ The Economic and Budget Outlook: Fiscal Years 2000-2009,
Congressional Budget Office, January 1999
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The Coalition also believes that, in addition to being
unnecessary, the broad-based proposals could seriously
undermine a corporation's ability to undertake legitimate
business transactions. The vague, generalized language of the
various proposals does not provide sufficient guidance to
corporate taxpayers as to what transactions will constitute a
``corporate tax shelter.'' As a result, virtually every
transaction, regardless of its purpose, undertaken by a
corporate taxpayer that minimizes the corporation's taxes in
any way will be potentially subject to the very harsh penalties
contained in the tax shelter proposals.
In addition, the Coalition also believes that the broad-
based corporate tax shelter proposals would unjustifiably
delegate too much authority to the IRS and allow the IRS to
impose harsh penalties on activities that represent legitimate
business transactions. The tenor and potential effect of these
broad-based proposals fly in the face of the Congressional
policy underlying enactment of the IRS Restructuring and Reform
Act of 1998. In particular, Congress expressed serious concerns
about the excessive amount of power in the hands of IRS agents
and, in response, modified the structure and operations of the
IRS and expanded the rights of taxpayers against the
intrusiveness of the IRS. The broad grant of authority to IRS
agents in the Administration's tax shelter proposals is
contrary to the theme of the IRS Restructuring and Reform Act
of 1998 to curtail the power that IRS agents have over
taxpayers.
Finally, the Coalition believes the level of penalties
proposed by the Administration is particularly harsh in light
of the overwhelming complexity of the current tax laws. The
combination of the proposals would create a cascading of
penalties that, both individually and in the aggregate, would
be unfair and excessive. Congress has already stated that
cascading penalties are unfair and expressed its disapproval of
them in the IRS Restructuring and Reform Act.
In sum, Congress should reject these overly broad and
unworkable proposals. The proposals transfer excessive and
unnecessary authority to the IRS and unfairly impact legitimate
business transactions that are not tax-motivated. Moreover, the
Administration's new definition of corporate tax shelter
creates additional uncertainty in a tax code that is already
overwhelmed with complexity.
II. Definition of Corporate Tax Shelter
One need look no further than the proposed new definition
of corporate tax shelter \3\ to find the genesis of the
problems with the Administration's budget proposals. Rather
than providing an objective definition of a ``corporate tax
shelter,'' the proposal simply defines a corporate tax shelter
as any entity, plan, or arrangement in which a corporation
obtained a ``tax benefit'' in a ``tax avoidance transaction.''
Under the proposal, it would no longer be necessary to find
that a transaction had a ``significant purpose,'' or indeed any
purpose, to avoid taxes for the transaction to be characterized
as a corporate tax shelter. As discussed below, these concepts
and definitions are overly broad and vague, and are so
subjective that they give virtually unlimited discretion to the
IRS to determine if a transaction is a corporate tax shelter.
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\3\ For transactions entered into before August 6, 1997, a ``tax
shelter'' is defined as a partnership or other entity, an investment
plan or arrangement, or any other plan or arrangement if the principal
purpose of the partnership, entity, plan, or arrangement is the
avoidance or evasion of Federal income tax. The Taxpayer Relief Act of
1997 amended section 6662(d)(2)(C)(ii) to provide a new definition of
tax shelter for purposes of the substantial understatement penalty.
Under this new definition of tax shelter, the tax avoidance purpose of
an entity or arrangement need not be its principal purpose. Now a tax
shelter is any entity, investment, plan, or arrangement with a
significant purpose of avoiding or evading Federal income taxes. The
new definition of tax shelter is effective for transactions entered
into after August 5, 1997.
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The proposal defines a ``tax benefit'' as a reduction,
exclusion, avoidance or deferral of tax (or an increase in a
refund) unless the benefit was ``clearly contemplated'' by the
applicable Code provision. The proposal provides no guidance on
how to determine when a tax benefit is clearly contemplated. It
appears that a benefit can be an impermissible ``tax benefit''
even if the benefit was permitted under the actual language of
the applicable Code provision. In the absence of any clear
guidance, the proposal would apparently provide IRS revenue
agents with the power to determine whether a taxpayer's tax
benefit was a ``clearly contemplated'' permissible benefit.
This part of the proposal simply grants too much authority to
individual revenue agents, which will inevitably result in
increased confrontations between taxpayers and revenue agents
and a backlog of litigation in the Tax Court.
The proposal defines a ``tax avoidance transaction'' as any
transaction in which the reasonably expected pre-tax profit
(determined on a present value basis, after taking into account
foreign taxes as expenses and transaction costs) of the
transaction is insignificant relative to the reasonably
expected net tax benefits (i.e., tax benefits in excess of the
tax liability arising from the transaction, determined on a
present value basis) of such transaction. In addition, a tax
avoidance transaction is defined to cover certain transactions
involving the improper elimination or significant reduction of
tax on economic income.
As in the case of the definition of ``tax benefit,'' the
Administration's proposal fails to provide any guidance on what
transactions would constitute ``tax avoidance transactions.''
For example, the proposal does not provide any guidance as to
the amount of expected pre-tax profit that would be
insignificant relative to the reasonably expected net tax
benefits. The proposal also fails to provide guidance as to how
a corporate taxpayer is to accomplish the impossible task of
present valuing expected net tax benefits. This inflexible,
mathematical analysis does not allow for the possibility of
legitimate business transactions that do not produce an easily
identifiable pre-tax profit. For example, a corporation may
need to structure its affairs to conform to regulatory
requirements or a company may reorganize its structure to gain
access to certain foreign markets. A company may also need to
restructure or reorganize to gain economies of scale. In
addition, a company may enter into a transaction to obtain
funds for working capital at a lower cost. \4\ These
transactions are motivated by business concerns, even though
they do not directly produce a pre-tax economic return by
themselves. If these legitimate transactions are done in a tax
efficient manner, they apparently will be characterized
automatically as a tax shelter because they do not produce a
direct economic return. Further, under the proposal, IRS agents
could attempt to classify any loss transaction as a tax shelter
when the transaction does not provide the expected return.
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\4\ The IRS recently issued a Technical Advice Memorandum, TAM
199910046 (November 16, 1998), in which it upheld the taxpayer's
interest deduction, ruling that merely because the taxpayer did not
earn a profit on the transaction did not imply that the transaction
lacked economic substance.
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Under the second part of the proposed definition of tax
avoidance transaction, any transaction that results in a
significant reduction of tax on economic income could be
classified as a corporate tax shelter. The proposal is silent
as to what types of transactions would involve the ``improper
elimination'' or ``significant reduction'' of tax on economic
income. The Administration's proposal contains no restraints on
the use of this provision by the IRS; therefore, the IRS can
classify any legitimate business transaction as a corporate tax
shelter if, in the opinion of the IRS, the transaction resulted
in a significant reduction of tax on economic income. For
example, the IRS could possibly classify such routine business
transactions as tax-free reorganizations, tax-free spinoffs, or
even check-the-box classification elections as corporate tax
shelters. In other words, this proposal would allow the IRS to
penalize corporate taxpayers for arranging their transactions
in a tax efficient manner. This proposals ignores Judge Learned
Hand's observation that:
Anyone may so arrange his affairs that his taxes shall be as
low as possible, he is not bound to chose that pattern which
will best pay the Treasury, there is not even a patriotic duty
to increase one's taxes.\5\
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\5\ Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934), aff'd
293 U.S. 465 (1935).
Despite Treasury's claims to the contrary, these proposed
broad definitions are not simply a codification of existing
judicial doctrines. Current case law views a significant pre-
tax profit as a sufficient, but not a necessary, condition for
finding that a transaction does not represent a corporate tax
shelter. In addition, case law has always considered valid
business reasons as part of the evaluation of corporate
transactions. For example, the Supreme Court has upheld a
transaction ``which is compelled or encouraged by business or
regulatory realities, is imbued with tax-independent
considerations, and is not shaped solely by tax-avoidance
features that have meaningless labels attached.'' Frank Lyon
Co. v. United States, 435 U.S. 561, 583-84 (1978). Similarly,
cases have held that ``when a transaction has no substance
other than to create deductions, the transaction is disregarded
for tax purposes.'' Knetsch v. United States, 364 U.S. 361, 366
(1960). The most recent case applying this analysis examined
both the objective economics of a transaction, as well as the
subjective business motivations claimed by the parties. ACM
Partnership v. Commissioner, 157 F.3d 231 (3d Cir. 1998).
Therefore, adopting a purely mechanical test that compares pre-
tax profits to tax benefits, without looking to business
reasons for the transaction, goes far beyond the holdings in
current case law.
Analysis of Corporate Tax Shelter Proposals
A. Modified Substantial Understatement Penalty
The Administration's budget proposal would increase the
substantial understatement penalty from 20 percent to 40
percent with respect to any item attributable to a corporate
tax shelter.\6\ A corporation can reduce the 40 percent penalty
to 20 percent by fulfilling specific disclosure requirements.
This proposal would also eliminate the reasonable cause
exception to the imposition of the penalty for any item
attributable to a corporate tax shelter.
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\6\ Generally, Section 6662(a) of the Internal Revenue Code imposes
a 20 percent penalty on the portion of an underpayment of tax
attributable to a substantial understatement of income tax.
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There is no rationale for increasing the substantial
understatement penalty from 20 to 40 percent. The current 20
percent penalty is a powerful incentive for corporate taxpayers
to closely analyze any proposed business transaction that
results in tax benefits. Moreover, Treasury has failed to
provide objective evidence to establish that doubling the
substantial understatement will have any incremental behavioral
effect. In addition, the proposed definition of ``corporate tax
shelter'' is too vague, and creates too much uncertainty, to
justify a 40 percent penalty. Such an increase in penalties is
also inconsistent with the intent of the IRS Restructuring and
Reform Act to simplify penalty administration and reduce
burdens on taxpayers.
Even less justified is the elimination of the reasonable
cause exception to the penalty. The reasonable cause exception
is an essential function of the penalty regime and is found in
virtually every penalty provision of the Code. The rationale
for such an exception is simple: in light of the complexity of
the Code and the significant uncertainty in its interpretation,
it is unfair to automatically impose a penalty upon a taxpayer
who has made a good faith effort to comply with the tax law.
Without such an exception, taxpayers will be faced with a
draconian 40 percent penalty for a misinterpretation of the
law, even if there is an honest disagreement on the
interpretation of fact and law that is reasonable in light of
all the facts and circumstances. In effect, taxpayers will be
held to a strict liability standard in interpreting overly
complex tax laws.
The elimination of the reasonable cause exception will also
have a serious impact on the administration of the tax law. For
example, preventing the IRS from waiving penalties for
reasonable cause will result in a decline in the number of
cases settled administratively. The size of the penalty and the
inability on the part of the IRS to waive the penalty will
require taxpayers to litigate the underlying issue of whether
the transaction was a corporate tax shelter. In addition, the
combination of the elimination of the reasonable cause
exception and the creation of a subjective definition of
corporate tax shelter will give agents an unwarranted
opportunity to hold corporate taxpayers hostage during the
examination process. Revenue agents can threaten to propose
adjustments based on alleged corporate tax shelter transactions
to extract unreasonable concessions by the corporate taxpayer
on other issues. The use of the increased substantial
understatement penalty to obtain concessions from corporate
taxpayers is inconsistent with the goals expressed in the IRS
Restructuring and Reform Act of 1998.
B. Deny Certain Tax Benefits to Persons Avoiding Income Tax as
a Result of Tax Avoidance Transactions
Currently, under section 269 of the Code, the Secretary of
the Treasury has the authority to disallow a tax benefit in
certain acquisition transactions where the principle purpose
for entering into the transaction is the evasion or avoidance
of Federal income tax by obtaining the benefit of a deduction,
credit, or other allowance. This provision applies to
transactions involving the acquisition of control of a
corporation (directly or indirectly), or to transactions where
a corporation acquires (directly or indirectly) carryover basis
property of another corporation that was not controlled by the
acquiring corporation immediately before the transaction. The
tax benefits that may be disallowed under section 269 include
net operating losses, foreign tax credit carryovers, investment
credit carryovers, depreciation deductions, and a wide range of
other tax attributes.
The Administration's proposal would dramatically expand
section 269 and give the IRS authority to disallow a deduction,
credit, exclusion, or other allowance obtained in a ``tax
avoidance transaction.'' \7\ Thus, the proposal goes well
beyond the context of the current section 269 and would
represent an inappropriate delegation of authority to Treasury
and IRS personnel. Under this proposal, revenue agents could
disallow any deduction, credit, exclusion, or other allowance
obtained by a corporate taxpayer based on their subjective
determination that a transaction falls within the vague
definition of a ``tax avoidance transaction.'' This authority
could be used to deny a corporate taxpayer a tax benefit
provided by the Code merely because the IRS believes that the
transaction yielded too much tax savings, regardless of a
corporate taxpayer's legitimate business purpose for entering
into the transaction. Again, this is giving an IRS agent too
much discretion and is inconsistent with the IRS Restructuring
and Reform Act.
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\7\ The definition of ``tax avoidance transaction'' for purpose of
this transaction is the same as is used to define a corporate tax
shelter, discussed above.
C. Deny Deductions For Certain Tax Advice and Imposition of an
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Excise Tax on Certain Fees Received.
The Administration's proposal would deny a deduction for
fees paid or incurred in connection with the purchase and
implementation, as well as the rendering of tax advice related
to, corporate tax shelters and impose a 25-percent excise tax
on fees received in connection therewith. This proposal relies
on the same vague and faulty definition of ``tax avoidance
transaction'' as the previously discussed proposals. Thus, if
in the IRS's view a transaction significantly reduces tax on
economic income, or if the transaction does not meet the
economic profit test, a tax deduction can be denied for tax
advice that represents an ordinary and necessary business
expense associated with a legitimate business transaction. An
even more absurd result is that a deduction would be disallowed
for fees related to tax advice where the advice is to not
invest in a particular transaction because it may be considered
a tax shelter.
This provision also illustrates the overlapping nature of
the corporate tax shelter proposals and the potentially
cascading penalties they can impose on a corporate taxpayer.
For example, assume that a taxpayer entered into a legitimate
business transaction on the advice of its tax adviser that the
transaction was not a tax avoidance transaction. If the IRS
subsequently determines that the transaction did not have
sufficient pre-tax benefits, the transaction could be
classified as a tax avoidance transaction. The corporate
taxpayer would be subject to at least three penalties: (1)
denial of the deduction for fees paid to the tax adviser for
what has previously always been considered an ordinary and
necessary business expense, (2) the 40 percent modified
substantial understatement penalty on the disallowed deduction
for the fees paid, and (3) the 40 percent modified substantial
understatement penalty on the tax attributed to the tax
benefits denied as a result of the IRS characterizing the
transaction as a tax avoidance transaction.
Finally, this particular proposal to impose an excise tax
on fees received in connection with a tax shelter raises
numerous administrative issues. The determination that a
transaction falls within the new definition of corporate tax
shelters may not be made until years after the payment or the
receipt of fees, which raises questions concerning the statute
of limitations and the IRS's assessment authority against the
``shelter provider.'' Fairness demands that the fee recipient
also be provided an opportunity to challenge the tax shelter
determination, which may result in the issue being litigated
twice. These are only a few of the practical problems that need
resolution in order to implement this vague proposal.
D. Impose Excise Tax on Certain Rescission Provisions and
Provisions Guaranteeing Tax Benefits
The Administration's budget proposal would impose an excise
tax on a ``tax benefit protection arrangement'' provided to the
purchaser of a corporate tax shelter. A tax benefit protection
arrangement would include a rescission clause requiring a
seller or counterparty to unwind the transaction, a guarantee
of tax benefits arrangement, or any other arrangement that has
the same economic effect (e.g., insurance purchased with
respect to the transaction). The Administration's plan would
impose on the purchaser of a corporate tax shelter an excise
tax of 25% on the maximum payment to be made under a tax
benefit arrangement if the tax benefits are denied.
