[JPRT 106-1-99]
[From the U.S. Government Publishing Office]


                        [JOINT COMMITTEE PRINT]


 
                   DESCRIPTION OF REVENUE PROVISIONS
                     CONTAINED IN THE PRESIDENT'S
                   FISCAL YEAR 2000 BUDGET PROPOSAL

                               __________

                         Prepared by the Staff

                                 of the

                      JOINT COMMITTEE ON TAXATION

[GRAPHIC] [TIFF OMITTED]CONGRESS.#13


                           FEBRUARY 22, 1999




                     U.S. GOVERNMENT PRINTING OFFICE
54-622                       WASHINGTON : 1999                    JCS-1-99






                      JOINT COMMITTEE ON TAXATION

                      106th Congress, 1st Session
                                 ------                                
               HOUSE                               SENATE
BILL ARCHER, Texas,                  WILLIAM V. ROTH, Jr., Delaware,
  Chairman                             Vice Chairman
PHILIP M. CRANE, Illinois            JOHN H. CHAFEE, Rhode Island
WILLIAM M. THOMAS, California        CHARLES GRASSLEY, Iowa
CHARLES B. RANGEL, New York          DANIEL PATRICK MOYNIHAN, New York
FORTNEY PETE STARK, California       MAX BAUCUS, Montana

                     Lindy L. Paull, Chief of Staff
               Bernard A. Schmitt, Deputy Chief of Staff
                 Mary M. Schmitt, Deputy Chief of Staff
              Richard A. Grafmeyer, Deputy Chief of Staff

                                  (II)


                            C O N T E N T S

                              ----------                              
                                                                   Page
Introduction.....................................................     1

I. Provisions Reducing Revenues..................................     2

        A. Health Care Tax Provisions............................     2
            1. Long-term care tax credit.........................     2
            2. Disabled workers tax credit.......................     6
            3. Provide tax relief for small business health plans     9
        B. Education Tax Provisions..............................    13
            1. Tax credits for holders of qualified school 
                modernization bonds and qualified zone academy 
                bonds............................................    13
            2. Exclusion for employer-provided educational 
                assistance.......................................    19
            3. Tax credit for employer-provided workplace 
                literacy and basic education programs............    23
            4. Tax credit for contributions to qualified zone 
                academies........................................    25
            5. Eliminate 60-month limit on student loan interest 
                deduction........................................    29
            6. Eliminate tax on forgiveness of direct student 
                loans subject to income contingent repayment.....    31
            7. Tax treatment of education awards under certain 
                Federal programs.................................    34
                a. Eliminate tax on awards under National Health 
                    Corps Scholarship Program and F. Edward 
                    Hebert Armed Forces Health Professions 
                    Scholarship and Financial Assistance Program.    34
                b. Eliminate tax on repayment or cancellation of 
                    student loans under NHSC Scholarship Program, 
                    Americorps Education Award Program, and Armed 
                    Forces Health Professions Loan Repayment 
                    Program......................................    36
        C. Child Care Provisions.................................    37
            1. Expand the dependent care credit..................    37
            2. Tax credit for employer-provided child care 
                facilities.......................................    43
        D. Tax Incentives to Revitalize Communities..............    45
            1. Increase low-income housing tax credit per capita 
                cap..............................................    45
            2. Tax credits for holders of Better America Bonds...    50
            3. New markets tax credit............................    56
            4. Specialized small business investment companies...    60
            5. Extend wage credit for two new empowerment zones..    62
        E. Energy and Environmental Tax Provisions...............    64
            1. Tax credit for energy-efficient building equipment    64
            2. Tax credit for purchase of energy-efficient new 
                homes............................................    66
            3. Extend tax credit for high-fuel-economy vehicles..    66
            4. Tax credit for combined heat and power (``CHP'') 
                systems..........................................    68
            5. Tax credit for rooftop solar equipment............    69
            6. Extend wind and biomass tax credit................    70
        F. Retirement Savings Provisions.........................    77
             1. IRA contributions through payroll deduction......    77
             2. Small business tax credit for new retirement plan 
                expenses.........................................    79
             3. Simplified pension plan for small business 
                (``SMART'')......................................    80
             4. Faster vesting of employer matching contributions    84
             5. Count FMLA leave for retirement eligibility and 
                vesting purposes.................................    86
             6. Require joint and 75-percent survivor annuity 
                option for pension plans.........................    87
             7. Pension disclosure...............................    89
             8. Benefits of nonhighly compensated employees under 
                section 401(k) safe harbor plans.................    91
             9. Modify definition of highly compensated employee.    92
            10. Modify benefit limits for multiemployer plans 
                under section 415................................    93
            11. Modify full funding limit for multiemployer plans    95
            12. Eliminate partial termination rules for 
                multiemployer plans..............................    96
            13. Allow rollovers between qualified retirement 
                plans and section 403(b) tax-sheltered annuities.    97
            14. Allow rollovers from deductible IRAs to qualified 
                plans or section 403(b) tax-sheltered annuities..    99
            15. Allow rollovers of after-tax contributions.......   100
            16. Allow rollovers of contributions from 
                nonqualified deferred compensation plans of State 
                and local governments to IRAs....................   101
            17. Purchase of service credits in governmental 
                defined benefit plans............................   103
        G. Extend Certain Expiring Tax Provisions................   104
            1. Extend minimum tax relief for individuals.........   104
            2. Extend the work opportunity tax credit............   109
            3. Extend the welfare-to-work tax credit.............   112
            4. Extend the research tax credit....................   114
            5. Make permanent the expensing of brownfields 
                remediation costs................................   124
            6. Extend tax credit for first-time D.C. homebuyers..   127
        H. Simplification Provisions.............................   130
            1. Optional Self-Employment Contribution Act 
                (``SECA'') computations..........................   130
            2. Statutory hedging and other rules to ensure 
                business property is treated as ordinary property   132
            3. Clarify rules relating to certain disclaimers.....   136
            4. Simplify the foreign tax credit limitation for 
                dividends from 10/50 companies...................   137
            5. Interest treatment for dividends paid by certain 
                regulated investment companies to foreign persons   139
            6. Expand declaratory judgment remedy for non-
                charitable organizations seeking determinations 
                of tax-exempt status.............................   141
            7. Simplify the active trade or business requirement 
                for tax-free spin-offs...........................   144
        I. Miscellaneous Provisions..............................   146
            1. Extend and modify Puerto Rico tax credit..........   146
            2. Exempt first $2,000 of severance pay from income 
                tax..............................................   149
            3. Extend carryback period for net operating losses 
                of steel companies...............................   151
        J. Electricity Restructuring.............................   152
            1. Tax-exempt bonds for electric facilities of public 
                power entities...................................   152
            2. Modify treatment of contributions to nuclear 
                decommissioning funds............................   159