As a practical matter, this proposal fails to consider how
rescission clauses or guarantees work. Generally, these
agreements put a tax adviser at risk for an agreed-upon
percentage of any additional tax that the taxpayer ultimately
owes as a result of the transaction. This amount cannot be
determined unless and until the Service proposes adjustments to
the taxpayer's liability with respect to the transaction and
the taxpayer's correct tax liability is either agreed upon by
the parties or determined by a court. Until such time, a
corporate taxpayer cannot determine the maximum payment
possible under the arrangement. Moreover, assessing an excise
tax based upon the highest potential benefits that could
possibly be obtained in the future under such an agreement is
fundamentally unfair and is too onerous a penalty.
E. Preclude Taxpayers From Taking Tax Positions Inconsistent
With the Form of Their Transaction
The Administration's budget proposal would generally
provide that a corporate taxpayer is precluded from taking any
position that is inconsistent with its form if a ``tax
indifferent party'' is involved in the transaction. This rule
would not apply (1) if the taxpayer discloses the inconsistent
position on a timely filed original return; (2) to the extent
provided in regulations, if reporting the substance of the
transaction more clearly reflects income; or (3) to certain
transactions (such as publicly-available securities, lending
and sale-repurchase transactions) identified in regulations.
This proposal would essentially require a U.S. taxpayer to
be bound by the form of a transaction unless it disclosed the
inconsistent position to the IRS. Presumably, an IRS agent
could then scrutinize the transaction to determine whether it
would be considered a tax shelter. This would place undue
authority in the hands of IRS agents to change the tax
treatment of a transaction and would result in arbitrary and
inconsistent application of the tax law.
For example, a foreign jurisdiction may respect a note as
debt even though it would be characterized as equity for U.S.
tax purposes. (A 100-year note is generally treated as equity
for U.S. tax purposes; however, another country's tax laws may
respect the note as debt.) As a result, payments on the note by
a foreign subsidiary to its U.S. parent would be treated as
deductible interest under the foreign country's tax laws. The
U.S. would treat the payment as a dividend that would provide
the U.S. parent with a deemed paid foreign tax credit. Because
the instrument was formally labeled a note, however, the
taxpayer's treatment of the note as equity for U.S. purposes
would be inconsistent with the form. Assuming the parent had
expiring foreign tax credits, the U.S. parent would be a tax-
indifferent party under the proposal. Therefore, an agent on
audit might deny the foreign tax credit generated by the
dividend payment on the grounds that the taxpayer treated the
note as debt for foreign tax purposes and the foreign tax
benefit created a tax shelter.
This result is especially harsh for three reasons. First,
the appropriate goal of U.S. tax policy should be to determine
the proper character of a transaction for federal income tax
purposes and then to tax the transaction in accordance with
that character. A rule that allows recharacterization based
upon inconsistent treatment under foreign law is at odds with
this policy because two transactions that are economically
indistinguishable will be treated differently. Furthermore, it
violates the general principle that U.S. tax principles and not
foreign principles should control. Second, the foreign country
may have made a conscious policy decision to respect the note
as debt. It is inappropriate to give an agent on audit the
ability to penalize a taxpayer for using a benefit provided by
the foreign tax law; the agent would essentially be
substituting the agent's judgment for the judgment of the
foreign country's lawmakers. Third, this provision interferes
with the consistent application of U.S. tax law because an
agent on audit would have tremendous discretion to choose not
to follow normal tax principles. The determination of the tax
treatment of a transaction would be made by individual agents,
not by Congress or by Treasury in its regulatory capacity.
F. Tax Income From Corporate Tax Shelters Including Tax-
Indifferent Parties.
The Administration's budget plan would impose a tax on
corporate tax shelter transactions involving ``tax-
indifferent'' parties. A ``tax-indifferent'' party is defined
as a foreign person, a Native American tribal organization, a
tax-exempt organization, or a domestic corporation with
expiring loss or credit carryforwards (generally more than 3
years old). The transactions targeted by this proposal
generally result in the tax-indifferent parties having income
or gain from the transaction, while taxable corporate
participants may have deductions or loss from the transaction.
The proposal would impose tax on the tax-indifferent party by
recharacterizing the item of gain or income as taxable. For
example, a foreign person would be treated as earning taxable
effectively connected income; a tax-exempt organization would
be treated as earning unrelated business taxable income. All
other participants in the corporate tax shelter would be
jointly and severally liable for the tax.
As with the other corporate tax shelter provisions, the
broad definition of corporate tax shelter does not provide
sufficient specificity for taxpayers or tax-indifferent parties
to determine what transactions might run afoul of these rules.
The vague and subjective definition creates an environment of
uncertainty for such parties when making business and
investment decisions, and it is likely that many routine
business arrangements would fall within this broad definition.
The proposal also raises treaty issues because it would
provide that tax on income or gain allocable to a foreign
person would be determined without regard to applicable
treaties. Even though the other parties to a transaction might
bear the ultimate liability for the tax under this proposal,
the proposal would in essence impose a U.S. tax burden on a
transaction that should be exempt from U.S. tax under the
treaty, thus changing the economics of the transaction. The
imposition of tax on a transaction that should be exempt under
a treaty could raise concerns from treaty partners.
IV. Current Legislative And Regulatory ``Tax Shelter'' Provisions
As discussed above, the Administration's broad-based
proposals would grant the IRS unfettered authority to determine
what is a corporate tax shelter and to subject these
transactions to harsh and cascading penalties. We are concerned
with Treasury's request for this broad authority when they have
not even tried to use some of the tools that Congress has
granted within the last few years. A better approach to any
perceived problem would be for Treasury to use the tools
currently within its arsenal, along with specific legislative
or regulatory actions targeted at closing perceived loopholes.
The broad scope of such current alternatives is illustrated
below.
A. Substantial Understatement Penalty
Current law imposes a 20 percent penalty on the portion of
an underpayment of tax attributable to a substantial
understatement of income tax. For corporations, a substantial
understatement of income tax exists if it exceeds the greater
of 10 percent of the tax required to be shown on the tax return
or $10,000.\8\ If a corporation has a substantial
understatement of income tax attributable to a tax shelter
item, a corporation is liable for the substantial
understatement penalty unless it can demonstrate reasonable
cause.
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\8\ The Administration has also proposed to treat a corporation's
understatement of more than 10 million dollars of income tax as
substantial for purposes of the substantial understatement penalty,
whether or not it exceeds 10 percent of the taxpayer's total tax
liability.
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As discussed above, Congress expanded the definition of tax
shelter for purposes of the substantial understatement penalty
in the Taxpayer Relief Act of 1997. Under this expanded
definition, a transaction may be a tax shelter if a significant
purpose of the transaction was to avoid taxes. (Under the prior
provision, a transaction was a tax shelter only if the
principal purpose of the transaction was to avoid taxes). This
significant expansion of the definition of tax shelter has been
in the law for less than two years, and there has not been
sufficient time to determine whether this new definition is
effective. Before enacting a plethora of new penalties and
granting revenue agents larger and more potent weapons, the
expanded definition in current law should be given a chance to
work.
B. Tax Shelter Registration
The 1997 Act added section 6111(d), which treats certain
confidential arrangements as tax shelters that must be
registered with the IRS. For purposes of this provision, a
``tax shelter'' includes any entity, plan, arrangement, or
transaction: (1) a significant purpose of the structure of
which is tax avoidance or evasion by a corporate participant;
(2) that is offered to any potential participant under
conditions of confidentiality; and (3) for which promoters may
receive fees in excess of $100,000 in the aggregate. An offer
is considered to be made under conditions of confidentiality
if: (1) the potential participant has an understanding or
agreement with or for the benefit of any promoter that
restricts or limits the disclosure of the transaction or any
significant tax benefits; or (2) any promoter of the tax
shelter claims, knows, or has reason to know that the
transaction is proprietary to the promoter or any other person
other than the potential participant, or is otherwise protected
from disclosure or use by others.\9\ The penalty for failing to
timely register a corporate tax shelter can be severe: the
greater of $10,000 or 50 percent of the fees paid to all
promoters from offerings prior to the date of registration. If
the failure to file is intentional, the penalty is increased to
75 percent of the fees.\10\
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\9\ Section 6111(d)(2).
\10\ Section 6707
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This registration requirement was intended to provide
Treasury and the IRS with useful information about corporate
transactions as early as possible, enabling them to more easily
identify these transactions. In addition, this information
enables Treasury to make determinations with respect to when
administrative or legislative action may be necessary. The
committee report explained the need for this corporate tax
shelter registration requirement:
The provision will improve compliance with the tax laws by
giving the Treasury Department earlier notification than it
generally receives under present law of transactions that may
not comport with the tax laws. In addition, the provision will
improve compliance by discouraging taxpayers from entering into
questionable transactions.\11\
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\11\ H.R. Rep. No. 105-148, 105th Cong., 1st Sess. 429.
These tax shelter registration provisions apply to any tax
shelter offered to potential participants after the date that
the Treasury Department issues guidance on registration. As of
this date, no guidance has been issued and, therefore, this
registration provision is not yet effective. It is premature to
propose a new and complex set of measures to deal with a
perceived increase in corporate tax shelter activity when
powerful provisions have already been enacted, but Treasury has
not, almost two years after enactment, implemented them. Rather
than enact a number of vague and subjective provisions as
proposed, the more prudent course would be to issue the
required guidance so that the registration requirements become
effective, then evaluate the registration provisions to
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determine whether they produce the desired result.
C. Anti-Abuse Rules
Treasury and the IRS have a wide range of general anti-
abuse provisions already available to combat the perceived
proliferation of corporate tax shelters. For example, if a
taxpayer's method of accounting does not clearly reflect
income, section 446(b) of the Code authorizes the IRS to
disregard the taxpayer's method of accounting and to compute
the taxpayer's income under a method of accounting it believes
more clearly reflects income. Under section 482 of the Code,
the IRS can allocate, distribute, or apportion income,
deductions, credits and allowances between controlled taxpayers
to prevent evasion of taxes or to accurately reflect their
taxable income.
Treasury has promulgated Treas. Reg. ' 1.701-2 as a broad
anti-abuse rule that permits the IRS to stop perceived abuses
with respect to partnerships. Under this anti-abuse regulation,
the IRS already has the ability to disregard the existence of a
partnership, adjust a partnership's method of accounting,
reallocate items of income, gain, loss, deduction or credit, or
adjust a partnership's or partner's tax treatment in situations
where a transaction meets the literal requirements of a
statutory or regulatory provision, but where the IRS believes
the results are inconsistent with the intent of the partnership
tax rules.
The IRS also has broad authority to stop abuses in the
corporate context. For example, the IRS can recharacterize
certain stock sales by shareholders as dividends when the
purchaser is the issuing corporation or a related corporation
under section 302(d) or section 304. Section 338(e)(3)
authorizes the IRS to treat certain stock acquisitions as
qualified stock purchases in order to prevent avoidance of the
requirements of section 338. Section 355(d)(9) gives the IRS
the regulatory authority to prevent the avoidance of certain
gain recognition requirements under section 355 through the use
of related persons, intermediaries, pass-through entities or
other arrangements.
D. Case Law
There is a well-established body of case law addressing tax
shelters. The principles developed in these cases include the
``sham transaction'' doctrine, the ``business purpose''
doctrine, and the ``economic substance'' doctrine. In applying
these principles, the IRS may assert that a transaction should
not be respected for tax purposes because it did not have a
substantive purpose beyond securing tax benefits. See, e.g.,
Gregory v. Helvering, 293 U.S. 465 (1935); Knetsch v. United
States, 364 U.S. 361 (1960); Rice's Toyota World, Inc. v.
Commissioner, 752 F.2d 89 (4th Cir. 1985); Goldstein v.
Commissioner, 364 F.2d 734 (2d Cir. 1966); Sheldon v.
Commissioner, 94 T.C. 738 (1990). These principles have been in
existence for many years, and they have not lost their utility.
They represent a set of standards that can be applied no matter
how sophisticated a transaction might be. Most recently, the
IRS successfully litigated two cases in this area, ACM
Partnership v. Commissioner, 157 F.3d 231 (3d Cir. 1998),
aff'g, rev'g in part and remanding, 73 TCM 2189 (1997), cert.
denied, S. Ct. Dkt. No. 98-1106 and ASA Investerings v.
Commissioner, 76 TCM 325 (1998).
E. IRS Announcements
The IRS has the authority to issue administrative
pronouncements to address perceived abusive transactions. These
pronouncements may take the form of notices, rulings, or other
announcements. In the past few years, the IRS has not hesitated
to take advantage of this authority. For example, Notice 97-21
effectively shut down ``step-down preferred'' transactions.
More recently, in fact within the past few days, the IRS has
attacked certain types of ``lease-in lease-out'' transactions
that it perceived to be abusive through the issuance of Rev.
Rul. 99-14. The number of announcements the IRS has issued in
the past few years addressing perceived tax shelter activity
has been substantial: Notice 98-11 (attacking ``hybrid branch
arrangements''); Notice 98-5 (attacking transactions that
generate foreign tax credits); Notice 96-39 (setting forth the
IRS' position on determining whether income from a partnership
represented Subpart F income); Notice 95-53 (attacking lease
stripping transactions); Notice 94-48 (scrutinizing tax-
deductible passthrough debt to buy back stock, or ``reverse
MIPs''); Notice 94-47 (scrutinizing tax-deductible preferred
instruments, or ``MIPS''); Notice 94-93 (attacking ``corporate
inversion'' transactions); Notice 94-46 (attacking outbound
``corporate inversion transactions'').
Note that as part of the IRS Restructuring and Reform Act,
Congress expressed its concern and disagreement with the policy
direction of Notice 98-11, as well as their interest in
reviewing these issues and taking legislative action they
deemed to be appropriate. This controversy demonstrates the
need for determinations of what constitutes an abusive
transaction to be made in a public manner, through issuance of
legislation or an administrative pronouncement, rather than
being made by individual IRS agents.
F. Legislation Targeted to Specific Transactions
Another important alternative to the broad-based
Administration proposals is specific, targeted statutory
changes. Each year Treasury transmits to Congress its
suggestions for changes to the tax laws, including targeted
proposals to stop abuses and, as a matter of course, Congress
has asserted its legislative powers to clarify and amend
statutes that are unclear or allow for abuse. On a number of
occasions, the Congressional tax writing committees have
enacted targeted statutory changes to end specific tax shelter
or abusive activity, often with the assistance and consultation
of the Treasury Department. For example, in 1998 and 1997
alone, Congress pursued and enacted a number of targeted
proposals, including:
Modification of certain deductible liquidating
distributions of regulated investment companies (RIC) and real
estate investment trusts (REIT);
Restrictions on 10-year net operating loss
carryback rules for specified liability losses;
Requirement of gain recognition on certain
appreciated financial positions in personal property;
Election of mark-to-market for securities traders
and for traders and dealers in commodities;
Limitation on the exception for investment
companies under section 351;
Determination of original issue discount where
pooled debt obligations are subject to acceleration;
Denial of interest deduction for on certain
convertible preferred stock;
Requirement of gain recognition for certain
extraordinary dividends;
Anti-Morris Trust provisions;
Reform of the tax treatment of certain corporate
stock transfers;
Treatment of certain preferred stock as boot;
Modification of holding period for the dividends-
received deduction;
Inclusion of income from notional principal
contracts and stock lending transactions under Subpart F;
Restriction on like-kind exchanges involving
foreign personal property;
Imposition of holding period requirement for
claiming foreign tax credits with respect to dividends;
Allocation of basis of properties distributed to a
partner by a partnership;
Elimination of the substantial appreciation
requirement for inventory on sale of partnership interest; and
Modification of treatment of company-owned life
insurance.
These proposals, which raise nearly $20 billion in tax
revenue over 10 years, were targeted at clarifying the statute
and/or stopping abuses of the tax law and have been effective
in ending certain tax shelter activity. While we believe that
many of these items are not abuses, this incomplete list
demonstrates that if a statutory provision allows for broader
application than Congress may have intended, Congress and the
Treasury can statutorily shut them down. Treasury is now
essentially asking Congress to short-circuit this well-
established legislative approach and provide the IRS with broad
authority to characterize a wide range of transaction as ``tax
shelters'' without the need for Congressional oversight or
approval.
Conclusion
The Administration's ``corporate tax shelter'' proposals go
far beyond simply closing unwarranted loopholes: the proposals
would have a detrimental impact on legitimate business
transactions and could result in the imposition of draconian
penalties on taxpayers. The unfettered power transferred to IRS
agents would shift the formulation of tax policy from Congress
to the tax collector by giving IRS agents unprecedented
latitude to reclassify transactions as corporate tax shelters.
Congress, not the tax administrator, should make these tax
policy decisions.
Statement of Coalition of Mortgage REITs
The following comments are offered by a group of mortgage
real estate investment trusts (hereinafter referred to as the
``Coalition'') to the Committee on Ways and Means in
conjunction with its March 10 hearing on the revenue-raising
provisions of the Clinton Administration's FY 2000 budget plan.
Coalition members include IndyMac Mortgage Holdings, Inc.,
Dynex Capital, Inc., IMPAC Mortgage Holdings, Inc., IMPAC
Commercial Holdings, Inc., Redwood Trust, Inc., and Capstead
Mortgage Holdings. These comments focus on the Administration's
proposal to modify the structure of businesses indirectly
conducted by real estate investment trusts (``REITs'').
IndyMac Mortgage Holdings, Inc., based in Pasadena,
California, is the largest publicly traded mortgage REIT \1\ in
terms of stock market capitalization, and its structure and
business activities make it a useful reference point in
discussing the impact of the Administration's proposal. IndyMac
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. IndyMac is a NYSE-traded company with $6
billion in assets and nearly 1,000 employees. IndyMac Mortgage
Holdings participates in the mortgage conduit and
securitization business through an affiliated taxable operating
company, IndyMac, Inc.
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\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.
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The Coalition has specific concerns over the
Administration's proposal to modify the structure of businesses
indirectly conducted by REITs. As a result of these concerns,
the Coalition's support for this proposal would be contingent
on critical modifications being made. Without these
modifications, IndyMac and other REITs would be unable to
continue to participate in the mortgage conduit or
securitization business. The changes requested by the Coalition
would be consistent with the Administration's goal not to
impede the competitiveness of REITs, while at the same time
addressing--more than adequately, we believe--the concerns of
the Treasury Department over any potential for tax avoidance by
mortgage REITs.
The Mortgage Conduit Business
As one of its most important business activities, IndyMac
operates 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 are 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 IndyMac play a similar role for
``nonconforming'' mortgage loans that do not meet GSE selection
criteria. Mortgage loans purchased by IndyMac include ``Alt-
A,'' nonconforming and jumbo residential loans, sub-prime
loans, consumer construction loans, manufacturing housing
loans, home improvement loans, and other mortgage-related
assets. Many of IndyMac's borrowers are low-income and minority
consumers who are not eligible for programs currently offered
by the GSEs or Ginnie Mae. In sum, IndyMac, through its conduit
activities, has helped to fill a significant void in the
residential mortgage and mortgage investment industry that the
GSEs have been unable to fill.
IndyMac's Business Structure
IndyMac's mortgage conduit business is conducted primarily
through two entities: IndyMac Mortgage Holdings, Inc., which as
discussed above is a REIT (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, which is a taxable C corporation.
IndyMac REIT is the arm of the conduit business that
purchases and holds mortgage loans. IndyMac Operating is the
arm of IndyMac REIT that acquires loans for IndyMac REIT,
pursuant to a contractual sales commitment, and securitizes and
services the loans. In order to control the interest rate risks
associated with managing a pipeline of loans held for sale,
IndyMac Operating also conducts necessary 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 as
well as servicing fee income.
Use of this ``preferred stock'' structure for conducting
business is, in part, an outgrowth of the tax laws governing
REITs. IndyMac REIT, by itself, effectively is unable to
securitize its loans through the most efficient capital markets
structure, called 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.'' Similarly, it is well
understood that the ability to service a loan is critical to
owning a loan, and IndyMac REIT would be subject to strict and
unworkable limits on engaging in mortgage servicing activities
for third parties. 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.
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\2\ The 95-percent test generally limits REITS to receiving income
that qualifies as rents from real property and portfolio income.
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In business terms, IndyMac's use of the preferred stock
structure aligns its ``core competencies,'' which has allowed
it to compete in the mortgage banking and conduit business.
This alignment makes available the benefits of centralized
management, lower costs, and operating efficiencies, and has
allowed IndyMac to respond to market changes, such as trends
toward securitization, all to the benefit of homeowners who do
not fit within traditional GSE lending criteria.
Administration Proposal
The proposal in the Administration's FY 2000 budget would
prohibit use of the REIT 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.
This proposal has arisen out of a concern on the part of
Treasury that income earned by preferred stock subsidiaries
escapes corporate tax as a result of ``transmuting of operating
income into interest paid to the REIT and other non-arm's
length pricing arrangements.'' \3\
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\3\ General Explanations of the Administration's Revenue Proposals,
Department of the Treasury, February 1999, p. 140. IndyMac believes
Treasury's income-shifting argument is significantly overstated. The
REIT rules strictly regulate the types and amount of income that may be
earned by a REIT. IndyMac REIT 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.
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At the same time, Treasury recognizes that many activities
conducted by REIT preferred stock subsidiaries represent
legitimate business activities that should continue to be
available to REIT investors: \4\
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\4\ Id, at 140.
Many of the businesses performed by the REIT subsidiaries are
natural outgrowths of a REIT's traditional operations, such as
third-party management and development businesses. While it is
inappropriate for the earnings from these non-REIT businesses
to be sheltered through a REIT, it also is counter-intuitive to
prevent these entities from taking advantage of their evolving
experiences and expanding into areas where their expertise may
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be of significant value.
In light of these concerns, the Administration proposal
would allow a REIT to establish a ``taxable REIT subsidiary''
(``TRS'') to perform certain activities that cannot be
conducted directly by a REIT. These TRSs would be subject to a
number of restrictions, including a provision that a TRS could
not deduct any interest incurred on debt funded directly or
indirectly by the REIT. Other restrictions would place limits
on the value of TRSs that could be owned by REITs; impose an
excise tax on any excess payments made by the TRS to the REIT;
and limit intercompany rentals between the REIT and the TRS.
\5\
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\5\ The proposal would allow REITs to convert preferred stock
subsidiaries into TRSs on a tax-free basis within a window period, as
yet unspecified.
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It is not clear that the Treasury proposal ever
contemplates mortgage REIT preferred stock subsidiaries like
IndyMac Operating.\6\ If not, the inability of mortgage REITs
to utilize the ``taxable REIT subsidiary'' structure would have
a severe negative impact on IndyMac and the housing industry.
If mortgage REITs are intended to be permitted to establish
TRSs, it is still the case that the Administration's current
proposal contains unworkable restrictions that effectively
would end the synergies between mortgage REITs and taxable
entities that have so benefited homeowners and the housing
industry.
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\6\ For example, the Treasury explanation of the proposal discusses
activities of a TRS by reference to ``tenant'' and ``non-tenant''
activities.
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In allowing REITs to conduct otherwise disqualifying
business activities through taxable subsidiaries, the
Administration's FY 2000 budget proposal represents a
significant improvement over a similar proposal included in
last year's Administration budget submission. Like the current
proposal, last year's proposal would have prohibited use of the
REIT preferred stock subsidiary structure. However, last year's
proposal, rather than allowing REITs to convert preferred stock
subsidiaries into a taxable subsidiary, would have
``grandfathered'' existing preferred stock structures, but
under an overly restrictive set of rules that was viewed as
unworkable by industry.
Impact on Mortgage REITs
If the Administration's FY 2000 budget proposal were
enacted, IndyMac REIT would be forced to end its preferred
stock affiliation with IndyMac Operating. In order to continue
in the mortgage conduit business, IndyMac REIT and other
mortgage REITs would have to consider converting their
affiliates into a TRS under the terms outlined by the
Administration in its proposal, assuming that the
Administration's proposal contemplates this provision applying
to mortgage REIT subsidiaries.
At least in concept, IndyMac would be willing to entertain
a conversion of IndyMac Operating from a preferred stock
affiliate into a taxable subsidiary. As discussed above,
IndyMac Operating does not engage in the type of income
shifting activities that have prompted Treasury's concerns.
However, certain restrictions proposed by the Treasury
Department with respect to the operation of the TRS would be
completely unworkable for IndyMac and other mortgage REITs.
Most significant, by far, is the Administration's proposed
disallowance of interest deductions on debt funded directly or
indirectly by the REIT.
This proposed restriction overlooks the fundamental element
of debt in the day-to-day business operations of finance
companies, like mortgage conduits. IndyMac Operating borrows
extensively to finance its operations, such as the purchase of
mortgages. These loans can come from outside third parties,
such as banks or investment banks, with the sponsoring REIT as
effective guarantor, or from loans directly from the sponsoring
REIT.
Direct loans from the sponsoring REIT clearly would be
impacted by the Administration's proposal, and it is possible
that guaranteed loans would also be covered as ``indirect''
loans. To the extent that any or all of these types of loans
are considered direct or indirect loans subject to the interest
expense disallowance, the inability to deduct a finance
company's core and largest business expense would make it
impossible for IndyMac Operating to compete with all other
finance companies which are entitled to deduct such expenses.
This exposure would be sufficient to force an end to IndyMac
Operating's ability to conduct its business activities in
conjunction with IndyMac REIT, thus divorcing the two critical
elements of IndyMac's mortgage conduit business. If IndyMac and
the other mortgage REITs were unable to conduct their business,
it would have a severe impact on the housing market, because
IndyMac and other mortgage REITs provide a vital link between
investors and borrowers in the non-conforming and jumbo markets
who are not served by the GSEs.
The taxable preferred stock subsidiaries of IndyMac and
other mortgage REITs operate in the same manner as a finance
company that makes loans and securitizes or sells them to
investors. All finance companies that are not depository
institutions require external debt to fund loan originations.
All operate at relatively high leverage because loan assets
typically are saleable and thus relatively liquid.
Through their affiliation with a REIT, these taxable
preferred stock subsidiaries are able to access capital to fund
operations at lower rates than would be the case if they tried
to access public debt markets directly. Compared to the taxable
entity, the REIT is generally better capitalized and larger, in
terms of assets and borrowings, and thus can borrow at lower
rates than the preferred stock subsidiary. Lenders generally
lend to the REIT and the taxable entity on a combined basis,
and require credit support from the larger entity.
Without credit support, the taxable subsidiaries would have
higher borrowing costs, which ultimately would be passed on to
borrowers served through the mortgage conduit businesses
operated by IndyMac and others as higher interest rates and
costs.\7\ The proposal would operate, therefore, like a tax on
these homeowner/borrowers. There is no reason to impose this
tax--there are specific rules already in the Code that could be
adopted to prevent the potential for tax abuse that has given
rise to the Administration's proposal. These rules are
described in the following section.
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\7\ These higher borrowing costs would translate into increased
deductible interest expenses for the taxable subsidiaries, which would
reduce the amount of revenues that would be collected as a result of
the proposal.
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Necessary Modifications
The Administration's proposed interest deduction
disallowance is intended to prevent excessive interest charges
by a sponsoring REIT to its taxable subsidiary, or TRS. As
opposed to the TRS interest expense disallowance proposed by
the Treasury Department, the Coalition strongly believes that
the ``earnings stripping'' limitations imposed under section
163(j) of the Internal Revenue Code for interest paid to or
accrued by tax-exempt entities and foreign persons would
adequately, and more fairly, prevent any perceived abuses
resulting from direct or indirect lending between a REIT and a
TRS. At the same time, adoption of this rule would preserve the
TRS's ability to conduct its business and serve its customers.
Enacted in 1989, section 163(j) was crafted specifically to
prevent the siphoning of earnings from a corporation by a
related person that is exempt from U.S. tax, e.g., a foreign
company. Those rules extend both to direct lending activities
as well as to guarantees by a related person of loans obtained
by the corporation from unrelated persons. Under these rules, a
corporation's interest deductions for a taxable year may be
denied if the corporation has excess interest expense for a
year and its ratio of debt to equity exceeds 1.5 to 1.
Substitution of this earnings stripping rule for the
complete interest deduction disallowance under the
Administration's proposal would guard against true abuse while
accommodating legitimate mortgage conduit business activities.
The purpose of section 163(j) was to limit interest deductions
for leveraged companies that generate a negative spread in view
of the likelihood that the negative spread was attributable to
earnings stripping. In contrast, the companies affiliated with
IndyMac and other mortgage REITs in the mortgage conduit
business generally generate excess interest income--i.e., they
generate a positive spread on interest income. IndyMac
Operating has never incurred negative spread in its six years
of operation. In fact, IndyMac's taxable affiliate has incurred
tax liability for positive spread it has earned in each year
since its founding in 1993.
It is a fundamental fact in the finance industry that
companies operating in the mortgage banking and conduit
business, like IndyMac Operating, operate at relatively high
leverage ratios. The same is true for GSEs like Ginnie Mae and
Fannie Mae, as it is for Merrill Lynch, Bank of America, and
other well-known industry names. The presence of this debt is
inherent in the business of a finance company and is not, in
and of itself, any indication of a situation where earnings are
being stripped. In enacting the rules under section 163(j),
Congress made clear that an earnings stripping situation
involves the combination of high leverage and a negative
interest spread. The Coalition agrees.
In sum, the Coalition believes that adoption of the section
163(j) rules would allow IndyMac and other mortgage REITs to
continue to participate in the mortgage conduit business and
provide financing to segments of the housing industry not
currently served by the GSEs. At the same time, we believe the
section 163(j) rules would guard effectively against true
earnings stripping situations. It would be unreasonable to
subject REITs and their affiliates to the Administration's
complete disallowance of interest deductions, a rule that would
be more stringent than those currently applied with respect to
transactions between U.S. and related foreign companies.
Conclusion
Congress enacted the REIT rules in 1960 to give small
investors the same access to dynamic real estate markets that
are available to larger investors. Working with the National
Association of Real Estate Investment Trusts (``NAREIT''),
Congress has amended the REIT statute many times since to
respond to dramatic changes in the real estate industry. The
Administration's proposal to modify the structure of businesses
that may be conducted indirectly by REITs may be viewed, and
commended, as a further effort to modernize the REIT rules.
However, as discussed above, the Administration proposal
must be modified to address the concerns of an important sector
of the REIT industry, namely mortgage REITs. Specifically, the
proposed restrictions on the operation of the taxable REIT
subsidiaries under the Administration's proposal would
fundamentally impede the business practices of REITs like
IndyMac involved in the mortgage conduit business. The proposed
outright elimination of deductions for interest on intercompany
debt or REIT-guaranteed debt would lead IndyMac and other
mortgage REITs to sever themselves from the core competencies
of servicing and securitizing mortgage loans. Thus, IndyMac's
individual investors no longer would be able to participate
effectively in the mortgage conduit business, contrary to
Congressional intent to give these REIT investors access to the
real estate mortgage markets.
If the Administration's proposal is to receive serious
consideration, it will be paramount to replace the proposed
wholesale interest deduction disallowance with the earnings
stripping rules under section 163(j). The Coalition also
believes that the intended applicability of the TRS provisions
to mortgage REITs should be made explicit. In addition, we
believe it will be necessary to apply these rules over an
appropriate transitional period. The Coalition is prepared to
work with Congress, the Treasury, and NAREIT to develop
solutions in this regard.
Statement of Coalition of Service Industries \1\
The Coalition of Service Industries, which represents a
broad range of financial institutions, including both large and
small institutions, strongly opposes the Administration's
proposal to increase penalties for failure to file correct
information returns.
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\1\ The Coalition of Service Industries (CSI) was established in
1982 to create greater awareness of the major role services industries
play in our national economy; promote the expansion of business
opportunities abroad for US service companies; and encourage US
leadership in attaining a fair and competitive global marketplace. CSI
represents a broad array of US service industries including the
financial, telecommunications, professional, travel, transportation,
information and information technology sectors.
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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.
The Proposal
As included in the President's fiscal year 2000 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.\2\ The increased penalties would not apply if the
aggregate amount that is timely and correctly reported for a
calendar 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.
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\2\ A similar proposal was included in President Clinton's fiscal
year 1997, 1998 and 1999 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,\3\ severe sanctions are
imposed for intentional reporting failures. In general, the
current penalty structure is as follows:
---------------------------------------------------------------------------
\3\ 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).
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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.\4\
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\4\ 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.
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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.\5\ 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.
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\5\ 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,
1999. 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.
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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.'' \6\ Congress endorsed the IRS Task
Force's conclusions by specifically enumerating them in the
Conference Report to the Omnibus Budget Reconciliation Act of
1989.\7\ 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.
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\6\ Statement of former IRS Commissioner Gibbs before the House
Subcommittee on Oversight (February 21, 1989, page 5).
\7\ OBRA 1989 Conference Report at page 661.
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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,\8\ 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.
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\8\ For example, Form 1099-C, discharge of indebtedness reporting,
or Form 1042-S, reporting for bank deposit interest paid to certain
Canadian residents.
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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).\9\
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\9\ If the corrected returns were filed after August 1, the
penalties would be capped at $250,000 per plan.
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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 \10\ should be
treated as a single payor for purposes of applying the penalty
cap.
---------------------------------------------------------------------------
\10\ 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 Coalition of Service Industries represents 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. In addition to this
testimony, we sent a letter to Secretary of the Treasury Robert
Rubin, signed by some of our member associations, voicing our
opposition to the proposal. A copy of the letter is attached.
Congress has considered and rejected this proposal on three
previous occasions, and we hope it will continue to reject this
unwarranted penalty increase. Thank you for your consideration
of our views.
[An attachment is being retained in the Committee files.]
Statement of Coalition of Service Industries \1\
Introduction
The Administration's Budget Proposal for fiscal year 2000
(the ``FY2000 Budget'') provides for the extension of six
expiring provisions, but fails to extend the active financing
exception to subpart F.\2\ The active financing exception to
subpart F should be extended at the same time as other
provisions that will expire during calendar year 1999.
Moreover, at a time when the Administration and the
Congressional Budget Office are predicting ``on budget''
surpluses in the near term, CSI, on behalf of the undersigned
industry groups, believes that the active financing exception
to subpart F should be made a permanent provision in the law.
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\1\ The Coalition of Service Industries (CSI) was established in
1982 to create greater awareness of the major role services industries
play in our national economy; promote the expansion of business
opportunities abroad for US service companies; and encourage US
leadership in attaining a fair and competitive global marketplace. CSI
represents a broad array of US service industries including the
financial, telecommunications, professional, travel, transportation,
information and information technology sectors.
\2\ ``Subpart F'' refers to the regime prescribed by Sections 951-
964 of the Internal Revenue Code of 1986, as amended (the ``Code'');
except as noted, all references to ``sections'' hereinafter are to the
Code.
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Background
When subpart F was first enacted in 1962, the original
intent was to require current U.S. taxation of foreign income
of US multinational corporations that was passive in nature.
The 1962 law was careful not to subject active financial
services business income to current taxation through a series
of detailed carve-outs. In particular, dividends, interest and
certain gains derived in the active conduct of a banking,
financing, or similar business, or derived by an insurance
company on investments of unearned premiums or certain reserves
were specifically excluded from current taxation if such income
was earned from activities with unrelated parties. In 1986, the
provisions that were put in place to ensure that a controlled
foreign corporation's (CFC) active financial services business
income would not be subject to current tax were repealed in
response to concerns about the potential for taxpayers to route
passive or mobile income through tax havens. In 1997,\3\ the
1986 rules were revisited, and an exception to the subpart F
rules was added for the active income of US based financial
services companies, along with rules to address concerns that
the provision would be available to passive operations. The
active financing income provision was revisited in 1998, in the
context of extending the provision for the 1999 tax year, and
considerable changes were made to focus the provision on active
financial services businesses that perform significant
operations in their home country.
---------------------------------------------------------------------------
\3\ Taxpayer Relief Act of 1997, Conference Report to H.R. 2014, H.
Rept. 105-220, pages 639-645.
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A comparison of current U.S. law with the laws of foreign
countries shows that the United States imposes significantly
stricter standards on CFCs of U.S.-based financial services
companies in order for them to qualify as active financing
income. For example, German law merely requires that income be
earned by a bank with a commercially viable office established
in the CFC's jurisdiction. Germany does not require that the
CFC conduct the activities generating the income or that the
income come from transactions with customers solely in the
CFC's country of incorporation. The United Kingdom has an even
less restrictive regime than Germany. These countries do not
impose current taxation on CFC income as long as the CFC is
engaged primarily in legitimate business activities primarily
with unrelated parties. In sum, current U.S. treatment of CFC
active financing income is more restrictive than the treatment
afforded such income by many of the United States' competitors.
Active financial services income is universally recognized
as active trade or business income. Thus, if the current law
provision were permitted to expire at the end of this year,
U.S. financial services companies would find themselves at a
significant competitive disadvantage vis-a-vis all their major
foreign competitors when operating outside the United States.
In addition, because the U.S. active financing exception is
currently temporary, it denies U.S. companies the certainty
their foreign competitors have. The need for certainty in this
area cannot be overstated. U.S. companies need to know the tax
consequences of their business operations. Over the last two
years US companies have implemented numerous system changes in
order to comply with two very different versions of the active
financing law, and are unable to take appropriate strategic
action if the tax law is not stable.
The Active Financing Exception to Subpart F Is Essential to the
Competitive Position of American Financial Services Industries
in the Global Marketplace
The financial services sector is the fastest growing
component of the U.S. trade in services surplus (which is
expected to exceed $80 billion this year). It is therefore very
important that the Congress act to maintain a tax structure
that does not hinder the competitive efforts of the U.S.
financial services industry, rather than allowing the active
financing exception to subpart F to expire (and thereby revert
to a regime that penalizes U.S.-owned financial services
companies).
The growing interdependence of world financial markets has
highlighted the urgent need to rationalize U.S. tax rules that
undermine the ability of American financial services industries
to compete in the international arena. From a tax policy
perspective, financial services businesses should be eligible
for the same U.S. tax treatment of worldwide income as that of
manufacturing and other non-financial businesses. The
inequitable treatment of financial services industries under
prior law jeopardized the international expansion and
competitiveness of U.S.-based financial services companies,
including finance and credit entities, commercial banks,
securities firms, and insurance companies.
This active financing provision is particularly important
today as the U.S. financial services industry is the global
leader and plays a pivotal role in maintaining confidence in
the international marketplace. Also, recently concluded trade
negotiations have opened new foreign markets for this industry,
and it is essential that our tax laws complement this trade
effort. The Congress must not allow the tax code to revert to
penalizing U.S.-based companies upon expiration of the
temporary provision this year.
The Active Financing Exception Should Be Made Permanent.
According to Ways and Means Committee member Amo Houghton's
floor statement during the debate on the Conference Report on
the 1997 legislation that first enacted an active financing
exception to subpart F, the fact that the provision would
sunset after one year was ``a function of revenue concerns, not
doubts as to its substantive merit.'' \4\ Indeed, even in the
course of subjecting the original active financing exception to
a (now defunct) line-item veto, the Administration
acknowledged, and continues to acknowledge that the ``primary
purpose of the provision was proper.'' \5\
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\4\ Congressional Record, July 31, 1997.
\5\ White House Statement, August 11, 1997.
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The international growth of American finance and credit
companies, banks, securities firms, and insurance companies
will be impaired by an ``on-again, off-again'' system of annual
extensions that does not allow for certainty. Making this
provision a permanent part of the law would enhance the
position of the U.S. financial services industry.
Conclusion
On behalf of the entire American financial services
industry, the Coalition of Service Industries urges the Ways
and Means Committee to adopt H.R. 681, the bipartisan bill
(recently introduced by Reps. McCrery, Neal, and other members
of the committee) to make the active financing exception to
subpart F permanent. H.R. 681 would provide a consistent,
equitable, and stable international tax regime for the U.S.
financial services industry.
Signatories:
American Bankers Association
American Council of Life Insurance
American Financial Services Association
American Insurance Association
The Bankers Roundtable
Coalition of Finance and Credit Companies
Coalition of Service Industries
Council of Insurance Agents and Brokers
National Association of Manufacturers
Securities Industry Association
The New York Clearing House Association L.L.C.
The Tax Council
US Council for International Business
Statement of Coalition to Preserve Employee Ownership of S Corporations
This statement is respectfully submitted on behalf of the
Coalition to Preserve Employee Ownership of S Corporations
(``Coalition'') in connection with the Committee's hearings on
revenue provisions included in the President's fiscal year 2000
budget. The Coalition appreciates the Committee's interest in
public comments on the Administration's budget proposals and
welcomes the opportunity to express its strong opposition to
one of these proposals in particular--the proposal to repeal
the recently-enacted provision of The Taxpayer Relief Act of
1997 (``1997 Act'') that exempts S corporation income that
flows through to an ESOP shareholder from the unrelated
business income tax (``UBIT''). As explained below, we believe
that the 1997 Act provision is furthering the goal Congress
intended of facilitating employee ownership of closely-held
businesses and should not be repealed; that it is inappropriate
as a matter of tax policy to keep changing tax laws upon which
businesses rely; that the Administration's tax proposal is
inconsistent with the general intent of Congress underlying
Subchapter S, is overly complex, and would impose a new tax
burden on employees; and that the proposal cannot be justified
on ``anti-tax shelter'' grounds. Therefore, we respectfully
request this Committee to reject the Administration's proposal
and to keep in place the law it enacted not two years ago.
BACKGROUND
ESOPs provide an opportunity for millions of Americans to
own a piece of the businesses for which they work. They not
only provide greater incentives for employees to help the
companies grow, but also play a critical role in the employees'
retirement planning strategies. As explained below, Congress
recently has taken important steps to remove some of the
barriers to employee ownership that existed for closely-held
businesses. The Coalition commends the Congress for its
recognition of the value of employee ownership and hopes that
this Committee will continue to support employee ownership in
the future.
In the Small Business Job Protection Act of 1996 (the
``1996 Act''), Congress allowed ESOPs to be shareholders of S
corporations, in recognition of the fact that the previous-law
``prohibition of certain tax-exempt organizations being S
corporation shareholders may have inhibited employee-ownership
of closely-held businesses.'' Joint Committee on Taxation's
General Explanation of Tax Legislation Enacted in the 104th
Congress (JCS-12-96). The 1996 Act, however, included a number
of restrictive tax rules with respect to ESOPs of S
corporations that generally made employee ownership of an S
corporation unattractive. For example, the 1996 Act provided
that:
The income of the S corporation that flowed through to the
ESOP shareholder, as well as any gain on the sale of S
corporation stock, would be treated as unrelated business
taxable income (``UBTI'') and would be subject to tax at the
ESOP level. Thus, the S corporation income would be subject to
tax twice--once to the ESOP and once to the participants upon
distribution.
The increased deduction limitation under Section 404(a)(9)
of the Internal Revenue Code of 1986, as amended (``Code''),
would not apply to S corporations. As a result, even though a C
corporation generally can deduct contributions to an ESOP that
are made to allow the ESOP to pay interest and principal on the
loan it incurred to acquire the corporation's stock, up to an
amount equal to 25 percent of the compensation paid or accrued
to employees under the plan, an S corporation generally is
limited to a deduction for contributions equal to 15 percent of
the compensation paid or accrued to such employees.
The deduction for dividends paid on certain employer
securities under Code Section 404(k)(1) would not be available
to S corporations. As a result, even though a C corporation may
deduct the amount of certain cash dividends that ultimately are
passed through to the participants of the ESOP, an S
corporation is not entitled to such a deduction.
The special ``rollover'' rules of Code Section 1042 that
are designed to encourage the contribution of employer stock to
ESOPs would not apply to S corporation stock. As a result, even
though shareholders may be able to defer gain on the sale of C
corporation stock to an ESOP if they reinvest the proceeds in
certain qualifying securities, such deferral is not available
on the sale of S corporation stock.
In the 1997 Act, Congress decided to repeal the first of
these restrictions, such that S corporation income or loss that
passes through to an ESOP shareholder, and any gain or loss on
the sale by the ESOP of S corporation stock, would not be
subject to UBIT. The legislative history indicates that this
change was made because the Congress believed ``that treating S
corporation income as UBTI is not appropriate because such
amounts would be subject to tax at the ESOP level, and also
again when benefits are distributed to ESOP participants.'' S.
Rept. 105-33 (105th Cong., 1st Sess.), at p. 80. This change
became effective for taxable years beginning after December 31,
1997. In reliance on this law change, many employee-owned
businesses have elected S corporation status, in some cases
increasing the amount of stock owned for the benefit of their
employees. Further, some existing S corporations have
established ESOPs. Finally, some corporations are in the
process either of establishing ESOPs or restructuring so that
they will be eligible to elect S corporation status. These
companies are furthering the goal of increasing employee
ownership that Congress was trying to advance in enacting the
1997 Act provision.
Now, barely a year after the 1997 Act provision became
effective, the Administration is asking the Congress to reject
the decision it made in the 1997 Act. In particular, the
Administration has included in the ``corporate tax shelter''
section of its budget a proposal to repeal the 1997 Act
provision and, instead, to allow an S corporation ESOP a
deduction for distributions to participants and beneficiaries
to the extent of the S corporation income on which it has paid
UBIT. The proposal also would modify net operating loss rules
in effect to allow for the carryback of ``excess'' distribution
deductions for 2 years, and the carryforward of such deductions
for 20 years. The proposal would be effective for tax years
beginning after the date of first committee action. Thus, it
would apply to income and gain of corporations that already
have ESOPs and/or that already have converted to S corporation
status, as well as to corporations that are in the process of
establishing ESOPs or converting to S corporation status.
PROBLEMS WITH THE ADMINISTRATION'S PROPOSAL
The Coalition believes that the Administration's proposal
is fundamentally flawed for the reasons set forth below.
The 1997 Act Provision Is Furthering the Laudable Goal of
Increasing Employee Ownership and Should Not Be Repealed
As indicated above, Congress enacted the 1996 and 1997 Act
provisions regarding S corporation ESOPs in order to remove
obstacles that had deterred employee ownership of closely-held
corporations. Thus far, these provisions have been successful
in achieving this objective of facilitating employee ownership.
As a direct result of the law changes, employees have increased
their ownership of closely-held businesses, shareholders have
decided to transfer more stock to ESOPs, and S corporations
that previously could not have had ESOPs have been able to give
their employees an ownership interest in the business. It is
virtually certain that Congress's decisions in 1996 and 1997
will encourage even greater employee ownership in the future.
It makes no sense to repeal a provision which is doing exactly
what Congress intended it to do and which is furthering a
valuable policy goal.
It Is Inappropriate as a Matter of Tax Policy to Change a Tax
Law on Which Businesses Have Relied in Making Costly Business
Decisions
The Coalition also believes it would be grossly
inappropriate as a matter of tax policy to encourage ESOP
ownership of S corporations in 1997 and, not two years later,
to fundamentally alter the tax consequences of such ownership.
As explained further below, converting to S corporation status,
selling more stock to an ESOP, and establishing an ESOP are all
important decisions that have real economic consequences.
Businesses that are considering these actions should be able to
make their decisions based on a relatively stable set of tax
rules, rather than to have to suffer from tax laws that become
effective in one tax year and are repealed in the next.
Corporations that converted to S corporation status in
reliance on the 1997 Act provision (or that are in the process
of converting) have had to weigh the costs and benefits of
their decision in order to determine whether it was (or is)
prudent. As indicated above, for a company with an ESOP,
converting to S corporation status involves losing certain
benefits (such as Code Sections 404(a)(9) and 404(k)(1)) that
are available to C corporations, but not to S corporations.
Further, converting to S corporation status in many cases
involves eliminating the economic interests of ``ineligible''
shareholders; restructuring debt, options and other
arrangements that could be recharacterized as a ``second class
of stock''; implementing new shareholders' agreements; paying a
``LIFO recapture tax,'' etc. Companies that also elected to
treat subsidiaries as ``Qualified Subchapter S Subsidiaries''
will have lost forever their basis in the stock of such
subsidiaries, which could have significant negative
consequences in the event of a future sale of those businesses.
If the 1997 Act provision had not been enacted, these companies
likely would not have incurred the costs, or accepted the
consequences, associated with becoming S corporations. It would
be improper from a tax policy perspective to encourage
conversions in 1997 and to fundamentally change the
consequences thereof not more than two years later.
Similarly, companies that have increased the extent to
which they are employee owned, or that are in the process of
establishing ESOPs, have relied on the 1997 Act provision in
determining whether the costs of establishing ESOPs are
outweighed by the benefits. In this regard, it is critical to
understand that establishing an ESOP is a very costly process.
It typically involves, among other things, conducting a
feasibility study; obtaining valuations; making comprehensive
changes to the overall compensation arrangements; and making
difficult decisions about the extent to which employees should
have access to information about, and be involved in, the
business. ESOPs also are subject to numerous regulatory and
disclosure requirements by the Department of Labor. In
addition, in the case of a leveraged ESOP, significant
financing costs may be incurred. Companies that undertake
actions with such significant consequences and costs should be
able to rely on a relatively stable set of tax laws.
The Administration's Proposal Not Only Is Complex, But Also
Could Result in S Corporation Income Being Subject to Two
Levels of Tax and in Employees Bearing a New Tax Burden
As a general matter, Congress has recognized throughout
Subchapter S that, subject to limited exceptions, S corporation
income should only be subject to one level of tax. However, as
explained below, the Administration's proposal in some
situations improperly would result in S corporation income
being subject to two levels of tax--one at the ESOP level and
one at the participant level. Such a result not only would be
inconsistent with the general Congressional intent underlying
Subchapter S, but also would create an untenable new tax burden
on the employee-owners of ESOP-owned companies.
The Administration's proposal apparently attempts to ensure
that S corporation income is subject to only one level of tax
by introducing a new deduction mechanism. However, this
deduction mechanism not only introduces needless complexity
into an already overly complex tax law, but also is
fundamentally flawed. For example, assume an ESOP had S
corporation income in excess of distributions for a number of
years prior to the termination or revocation of the
corporation's S election. Under the Administration's proposal,
the S corporation earnings would be subject to immediate tax at
the ESOP level. However, if the ESOP distributed those earnings
to participants more than two years after the corporation
terminated or revoked its S corporation election, neither the
carryback nor carryforward provisions of the proposal likely
would be useful because the ESOP would be unlikely to have
earnings subject to UBTI at that time (i.e., after the
corporation has become a C corporation). Thus, the S
corporation earnings in effect would be subject to tax at both
the ESOP level (when earned) and the participant level (when
distributed), with the employees bearing the burden of the
double-level tax.
By contrast, the Congressional decision in the 1997 Act to
exempt S corporation income from UBIT at the ESOP level is
simple and ensures that S corporation income properly is
subject to tax only once--when the income is distributed to
participants. The Coalition strongly endorses this decision and
encourages this Committee not to entertain the introduction of
a complex deduction mechanism that is technically flawed, can
engender tax results inconsistent with the general intent
underlying Subchapter S, and would produce a new tax burden on
employees.
Repealing the 1997 Act Provision Cannot Be Justified on
``Anti-Tax Shelter'' Grounds
As indicated above, the Administration included its
proposal to repeal the 1997 Act provision as part of the
``corporate tax shelter'' section of its budget. As should be
apparent from the above, the 1997 Act provision is playing a
valuable role in fostering employee ownership of closely-held
businesses and enabling people to enhance their retirement
savings. Members of this Coalition that have converted to S
corporation status, established ESOPs, or given ESOPs greater
stakes in the business are doing exactly what the Congress
intended when it enacted the 1997 Act provision--they are not
engaging in a tax shelter, taking advantage of a loophole, or
otherwise engaging in an abusive transaction.
The Coalition understands that this Committee may be
concerned about particular transactions in which taxpayers may
be using ESOPs in a manner not intended by the Congress in
1997. For example, the Joint Committee on Taxation, in its
Description of Revenue Provisions Contained in the President's
Fiscal Year 2000 Budget Proposal, suggested that there may be
concerns regarding S corporation ESOPs in cases where there are
only one or two employees. In addition, it referenced a
technique described by Prof. Martin Ginsburg in which the 1997
Act provision can be used to create a ``tax holiday'' for other
shareholders of an S corporation. \1\ If Congress is concerned
about particular transactions, the appropriate response is to
craft narrow solutions targeting those transactions, rather
than to reject wholesale the decision made in the 1997 Act to
further employee ownership of closely-held companies.
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\1\ Ginsburg, ``The Taxpayer Relief Act of 1997: Worse Than You
Think,'' 76 Tax Notes 1790 (September 29, 1997).
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RECOMMENDATIONS
For the reasons set forth above, the Coalition strongly
urges the Committee not to approve the Administration's
proposal. If the Committee is concerned about perceived abuses,
the Coalition would be happy to work with the Committee and its
staff in devising an appropriate solution that is tailored to
the particular transactions with which the Committee is
concerned.
The Coalition appreciates the Committee's interest in its
views on this significant issue.
This testimony was prepared on behalf of the Coalition by
Arthur Andersen LLP.
Statement of Committee of Annuity Insurers
The Committee of Annuity Insurers is composed of forty-two
life insurance companies that issue annuity contracts,
representing approximately 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 affecting 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.
All of the Administration's proposals relating to the
taxation of life insurance companies and their products are
fundamentally flawed. However, the focus of this statement is
the Administration's proposal to increase the so-called ``DAC
tax'' imposed under IRC section 848 and, in particular, the
increase proposed with respect to annuity contracts used for
retirement savings outside of pension plans (``non-qualified
annuities''). The Administration's proposal reflects unsound
tax policy and, if enacted, would have a substantial, adverse
effect on private retirement savings in America. As was the
case last year, the Administration has demonstrated that it
does not understand the important role that annuities and life
insurance play in assuring Americans that they will have
adequate resources during retirement and adequate protection
for their families.
Annuities are widely owned by Americans. At the end of
1997, there were approximately 38 million individual annuity
contracts outstanding, nearly three times the approximately 13
million contracts outstanding just 11 years before. The
premiums paid into individual annuities--amounts saved by
individual Americans for their retirement--grew from
approximately $34 billion in 1987 to $90 billion in 1997, an
average annual increase of greater than 10 percent.
Owners of non-qualified annuities are predominantly middle-
income Americans saving for retirement. The reasons for this
are obvious. Annuities have unique characteristics that make
them particularly well-suited to accumulate retirement savings
and provide retirement income. Annuities allow individuals to
protect themselves 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.
The tax rules established for annuities have been
successful in increasing retirement savings. Eighty-four
percent of owners of non-qualified annuities surveyed by The
Gallup Organization in 1998 reported that they have saved more
money than they would have if the tax advantages of an annuity
contract had not been available. Almost nine in ten (88%)
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.
As discussed below, the proposal contained in the
Administration's FY 2000 budget to increase the DAC tax is in
substance a tax on owners of non-qualified annuity contracts
and cash value life insurance. It would make these products
more expensive and less attractive to retirement savers. It
would also lower the benefits payable to savers and families.
Furthermore, as also discussed below, the DAC tax is
fundamentally flawed and increasing its rate would simply be an
expansion of bad tax policy.
1. The Administration's DAC proposal is in substance a tax on the
owners of annuities and life insurance.
Last year, the Administration's budget proposals included
several direct tax increases on annuity and life insurance
contract owners, including imposition of tax when a variable
contract owner changed his or her investment strategy and a
reduction in cost basis for amounts paid for insurance
protection. The proposals were rightly met with massive
bipartisan opposition and were rejected. This year's budget
proposal on DAC is simply an attempt to increase indirectly the
taxes of annuity and life insurance contract owners. We urge
this Committee to reject the Administration's back door tax
increase on annuity and life insurance contract owners in the
same decisive manner in which the Committee rejected last
year's proposed direct tax increases.
IRC section 848 denies life insurance companies a current
deduction for a portion of their ordinary and necessary
business expenses equal to a percentage of the net premiums
paid each year by the owners of certain types of contracts.
These amounts instead must be capitalized and then amortized
over 120 months. The amounts that currently must be capitalized
are 1.75 percent of non-qualified annuity premiums, 2.05
percent of group life insurance premiums, and 7.70 percent of
other life insurance premiums (including noncancellable or
guaranteed renewable accident and health insurance). Under the
Administration's proposal, these categories of contracts would
be modified and the percentages would be dramatically
increased. Specifically, the rate for annuity contracts would
almost triple to 5.15 percent while the rate for individual
cash value life insurance would almost double to 12.85 percent.
The tax resulting from the requirements of section 848 is
directly related to the amount of premiums paid by the owners
of the contracts. Thus, as individuals increase their annuity
savings (by paying more premiums), a company's taxes increase--
the higher the savings, the higher the tax. It is clear that
since the enactment of DAC in 1990, the DAC tax has been passed
through to the individual owners of annuities and life
insurance. Some contracts impose an express charge for the cost
of the DAC tax, for example, while other contracts necessarily
pay lower dividends or less interest to the policyholder. Still
other contracts impose higher general expense charges to cover
the DAC tax. (See The Wall Street Journal, December 10, 1990,
``Life Insurers to Pass Along Tax Increase.'')
According to the Joint Committee on Taxation, the increased
capitalization percentages proposed in the Administration's FY
2000 budget will result in increased taxes of $3.73 billion for
the period 1999-2004 and $9.48 billion for the period 1999-
2009. This tax increase will largely come from middle-income
Americans who are purchasing annuities to save for retirement
and cash value life insurance to protect their families.
According to a Gallup survey conducted in April 1998, most
owners of non-qualified annuities have moderate annual
household incomes. Three-quarters (75%) have total annual
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 (83%) or to avoid being a
financial burden on their children (82%).
The Administration's proposal will discourage private
retirement savings and the purchase of life insurance. 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. As described above, Americans
have been saving more and more in annuities, which are the only
non-pension retirement investments that can provide the owner
with a guarantee of an income that will last as long as the
owner lives. Life insurance contracts can uniquely protect
families against the risk of loss of income. Increasing the
cost of annuities and cash value life insurance and reducing
the benefits will inevitably reduce private savings and the
purchase of life insurance protection.
2. Contrary to the Administration's claims, an increase in the DAC tax
is not necessary to reflect the income of life insurance companies
accurately.
The Administration claims that the increases it proposes in
the DAC capitalization percentages are necessary to accurately
reflect the economic income of life insurance companies. In
particular, the Administration asserts that ``life insurance
companies generally capitalize only a fraction of their policy
acquisition expenses.'' In fact, as explained below, life
insurance companies already more than adequately capitalize the
expenses they incur in connection with issuing annuity and life
insurance contracts. The Administration's proposal would
further distort life insurance company income simply to raise
revenue.
As a preliminary matter, the Administration cites certain
data that life insurance companies report to state insurance
regulators as a basis for its claim that only a fraction of
policy selling expenses are being capitalized. In particular,
the Administration points to the ratio of commissions to net
premiums during the period 1993 -1997, and notes that the ratio
is higher than the current DAC capitalization percentage. The
Administration's ratios present an inaccurate and misleading
picture of the portion of commissions being capitalized under
current law.
The Administration's ratios apparently treat expense
allowances paid on reinsured contracts as commissions and in
doing so effectively count those amounts twice. As a result,
the numerators in the Administration's ratios are significantly
overstated. If expense allowances paid in connection with
reinsurance are accounted for properly, the ratio of
commissions to net premiums is significantly lower than
described by the Administration.
More importantly, the current tax rules applicable to life
insurance companies capitalize policy selling expenses not only
through the section 848 DAC tax, but also by requiring (in IRC
section 807) reserves for life insurance and annuity contracts
to be based on a ``preliminary term'' or equivalent method. It
is a matter of historical record that preliminary term reserve
methods were developed because of the inter-relationship of
policy selling expenses and reserves. Since the early 1900's,
when preliminary term reserve methods began to be accepted by
state insurance regulators, the relationship between policy
reserves and a life insurance company's policy selling expenses
has been widely recognized. See, e.g., K. Black, Jr. and H.
Skipper, Jr, Life Insurance 565-69 (12th ed. 1994); McGill's
Life Insurance 401-408 (edited by E. Graves and L. Hayes,
1994).
Under a preliminary term reserve method, the reserve
established in the year the policy is issued is reduced (from a
higher, ``net level'' basis) to provide funds to pay the
expenses (such as commissions) the life insurer incurs in
issuing the contract. The amount of this reduction is known as
the ``expense allowance,'' i.e., the amount of the premium that
may be used to pay expenses instead of being allocated to the
reserve. Of course, the life insurance company's liability for
the benefits promised to the policyholder remains the same even
if a lower, preliminary term reserve is established. As a
result, the amount added to the reserve in subsequent years is
increased to take account of the reduction in the first year.
In measuring a life insurance company's income, reducing
the first year reserve deduction by the expense allowance is
economically equivalent to computing a higher, net level
reserve and capitalizing, rather than currently deducting, that
portion of policy selling expenses. Likewise, increasing the
reserve in subsequent years is equivalent to amortizing those
policy selling expenses over the subsequent years. Thus, under
the current income tax rules applicable to life insurance
companies, policy selling expenses are capitalized both under
the section 848 DAC tax and through the required use of
preliminary term reserves. The Administration's FY 2000 budget
proposal completely ignores this combined effect.
This relationship between policy selling expenses and
preliminary term reserves has been recognized by Congress. In
accordance with the treatment mandated by the state regulators
for purposes of the NAIC annual statement, life insurance
companies have always deducted their policy selling expenses in
the year incurred in computing their Federal income taxes.
Until 1984, life insurance companies also computed their tax
reserves based on the reserve computed and held on the annual
statement. However, under the Life Insurance Company Income Tax
Act of 1959 (the ``1959 Act''), if a company computed its
annual statement reserves on a preliminary term method, the
reserves could be recomputed on the higher, net level method
for tax purposes. Because companies were allowed to compute
reserves on the net level method and to deduct policy selling
expenses as incurred, life insurance companies under the 1959
Act typically incurred a substantial tax loss in the year a
policy was issued.
When Congress was considering revisions to the tax
treatment of life insurance companies in 1983, concern was
expressed about the losses incurred in the first policy year as
a result of the interplay of the net level reserve method and
the current deduction of first year expenses. In particular,
there was concern that a mismatching of income and deductions
was occurring. As a consequence, as those who participated in
the development of the Deficit Reduction Act of 1984 (the
``1984 Act'') know, Congress at that time considered requiring
life insurance companies to capitalize and amortize policy
selling expenses.
Congress chose not to change directly the tax treatment of
policy selling expenses, however. Rather, recognizing that the
effect of the use of preliminary term reserve methods is
economically identical to capitalizing (and amortizing over the
premium paying period) the expense allowance by which the first
year reserve is reduced, Congress decided to alter the
treatment of selling expenses indirectly by requiring companies
to use preliminary term methods, rather than the net level
method, in computing life insurance reserves.
Although the published legislative history of the 1984 Act
does not explicitly comment on this congressional decision to
address the treatment of selling expenses through reduction of
the allowable reserve deduction, the legislative history of the
Tax Reform Act of 1986 does. In 1986, Congress became concerned
that there was a mismatching of income and deductions in the
case of property and casualty insurers. In particular, some
thought that allowing a property and casualty company a
deduction for both unearned premium reserves and policy selling
expenses resulted in such a mismatching.
Again, recognizing the relationship between the treatment
of reserves and selling expenses, Congress chose to reduce the
unearned premium reserve deduction of property and casualty
insurers by 20 percent, while allowing selling expenses to
remain currently deductible. See I.R.C. section 832(b)(4). The
legislative history of this rule noted that ``this approach is
equivalent to denying current deductibility for a portion of
the premium acquisition costs.'' Jt. Comm. on Taxation, General
Explanation of the Tax Reform Act of 1986, at p. 595 (``1986
Act Bluebook''). Moreover, Congress specifically excluded life
insurance reserves that were included in unearned premium
reserves from the 20 percent reduction. See I.R.C. section
832(b)(7). It did so, according to the legislative history,
because under the 1984 Act life insurance reserves ``are
calculated . . . in a manner intended to reduce the
mismeasurement of income resulting from the mismatching of
income and expenses.'' See 1986 Act Bluebook at p. 595
(emphasis added).
In summary, life insurance companies are already over
capitalizing policy selling expenses for income tax purposes
because of the combination of the current DAC tax and the
mandated use of preliminary term reserves. In these
circumstances, increasing the DAC capitalization percentages
will not result in a clearer reflection of the income of life
insurance companies. To the contrary, increasing the
percentages as the Administration proposes would further
distort life insurance company income simply to raise revenue.
3. Contrary to the Administration's suggestion, an increase in the DAC
tax is inconsistent with GAAP accounting.
The Administration's explanation of the DAC proposal
implies that increases in the DAC percentages are consistent
with generally accepted accounting principles (GAAP). The
Administration states that ``[l]ife insurance companies
generally capitalize only a portion of their actual policy
acquisition costs. In contrast, when preparing their financial
statements using [GAAP], life companies generally capitalize
their actual acquisition costs.'' What the Administration's
explanation fails to note is that, while it is correct that
under GAAP accounting actual acquisition costs are capitalized,
GAAP accounting does not mandate the use of preliminary term
reserves. In fact, no system of insurance accounting ``doubles
up'' on capitalization by requiring a combination of
capitalization of actual policy acquisition costs combined with
the use of preliminary term reserves.
It is clear from the legislative history of the Omnibus
Budget Reconciliation Act of 1990 (the ``1990 Act'') that
Congress expressly considered and rejected GAAP as a basis for
accounting for life insurance company policy selling expenses.
The Chairman of the Senate Budget Committee inserted in the
Congressional Record the language submitted by the Senate
Finance Committee describing the section 848 DAC tax. 136
Congressional Record at S15691 (Oct. 18, 1990). In this
explanation, the Finance Committee recognized that, while there
were some potential benefits to the GAAP approach, there were a
number of drawbacks to it. As a result, the Finance Committee
chose a proxy approach of amortizing a percentage of premiums
over an arbitrary 10 year period, rather than capitalizing
actual selling expenses and amortizing them over the actual
life of the contracts. In doing so, the Finance Committee
observed that
The Committee recognizes that this approach to the
amortization of policy acquisition expenses does not measure
actual policy acquisition expenses. However, the Committee
believes that the advantage of retaining a theoretically
correct approach is outweighed by the administrative simplicity
of this proxy approach. Further, the Committee believes that
the level of amortizable amounts obtained under this proxy
approach should, in most cases, understate actual acquisition
expenses. . . . Id.
The House legislative history contains similar explanatory
material. See Legislative History of Ways and Means Democratic
Alternative (WMCP 101-37), October 15, 1990, at 27-28.
In short, when Congress enacted the DAC tax in 1990, it
knew that the proxy percentages did not capitalize the full
amount of acquisition expenses as does GAAP accounting.
However, as discussed above, the combination of the current DAC
percentages with the mandated use of preliminary term reserves
already results in two different capitalization mechanisms. If
GAAP accounting is the appropriate model for taxing life
insurance companies, as the Administration suggests, then the
DAC tax should be repealed, not increased.
In conclusion, the Committee of Annuity Insurers urges the
Committee to reject the Administration's proposal to increase
the section 848 DAC tax. The proposal is simply a disguised tax
on the owners of annuities and life insurance contracts.
Furthermore, the proposal lacks any sound policy basis and
further distorts the income of life insurance companies.
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, Conseco, Inc.,
Carmel, IN
COVA Financial Services Life Insurance Co., Oakbrook Terrace, IL
Equitable Life Assurance Society of the United States, New York, NY
Equitable of Iowa Companies, DesMoines, IA
F & G Life Insurance, Baltimore, MD
Fidelity Investments Life Insurance Company, Boston, MA
GE Life and Annuity Assurance Company, Richmond, VA
Great American Life Insurance Co., Cincinnati, OH
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 Financial, Boston, MA
Merrill Lynch Life Insurance Company, Princeton, NJ
Metropolitan Life Insurance Company, New York, NY
Minnesota 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
The Principal Financial Group, Des Moines, IA
Travelers Insurance Companies, Hartford, CT
Zurich Kemper Life Insurance Companies, Chicago, IL
Statement of Committee to Preserve Private Employee Ownership
Introduction
This statement is submitted on behalf of the Committee to
Preserve Private Employee Ownership (``CPPEO''), which is a
separately funded and chartered committee of the S Corporation
Association. As of March 1, 1999, 19 employers have joined
CPPEO and over 20,000 employees in virtually every state in the
country are represented by companies that belong to CPPEO.
CPPEO welcomes the opportunity to submit this statement for
the written record to the Committee on Ways and Means regarding
two of the proposals in the President's Fiscal Year 2000
Budget. CPPEO strongly opposes the proposal to effectively
repeal the provision in the Taxpayer Relief Act of 1997 (the
``1997 Act'') \1\ that allowed S corporations to create ESOPs
in order to promote employee stock ownership and employee
retirement savings for S corporation employees. CPPEO urges the
Ways and Means Committee to reject the Administration's S
corporation ESOP proposal and continue to allow S corporations
to have ESOP shareholders as contemplated in the 1997 Act.
CPPEO also strongly opposes the Administration's proposal to
tax ``large'' C corporations and their shareholders upon a
conversion to S corporation status. CPPEO urges the Ways and
Means Committee to reject this proposal, which has been
included in the President's budget for the past three years and
has been rejected each year, on the grounds it would inhibit
the ability of S corporations to acquire C corporations, would
impose burdensome complexity, and may represent a first step in
an attempt to eliminate S corporations as a form of doing
business.
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\1\ 1 P.L. 105-34.
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Legislative History of S Corporation ESOPs
In the early 1990's, efforts began to enact legislation
that would allow S corporation employees to enjoy the benefits
of employee stock ownership that were conferred on C
corporation employees under the ESOP provisions. Finally, in
1996 Congress included a provision in the Small Business Jobs
Protection Act of 1996 (the ``1996 Act'') \2\ that allowed S
corporations to have ESOP shareholders, effective for taxable
years beginning after December 31, 1997, so that S corporation
employees could partake in the benefits of employee ownership
that were already afforded to employees of C corporations. This
provision, which was added just prior to enactment, did not
result in a viable method to allow S corporation ESOPs, though
it clearly expressed Congress' intent that S corporations
should be allowed to have employee plan owners.
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\2\ 2 P.L. 104-188.
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The 1996 Act did not provide S corporation ESOPs with all
of the incentives that are provided to encourage C corporation
ESOPs. For example, under Internal Revenue Code section 1042,
\3\ shareholders that sell employer stock to a C corporation
ESOP are allowed to defer the recognition of gain from such
sale. In addition, under section 404(a)(9), C corporations are
allowed to make additional deductible contributions that are
used by an ESOP to repay the principal and interest on loans
incurred by the ESOP to purchase employer stock. C corporations
are also allowed deductions under section 404(k) for dividends
paid to an ESOP that are used either to make distributions to
participants or to repay loans incurred by the ESOP to purchase
employer stock. In addition, as a practical matter S
corporation ESOP participants would be unable to use a
substantial tax break--the ``net unrealized appreciation''
exclusion in section 402(e)(4)--because this benefit applies
only to distributions of employer stock, which S corporations
typically cannot do, as described below.
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\3\ 3 All ``section'' references are to the Internal Revenue Code
of 1986, as amended.
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These incentives provided to C corporation ESOPs were not
provided to S corporation ESOPs and a major disincentive was
imposed on S corporation ESOPs by the 1996 Act. A 39.6 percent
tax (the unrelated business income tax of section 511, or
``UBIT'') was imposed on employees' retirement accounts with
respect to the ESOP's share of the income of the sponsoring S
corporation and any gain realized by the ESOP when it sold the
stock of the sponsoring S corporation. The imposition of UBIT
on S corporation ESOPs meant that the same income was being
taxed twice, once to employees' ESOP accounts and a second time
to the employees' distributions from the ESOP. Accordingly,
owning S corporation stock through an ESOP would subject
employees to double tax on their benefits, while individuals
holding S corporation stock directly would be subject to only a
single level of tax.
The 1996 Act had another defect that made ESOPs an
impractical choice for providing employee retirement benefits
to S corporation employees--the right of ESOP participants to
demand their distributions in the form of employer securities.
S corporations cannot have more than 75 shareholders and cannot
have IRAs or certain other qualified retirement plans as
shareholders. Therefore, S corporations generally could not
adopt ESOPs without taking the risk that the future actions of
an ESOP participant could nullify the corporation's election of
S corporation status--such as rolling over his or her stock
into an IRA.
In the 1997 Act, Congress reaffirmed its policy goal of
making ESOPs available to the employees of S corporations and
addressed the problems with the ESOP provisions in the 1996
Act. Congress did not provide S corporation ESOPs with all the
advantages and incentives provided to C corporation ESOPs,
including the favorable tax treatment for shareholders selling
stock to the ESOP and increased deductions and contribution
limits for the sponsoring employer discussed above, but it did
fix the critical problems. The double tax on S corporation
stock held by an ESOP was eliminated by exempting income
attributable to S corporation stock held by the ESOP from UBIT.
Thus, only one level of tax was to be imposed, which would be
imposed on the ESOP participant when he or she received a
distribution from the ESOP. S corporation ESOPs also were given
the right to distribute cash to participants in lieu of S
corporation stock in order to address the problems of
ineligible S corporation shareholders and the numerical limit
on S corporation shareholders.
In 1997 it was clear that a key feature of the legislation
was that S corporation ESOPs would not have the same incentives
afforded to C corporation ESOPs. The incentives provided to C
corporation ESOPs that were not allowed to S corporation ESOPs
under the 1996 Act, as described above, would continue to be
allowed only to C corporation ESOPs. However, S corporation
ESOPs would enjoy two benefits not available to C corporation
ESOPs.
First, the income of S corporation ESOPs under the 1997 Act
is subject to only a single level of tax. This is an inherent
attribute of the way S corporations and their shareholders are
taxed, and in fact is the fundamental characteristic of the S
corporation tax regime. No one, including the Administration,
disputes that only one level of tax should be imposed on S
corporations and their shareholders. The second benefit
provided to S corporation ESOPs is that the one level of tax is
deferred until benefits are distributed to ESOP participants.
Considerable thought was given in 1997 to whether this deferral
of tax should be allowed. Various ways of taxing S corporation
ESOPs and their participants were considered in 1997, including
ways essentially the same as the Administration's proposal, and
were rejected as too complex, burdensome, and unworkable. In
order to achieve a workable S corporation ESOP tax regime with
incentives that were commensurate with those available to C
corporation ESOPs, Congress determined that the deferral of the
one level of tax, in lieu of the special incentives afforded to
C corporation ESOPs, was appropriate. The Administration is
rejecting this determination just 18 months after Congress has
acted.
The Administration's S Corporation ESOP Proposal
The Administration proposes to reimpose UBIT on S
corporation ESOPs, both new and old. The specific provisions
relating to UBIT adopted in the 1997 Act would be repealed. As
explained by Assistant Secretary Donald Lubick in his testimony
before this Committee, the benefit of tax deferral would be
eliminated by reimposing UBIT on S corporation ESOPs.
Acknowledging that double taxation of S corporations and their
shareholders is not appropriate, the Administration would
provide S corporation ESOPs with a special deduction to be used
against their liability for UBIT when distributions are made to
ESOP participants.
The Administration's S Corporation ESOP Proposal Would Frustrate
Congressional Policy
The Administration's S corporation ESOP proposal would
frustrate the Congressional policy of allowing S corporations
to establish ESOPs for their employees principally because the
Administration proposal will not only end deferral, but also
will reinstate double taxation. The Administration's proposal
to allow a deduction to the ESOP for distributions to
participants will not prevent double taxation.
S corporation ESOPs will be required to pay UBIT for all
the years that they hold S corporation stock, but will not be
allowed any way to recover those taxes until distributions are
made to participants. The rules limiting the timing of
distributions by an ESOP to its employee participants, like the
rules for all qualified retirement plans, encourage long-term
retirement savings and are intended to produce the result that
distributions to an employee will occur many years, even
decades, after the employee first becomes a participant in the
ESOP. A 2-year carryback and a 20-year carryforward of excess
deductions will not ensure that the taxes paid by the ESOP over
many years, even decades, will be recovered. Thus, there is no
assurance that the deduction will prevent double taxation of
employee benefits. In fact, the estimated revenue to be raised
by the Administration's proposal is the same as the revenue
cost of the 1997 Act, demonstrating that the Administration's
proposal is simply an attempt to repeal the provisions of the
1997 Act and is not aimed at preventing unintended uses of
current law.
The Administration's proposed scheme for eliminating tax
deferral and attempting to prevent double taxation has another
substantial defect. That is, any tax refunds to the ESOP for
the tax deductions allowed to the ESOP cannot be fairly
allocated and paid to the employee participants. Assume, for
the sake of illustration, that employees A and B are the
participants in an S corporation ESOP, each owning an equal
number of shares of S corporation stock through the ESOP. A and
B work for the next 20 years and the ESOP pays tax on the
income of the S corporation attributable to their shares of
stock. Then A decides to retire and the ESOP sells the shares
of stock in A's account to the S corporation and pays A the
proceeds. The ESOP would receive a deduction for the
distribution to A and would be able to reduce its UBIT
liability for the year it makes a distribution to A. In this
example, there would be no way the ESOP could use the full
amount of the deduction for the year it makes a distribution to
A, nor would it be able to fully use the excess amount when it
carries the excess deduction back two years. Thus, the ESOP
would not be able to realize the full benefit of the deduction,
which was supposed to allow the ESOP to recoup the taxes it
paid over the past 20 years with respect to the stock in A's
account and, presumably, give A that benefit to offset the
second level of taxes A will pay. By the time the ESOP realizes
all the benefits of the deduction, A will have long ceased to
be a participant in the ESOP and those benefits will be
allocated to the remaining participant, namely B.
In addition, it is not clear how the ESOP could properly
allocate the benefits that it can immediately realize. The
deduction is allowed for distributions to participants. After
the proceeds from the sale of the stock in A's account are
distributed to A, A ceases to be a participant. The ESOP cannot
make any additional allocations or distributions to A. As the
sole remaining participant, B will receive the benefit of those
deductions.
The Administration's proposal also resurrects a problem
under ERISA that the 1997 Act eliminated. The imposition of
UBIT on S corporation ESOPs raises concerns about fiduciary
obligations under ERISA for potential ESOP plan sponsors and
trustees. The potential for double taxation and the inequitable
allocation of benefits among plan participants will make the
establishment of S corporation ESOPs unpalatable to anyone who
would be subject to ERISA. In addition, qualified plan trustees
typically avoid investments that give rise to UBIT because it
obligates the trustee to file a federal income tax return for
the plan's UBIT liability. Under the Administration's proposal,
the establishment of an S corporation ESOP would necessarily
involve making investments that give rise to UBIT liability
because ESOPs are required to invest primarily in employer
securities.
The Administration's proposal attempts to characterize the
treatment of S corporation ESOPs as a corporate tax shelter.
The beneficiaries of S corporation ESOPs are employees, not the
S corporation. Moreover, the IRS already has an arsenal of
anti-abuse tools to deal with any unintended benefits from
creating an S corporation ESOP. Current law was enacted to do
just what it is doing--encouraging employee ownership of S
corporations. Indeed, advocating the repeal of a successful
retirement program directly contradicts the Administration's
stated objective of increasing retirement savings, as reflected
in the 17 retirement savings proposals included in its fiscal
year 2000 budget.
Conversions From C Corporation Status to S Corporation Status
Under current law, the conversion of a C corporation into
an S corporation (whether by electing S corporation status or
by merging the C corporation into an existing S corporation)
generally does not result in the recognition of gain or loss by
either the C corporation or its shareholders. Current law
limits the potential for using the tax-free conversion to S
corporation status to shift appreciated assets from a C
corporation to an S corporation in order to avoid the corporate
level tax on the sale of the assets. Under current law, a
corporate level tax is imposed on an S corporation if it sells
appreciated assets within ten years of acquiring the assets in
a conversion from C corporation status. S corporation
shareholders are also taxed on the gain, reduced by the amount
of tax paid by the S corporation.
The Administration's Proposal to Tax Conversions to S Corporation
Status Is Bad Tax Policy
Under the Administration's proposal, a C corporation and
its shareholders would be taxed on a conversion of the C
corporation to S corporation status (whether by electing S
corporation status or by merger into an existing S
corporation), if the value of the corporation on the date of
conversion is more than $5 million. By imposing a tax on the
merger of C corporations into existing S corporations (and
mergers preceded by the election of S corporation status by an
existing C corporation), the Administration's proposal would
unfairly inhibit the ability of S corporations to expand their
businesses through corporate acquisitions. C corporations are
allowed to make tax-free corporate acquisitions, but S
corporations would be denied that privilege.
This unfair result would, moreover, come at the price of
burdensome complexity. The $5 million threshold value for
imposing tax on S corporation conversions would create a
``cliff'' effect that would result in disputes over valuation
that would be difficult to resolve for corporations that are
not publicly traded. In addition, more rules would be needed to
address the murky issues of whether conversions below the $5
million threshold were ``abusive'' transactions structured to
avoid the conversion tax.
The Administration's proposal may represent a first step
towards the repeal of the S corporation tax regime. The
restrictions on S corporations (primarily the ``one class of
stock'' rule and limitations on the number and type of
shareholders) do not compare favorably with the flexibility
afforded limited liability companies, which have expanded the
availability of corporate limited liability combined with a
single level of tax. Therefore, the desirability of S
corporation status for newly-formed businesses has been
decreased. The Administration's proposal would decrease the
desirability of C corporations converting to S corporation
status. Enactment of the Administration's proposal would
confine S corporation status principally to existing S
corporations, at which point the opponents of the S corporation
tax regime would challenge the need to preserve a separate tax
regime for the benefit of only existing S corporations and
their shareholders. The S corporation tax regime has served
small businesses well for the past 40 years and there is no
good reason to dismantle that regime now.
Conclusion
Current law encourages employee ownership of S corporations
and promotes employee retirement savings. Current law is
working exactly as it was intended to work when Congress
amended the ESOP rules for S corporations in the 1997 Act.
Accordingly, CPPEO urges this Committee to reject the
Administration's S corporation ESOP proposal. The tax and
retirement policies reflected in the 1997 Act, resolved just a
few months ago, should not now be undone.
In addition, current law fairly treats corporate
acquisitions by S corporations the same as corporate
acquisitions by C corporations. Accordingly, CPPEO urges this
Committee to reject the Administration's proposal to tax
conversions to S corporation status. The Administration's
proposal is not needed, would unfairly discriminate against S
corporations, would add burdensome complexity to the tax law,
and would threaten the continued existence of the S corporation
tax regime.
[By permission of the Chairman]
Statement of the Conservation Trust of Puerto Rico
Introduction and Overview
This testimony outlines the comments of the Conservation
Trust of Puerto Rico (``Conservation Trust'' or ``Trust'') on
the Administration's fiscal year 2000 budget proposal to
increase, for a five year period, the amount of the rum excise
tax that is covered over to Puerto Rico and the U.S. Virgin
Islands. The proposal would dedicate to the Conservation Trust
a portion of the amount covered over to Puerto Rico.
Congressman Phil Crane (R-IL) originally developed this
proposal in the 105th Congress, after the Trust lost its
funding source in 1996 upon repeal of the Qualified Possession
Source Investment Income (``QPSII'') provisions of Section 936
of the Internal Revenue Code (``Code'').
The Trust strongly supports the short-term funding proposal
included in the fiscal year 2000 budget request. Passage of
this proposal would allow the Trust to become more independent
by building a sufficient endowment to guarantee the Trust's
long-term viability. This short-term plan has bipartisan Ways
and Means Committee support, led by Congressmen Crane and
Rangel (D-NY), and will help the Trust continue to meet its
sole mission of preserving and protecting the most ecologically
valuable natural lands and historic sites of Puerto Rico.
Conservation Trust's Purpose and Financing
The Conservation Trust is a non-profit institution
specifically created to carry out a joint plan of the U.S. and
Puerto Rico for the protection and enhancement of the natural
resources and beauty of Puerto Rico. The Trust was established
in 1968 by an agreement between the U.S. Department of the
Interior and the Government of Puerto Rico. The Trust is
classified by the Internal Revenue Service as exempt under
501(c)(3) and 509(a)(3) of the Code as an institution organized
and operated to perform the functions of the U.S. and Puerto
Rico in the area of conservation. The Commonwealth Department
of the Treasury also classifies the Trust as a non-profit
institution.
Since its inception, the Trust has acquired more than 6,000
acres of endangered land and through various programs protects
an additional 7,000 acres. The Trust's acquisition represents
80% of all land acquired for permanent conservation in Puerto
Rico by public or private entities over the last 20 years. The
Trust also engages in educational programs which include, among
other things, the design of environmental and conservation
curricula, the adoption of schools, summer camps, and
environmental interpretation of properties, and a reforestation
program. Despite the Trust's active role, however, only 5% of
the Island is under some protection by either the Federal or
Commonwealth conservation agencies or the Conservation Trust.
For the first 10 years of its existence, the Trust was
funded through a fee imposed by the Department of the Interior
on petroleum and petrochemical companies operating in Puerto
Rico under the Oil Import Allocation Program. Upon expiration
of the Oil Import Allocation Program, the Trust sustained its
activities through the use of income generated by companies
doing business in the Island and eligible to take the
``possessions tax credit'' under Section 936 of the Code. The
Trust was authorized by local law to participate in financial
transactions that utilized QPSII. Through mid-1996, this
funding mechanism generated almost 80% of the Trust's revenues.
Section 936 Changes Eliminated Funding Source for Conservation Trust
The Omnibus Budget Reconciliation Act of 1993 (``OBRA
'93'') phased-down the possessions credit significantly during
tax years 1994 to 1998. Additionally, OBRA '93 increased the
rum tax cover over from $10.50 to $11.30 for the same five
taxable years, ending on September 31, 1998. Viewing the
Section 936 legislation as a signal that reliance on the QPSII
program was infeasible and the program was at risk of being
eliminated altogether after 1998, the Trust made significant
adjustments to its land acquisition plans and capital
improvement programs after passage of OBRA '93. In addition to
these adjustments, a major portion of the Trust's yearly income
was reallocated to build an endowment fund designed to reach
$90 million by 1998.
In 1996, however, Congress passed the Small Business Job
Protection Act. This legislation repealed the QPSII provisions
of Section 936, thereby cutting off an essential outside
funding source much earlier than any such loss was expected.
The elimination of the Section 936 and the QPSII provisions
has had a substantial negative impact on the Trust's
operations. Specifically, the repeal has eliminated the Trust's
primary income source used to meet endowment goals. Since
passage of the Small Business Job Protection Act in 1996, the
volume of funds invested in Trust notes has decreased from an
average of $1.3 billion to $1.4 billion to approximately $550
million, of which $120 million is from pre-1997 long-term
investments. Additionally, the net income made per transaction
has diminished because of the increase in the rates the Trust
must now pay to obtain new financing.
The loss of Section 936 income has also impeded the Trust's
ability to complete pre-1996 conservation efforts as well as
start new projects. Prior to the repeal of Section 936, the
Trust acquired and began restoring Esperanza, an historic sugar
mill site on the Island. The Trust had also planned to purchase
a salt landing necessary to preserving the fish and migratory
bird population on the Island. The loss of QPSII funds,
however, severely limited the Trust's ability to continue
restoration efforts at Esperanza or to make additional
acquisitions, such as the salt landing. The Trust's financial
constraints are also inhibiting its ability to properly address
the damage resulting from Hurricane Georges.
The Trust has proven extremely effective at advancing its
mission, however, there is still much more work that needs to
be done. These goals will be impossible to reach without short-
term financing to build an endowment sufficient to guarantee
the Trust's viability. Congressman Crane's proposal, which the
Administration included in its Fiscal Year 2000 budget request,
will provide such short-term support.
Description of Current Law and Proposed Solution for the Trust
I. Current law.
Section 5001 of the Internal Revenue Code (``the Code'')
imposes an excise tax of $13.50 per proof gallon on distilled
spirits made or imported into the U.S. Section 7652 of the Code
further provides for a payment (a ``cover over'') of $10.50 per
proof gallon of the excise tax levied on rum that is imported
into the U.S., Puerto Rico, or the Virgin Islands.
OBRA '93 provided that, for a five-year period, $11.30 of
the excise tax be covered over to the treasury of Puerto Rico.
After September 30, 1998, the amount covered over to Puerto
Rico returned to the pre-OBRA '93 amount of $10.50.
II. Proposed Solution.
The Administration's fiscal year 2000 budget proposal would
increase the rum excise cover over from $10.50 to $13.50 per
proof gallon for Puerto Rico and the Virgin Islands for five
years, beginning October 1, 1999. Of such amount that is
covered over to Puerto Rico, $.50 per proof gallon would be
dedicated to the Trust. The proposal would be effective for rum
imported or brought into the U.S. after September 30, 1999 and
before October 1, 2004. This proposal is also reflected in
legislation (S. 213) that Senator Daniel P. Moynihan (D-NY)
introduced this year.
Conclusion
Enactment of the cover-over proposal would allow the Trust
to become more independent by building a sufficient endowment
to guarantee the Trust's long-term viability. This short-term
infusion would ensure that the Trust's managers, including the
Department of the Interior, continue the Trust's mission of
preserving the environmental and historic beauty of the Island
of Puerto Rico.
Statement of Richard C. Smith, Partner, Bryan Cave LLP, Niche
Marketing, Inc., Costa Mesa, California, and Economics Concepts, Inc.,
Phoenix, Arizona
Mr. Chairman and Members of the Committee:
My name is Richard C. Smith, and I am a partner in the
Phoenix, Arizona office of Bryan Cave LLP, a leading
international law firm, where a significant portion of my
practice involves counseling clients with respect to employee
benefits and planning employee benefit plans and programs. I am
submitting this statement for the record today on behalf of two
clients that sponsor welfare benefit plans, Niche Marketing,
Inc. of Costa Mesa, California, and Economic Concepts, Inc. of
Phoenix, Arizona.
We believe that the Administration's proposal to further
limit the deductibility of contributions to multiple employer
welfare benefit plans under sections 419 and 419A of the
Internal Revenue Code is ill-advised and will undermine the
ability of smaller employers to fund bona fide benefits to
their employees at precisely the times in the business cycle
when those benefits would be most needed. In our opinion, the
Administration's proposal has gone further than is necessary to
eliminate the abuses described by the Treasury Department in
its explanation of the proposal.
By way of background, sections 419 and 419A were enacted to
limit certain abusive practices associated with the pre-funding
of welfare benefits and generally limit such pre-funding,
including severance and death benefits. Congress, however,
permitted a limited exception to the general limitations for
certain multiple employer welfare benefit funds with 10 or more
participating employers where the relationship of participating
employers would be closer to the relationship of insureds to an
insurer than to the relationship of an employer to a fund.
This exception for ten or more employer plans under section
419A(f)(6) has the specific purpose of allowing small employers
the ability to compete with larger employers in providing
severance and death benefits to their employees. Major
employers are able to fund such benefits on a pay-as-you-go
basis because of their financial resources. Small employers do
not have the cash resources to pay such benefits when they
become due. In fact, because layoffs and terminations most
often occur when there is a business slowdown--meaning cash
flow or profits are not available--severance benefits are most
important just at the time such employers are least likely to
be able to pay for them. Thus, smaller employers were given the
ability to fund such benefits in advance, when cash is
available, in recognition that the cash to pay such benefits
would likely be available to employers in the lean years.
Rather than curtailing the ability of smaller employers to
continue to provide bona fide severance and death benefits to
their employees by eliminating whole classifications of
benefits, as the Administration's proposal would do,
legislation if enacted should focus on the perceived abuses. In
that regard, the major perceived abuse cited in the Treasury
Department General Explanation of Revenue Proposals in the
Clinton Administration FY2000 Budget is the requirement that to
qualify as a ten or more employer plan under Section 419A of
the Code, the plan must not be experience rated with respect to
individual participating employers.
A plan may be deemed to be experience rated with respect to
an individual employer because the employer (a) reaps the
favorable economic consequences if its benefit costs are less
than those assumed when the employer's premium was set, and (b)
bears the economic risk that the benefit cost will exceed those
assumed when the premium was set. Experience rating may reflect
the employer's experience not only with regard to benefit
payments, but also with regard to administrative costs or
investment return. Thus, a plan provides an experience rating
arrangement with respect to an employer if the employer's
contributions are increased or decreased to reflect the benefit
payments or administrative costs with respect to the employer's
employees or the investment return with respect to the
employer's contributions.
In Robert D. Booth and Janice Booth v. Commissioner, 108
T.C. No. 25 (1997), which was cited in the Treasury Department
General Explanation, the Tax Court took the position that an
experience rating arrangement may also include one where
benefits rather than employer costs vary with fund experience.
However, even under this definition of experience rating, gains
or losses would still have to be segregated employer by
employer for the plan to be experience rated with respect to
individual participating employers.
It is true that some plans have attempted to disguise
experience rating by creating reserve or other similar funds to
which experience gains and losses are allocated. The final
disposition of such experience gains and losses in such case is
often unclear and a portion thereof may be allocated solely to
the group of employees of a particular employer with respect to
which the experience gain or loss relates. However, alleviating
this problem can be accomplished without eliminating severance
or death benefits funded with other than group term insurance.
This can be accomplished by first making sure that funding
requirements in such plans are based solely on compensation,
years of service, dates of employment, dates of birth,
insurance risk classification and reasonable actuarial
assumptions. Secondly, this can be accomplished by requiring
that all experience as to benefit payments, forfeitures,
investment returns, and administrative costs are allocated
throughout the plan and the experience with respect to the
employees of a particular employer are not segregated or
allocated to that employer or its employee group. In addition,
it could be required that all such experience gains or losses
are allocated on an annual basis and not used to establish a
reserve account. I would be happy to discuss these possible
provisions with you further or suggest specific statutory
changes if you wish.
In summary, the operation of welfare benefit plans under
section 419A(f)(6) of the Code enables small employers to
provide severance and death benefits to their employees by
allowing them to fund such benefits in advance when profits are
sufficient to do so. In no case are any funds paid into such a
plan ever permitted to revert to the employer that contributed
them. The Administration's proposed changes would eliminate the
use of cash value insurance that provides sufficient funding to
pay future mortality costs and severance benefits. Rather than
eliminating such benefits, the Committee should attempt to find
ways to expand the ability for employees to receive insured
death and severance benefits while merely eliminating abuses
that have occurred in certain cases. This can be done by more
carefully drafting the rules with respect to experience rating
as described above. As we have seen in the pension and other
areas in the past, if benefits are taken away from business
owners, the rank and file employees are more likely than not to
receive no benefits at all.
We appreciate the Committee's attention and would be
pleased to assist the Committee in resolving this important
issue for the many thousands of small employers who rely in
good faith on these plans to provide an important benefit to
their employees.
Statement of Edison Electric Institute
The Edison Electric Institute (EEI) appreciates the
opportunity to submit written comments to the Committee on Ways
and Means regarding the Administration's FY 2000 revenue
proposals.
EEI is the association of United States shareholder-owned
electric companies, international affiliates and industry
associates worldwide. Our U.S. members serve over 90 percent of
all customers served by the shareholder-owned segment of the
industry. They generate approximately three-quarters of all the
electricity generated by electric companies in the country and
service about 70 percent of all ultimate customers in the
nation.
The 135 revenue proposals included in the Administration's
fiscal year 2000 budget cover a broad range of topics, many of
which are of interest to EEI. However, rather than comment on
numerous provisions contained in the Administration's budget
and potentially obscure the issues of critical importance to
the electric industry, EEI will comment on three areas that are
unique to the electric industry: fair competition between
electric utilities, adequate funding of nuclear plant
decommissioning, and the extension and modification of the
production tax credit for wind and biomass facilities. EEI will
also comment on the provisions dealing with tax shelters
because this provision has the potential to adversely impact
numerous taxpayers including shareholder owned utilities. EEI
would be pleased to work with the Committee on any proposals
that will be considered by the Committee for legislative
action.
TREATMENT OF BONDS ISSUED TO FINANCE ELECTRIC OUTPUT FACILITIES
The electricity industry is shifting from regulation to the
use of competitive markets to sell power and related services
and products. For competition to work, the Federal government
needs to address the artificial competitive advantages of tax-
exemptions and tax-exempt financing used by government-owned
utilities when competing against other sellers of electricity,
so that all competitors can participate in open markets under
the same set of rules.
Shareholder-owned and government-owned utilities grew up
contemporaneously, but represented distinctly different
approaches to providing electrical power. Shareholder-owned
utilities started out as entrepreneurial businesses mainly
serving towns and cities and they were taxed like any other
business. By contrast, government-owned utilities came into
their own during the 1930s, when only about 15 percent of
small-town America had access to electricity. Tax-exemptions
and other kinds of government subsidies were used to finance
electrification in an attempt to break the grip of the Great
Depression. Today, 99 percent of America is electrified.
Up to now, the two systems have lived side-by-side serving
customers in their geographically defined service areas. The
different tax treatment of the two types of utilities creates
profound problems when they compete in open markets. In order
for competition to work well, the marketplace, and not tax law,
must determine the outcome. In a competitive marketplace,
providing some competitors with federal tax subsidies in the
form of exemption from income tax and the ability to finance
facilities using tax-exempt debt, merely because they are
instruments of State or local governments, can alter the
competitive outcome and result in a misallocation of societal
resources. The Council of Economic Advisers stated in the
``Economic Report of the President'' (Transmitted to Congress
February 1996) on pages 188-189 that:
``For competition to work well, it must take place on a level
playing field: competition will be distorted if producers are
given selective privileges ... to further even legitimate
social goals. ... As competition grows, increasing distortions
may result from some entities having access to special
privileges such as federally tax-exempt bonds ...''
When these tax-exemptions and tax-free bonds are used in
competitive markets, they act as subsidies that undermine
competition. As competitive markets are beginning to form, now
is the time to address the problem.
The Administration's Proposal
EEI supports the Administration's approach to addressing
this problem in that it acknowledges the need to change current
tax law to reflect the move to a competitive industry. It does
so by stipulating that no new facilities for electric
transmission or generation may be financed with tax-exempt
bonds. This represents a good start from which to resolve these
important issues.
Congressional Proposals
EEI strongly believes that there is no essential
governmental purpose served when a governmental utility goes
outside its service territory and sells output into areas in
which it has no legitimate governmental interest. Rather, such
a governmental utility is acting as a commercial entity and
should be treated as such. It should no longer be able to issue
new tax-exempt debt to finance power plants or transmission
facilities, and it should be subject to Federal income tax on
the income from the sales it makes to persons outside its
historical service area. Legislation accomplishing this
objective will be introduced this month by Representative Phil
English. EEI strongly supports this legislation and encourages
the Committee on Ways and Means to consider it during its
deliberations on a tax bill this year.
Legislation (H.R.721) also has been introduced that would
broaden the ability of government-owned utilities to leverage
their tax preferences to compete against taxpaying utilities.
It would allow government-owned utilities to sell power from
federally subsidized facilities to customers outside their
existing service territory without paying income tax on profits
from those sales. It would considerably broaden the ability of
government-owned utilities to build new transmission facilities
with tax-exempt bonds, facilitating government control of
transmission as the industry deregulates. EEI, therefore,
opposes this bill as it runs contrary to both the English and
Administration proposals.
TREATMENT OF CONTRIBUTIONS TO NUCLEAR DECOMMISSIONING TRUSTS
Code Section 468A allows a special rule for the future
costs of decommissioning nuclear power plants. A current
deduction is allowed for contributions to a qualified external
trust fund (``Fund''), the net assets of which are to be used
exclusively to provide for the safe and timely decommissioning
of a taxpayer's nuclear plant.
As Code Section 468A was being considered in 1984, Congress
was concerned about time value of money advantages then
described as ``premature accruals.'' Nuclear plant
decommissioning involves a significant fixed liability that, in
a regulated environment, is ideally suited for funding during
the operating life of the plant. Funding in this manner assures
that the electric customers that receive the electricity from
the plant also pay their ratable share of the decommissioning
costs. Safe and environmentally acceptable decommissioning was
considered of sufficient national importance to warrant a
special tax deduction. Congress did not intend that this
deduction would lower the taxes paid by the owner of a nuclear
plant in present value terms. The time value of money concern
was redressed by requiring that the income earned by the Fund
be taxed as it is earned and also taxed a second time when the
trust's funds are withdrawn by the plant owner to pay
decommissioning costs.\1\
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\1\ The fund is, in fact, a grantor trust for all purposes save
federal tax purposes. Section 468A(e)(2) taxes the fund as if it were a
corporation. However, in the case of a normal grantor trust, previously
taxed income would not be treated as income again as funds are
withdrawn.
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The original intent of Congress was to spread the deduction
of decommissioning costs over the operating life of the plant
and also to facilitate the creation of a dedicated external
trust fund.\2\ This was accomplished with Section 468(A) which
facilitates contributions to an independent trust to provide
reasonable assurance that the amounts will be available to pay
for the costs of decommissioning. We believe the current
circumstances have changed considerably and current provisions
of 468(A) are no longer pertinent nor appropriate.
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\2\ 1984 Tax Reform Act, Legislative Background of Senate Finance
Committee Deficit Reduction Provisions, pages 277-9.
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In addition to imposing a double tax on earnings, Congress
imposed limits: (1) to prevent the accumulation of more monies
in a Fund than are required to fund the portion of future
decommissioning costs allocable to the remaining plant life,
and (2) to ensure that contributions to the reserve are not
accelerated.
In an era in which the remaining lives of many nuclear
plants are being revised downward, restrictions that are based
upon concerns over accumulating more funds than are required or
accelerated funding are no longer well-founded. The important
national concern is that funds will be available when needed to
pay the costs of decommissioning. In fact, the limitations that
restrict the annual amount of qualified contributions could
serve as a deterrent to the transferability of the ownership
interest in the nuclear plants or in the deregulation of the
electric generation. Proper tax and public policy should be to
allow a tax deduction for nuclear decommissioning when the net
present value of the decommissioning liability is contributed
to the independent trust fund. For this reason, EEI strongly
believes that the purposes of these limits are no longer
appropriate due to changes in the electric industry.
In addition, Congress required that the contribution to the
Fund be paid only from monies, collected under regulatory
authority, from customers for that specific purpose. As
generating plants are deregulated this limitation may have the
unintended effect of prohibiting deductions for funding
decommissioning. Put another way, no regulatory authority, no
deduction. The Administration is to be commended for proposing
the repeal of this limitation.
ENERGY AND ENVIRONMENTAL TAX PROVISIONS
As producers of electricity and processors of the earth's
finite fuels, electric utilities continue to support the use of
tax credits to sponsor both the efficient uses of electricity
and the generation of electricity from wind or biomass.
Wind
The production tax credit (PTC) for wind (and closed-loop
biomass) facilities will expire on July 1, 1999. To promote the
continued development of wind energy production in the United
States, the Administration's budget includes a five-year
extension of the PTC. The credit provides an inflation-adjusted
1.5 cents/kilowatt-hour credit for electricity produced from a
new U.S. wind facility for the first ten years of its
existence. The credit is only available if the wind energy
equipment is located in the U.S. and electricity is generated
and sold in the marketplace.
The PTC assists wind-generated energy in competing with
fossil fuel-generated power. In the 1980's electricity
generated with wind could cost as much as 25 cents/kilowatt-
hour. Since then wind energy production has increased its
efficiency by a remarkable 80% to the current cost of under 5
cents/kilowatt hour. The current 1.7 cents/kilowatt-hour credit
enables the industry to compete with other generating sources
being sold within the range of 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 years. 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. This is exactly what Congress
envisioned when it enacted the PTC, the development and
improvement of wind energy technology.
The immediate extension of the PTC is critical. Since the
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 three or more years of lead-time. With the
credit due to expire on June 30, 1999, wind energy developers
and investors can not plan any new projects without the
assurance of the continued availability of the PTC. The
immediate extension of the PTC is therefore critical to
continued development of the wind energy market.
The Administration is to be commended for its commitment to
promote the continued development and improvement of wind
energy technology. At this stage of development, wind power is
unable to compete head to head with traditional electric
generation. The potential for further improvement exists and it
is therefore prudent to encourage development of this industry
with the extension of the PTC.
Biomass
The purpose of the closed-loop biomass credit is to provide
an incentive for locking carbon into plant cellulose material
temporarily, which reduces carbon dioxide's effect on global
warming.
The present biomass credit, which requires that the crop
must be raised for the exclusive use of producing electricity,
has not been effective. To our knowledge there is not one
facility in the nation that has been able to take advantage of
this credit.
However, electricity from crop by-products can accomplish
essentially the same purpose. Natural decomposition of forest
and agricultural by-products produce greenhouse gasses such as
methane in addition to carbon dioxide. Using forest or
agricultural by-products to produce electricity would serve the
dual role of reducing the use of irreplaceable fossil fuel,
allowing fossil fuel carbon to remain trapped, and the
conversion of otherwise wasted biomass products to valuable
fuel. The proposed definition allowing forest and agriculture
by-products to qualify as creditable biomass would provide the
needed economic stimulus that was originally intended for the
closed-loop biomass credit. EEI, therefore, believes that the
broadened definition of biomass fuel and the extension of the
tax credit are required steps to increase electric generation
from this fuel source.
UNDERSTATEMENT PENALTY FOR ``CORPORATE TAX SHELTERS''
EEI believes that proposed modifications to the
understatement penalty which proposes an automatic 40% penalty
based upon an overly broad and vague definition of ``corporate
tax shelter'' will cause major problems and interfere with
legitimate transactions. The 40% penalty question turns on
whether the arrangements of corporate affairs so that taxes
would be as low as possible were ``clearly contemplated by the
applicable provision (taking into account the Congressional
purpose for such provision and the interaction of such
provision with other provisions of the Code.)''
The clearly contemplated Congressional purpose of the
provisions of the Internal Revenue Code is currently the topic
of discussion at innumerable IRS Appellate hearings and court
cases. If the actual results of the IRS administrative appeals
process as reported by the General Accounting Office and court
case results of our members are valid indications of what
Congress clearly intended, the statistics demonstrate that the
disputed adjustments of the IRS agents are incorrect 80% of the
time.\3\ The record of the IRS Agents demonstrates that when it
comes to determining what is the clearly contemplated
Congressional purpose for such provision, the clear intention
appears to be more apparent to the corporate tax professionals
than IRS tax professionals.
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\3\ GAO/GGD-98-128 IRS Audit Results and Cost Measures Coordinated
Examination Program results, Table 2, page 10.
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Complex tax law will result in legitimate differences of
opinion. Different minds do understand the facts and the law
differently. Corporate tax professionals and IRS tax
professionals can deal within this technical realm, and the
substantial tax dollars and interest dollars in the balance.
The injection of a penalty into this situation is an altogether
different matter. A penalty, especially a penalty of this
magnitude, calls into question the honesty of the corporate tax
professionals and the corporate officers. The Administration is
proposing to inject a punishing 40% penalty for misinterpreting
the Congressional purpose without any consideration of a
determination, made contemporaneously with the decision to
enter into the transaction, that the position taken was more
likely than not to prevail and without consideration of any
reasonable cause.
The proper forum for dispute resolution is one that focuses
on the merits of the issue and the plain meaning of the law
which the penalty provision makes infinitely more complex. The
40% nondeductible provision will lead to deep seeded taxpayer
resentment of the tax system. The national system of taxation
will not be improved by the addition of a 40% penalty, based
upon the subjective opinion of the taxing authority, as to
whether or not a transaction was entered into for the purpose
of keeping taxes as low as possible within the clearly
contemplated Congressional purpose.\4\
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\4\ We also agree with Judge Learned Hand who stated, ``There is
nothing sinister in so arranging one's affairs to keep taxes as low as
possible.''
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CONCLUSION
EEI believes that a level playing field is essential for
efficient competition in the electric industry. Although the
Administration has proposed to reduce the prospective subsidies
received by governmental utilities through tax-exempt
financing, the Administration has not addressed their exemption
from income tax. EEI recommends that the Committee should
disallow the use of tax-exempt financing for government owned
utilities which choose to sell more than a de minimus amount of
electricity outside their municipal boundaries.
EEI supports the Administration's proposal to repeal the
cost of service requirement for contributions to a qualified
nuclear decommissioning fund. In addition, EEI believes that
the qualifying percentage and the limitation based on ruling
amounts should also be repealed.
EEI supports the Administration's proposal for the five-
year extension of the production tax credit for wind and
biomass facilities.
EEI also is concerned about the broad definition of an
improper corporate tax shelter and the unfavorable effect it
will have on our tax system.