II. Provisions Increasing Revenues...............................   161

        A. Corporate Tax Shelters................................   161
             1. Modify the substantial understatement penalty for 
                corporate tax shelters...........................   161
             2. Deny certain tax benefits to persons avoiding 
                income tax as a result of tax avoidance 
                transactions.....................................   166
             3. Deny deductions for certain tax advice and impose 
                an excise tax on certain fees received...........   168
             4. Impose excise tax on certain rescission 
                provisions and provisions guaranteeing tax 
                benefits.........................................   169
             5. Preclude taxpayers from taking tax positions 
                inconsistent with the form of their transactions.   171
             6. Tax income from corporate tax shelters involving 
                tax-indifferent parties..........................   174
             7. Require accrual of time value element on forward 
                sale of corporate stock..........................   178
             8. Modify treatment of built-in losses and other 
                attribute trafficking............................   180
             9. Modify treatment of ESOP as S corporation 
                shareholder......................................   185
            10. Limit tax-free liquidations of U.S. subsidiaries 
                of foreign corporations..........................   187
            11. Prevent capital gains avoidance through basis 
                shift transactions involving foreign shareholders   188
            12. Limit inappropriate tax benefits for lessors of 
                tax-exempt use property..........................   191
            13. Prevent mismatching of deductions and income 
                inclusions in transactions with related foreign 
                persons..........................................   194
            14. Restrict basis creation through section 357(c)...   196
            15. Modify anti-abuse rules related to assumption of 
                liabilities......................................   199
            16. Modify company-owned life insurance (``COLI'') 
                rules............................................   201
        B. Financial Products....................................   204
            1. Require banks to accrue interest on short-term 
                obligations......................................   204
            2. Require current accrual of market discount by 
                accrual method taxpayers.........................   206
            3. Limit conversion of character of income from 
                constructive ownership transactions with respect 
                to partnership interests.........................   208
            4. Modify rules for debt-financed portfolio stock....   211
            5. Modify and clarify certain rules relating to debt-
                for-debt exchanges...............................   213
            6. Modify and clarify straddle rules.................   215
            7. Defer interest deduction and original issue 
                discount (``OID'') on certain convertible debt...   217
        C. Corporate Provisions..................................   220
            1. Conform control test for tax-free incorporations, 
                distributions, and reorganizations...............   220
            2. Tax issuance of tracking stock....................   222
            3. Require consistent treatment and provide basis 
                allocation rules for transfers of intangibles in 
                certain nonrecognition transactions..............   225
            4. Modify tax treatment of downstream mergers........   227
            5. Deny dividends-received deduction for certain 
                preferred stock..................................   229
        D. Provisions Affecting Pass-Through Entities............   231
            1. Require partnership basis adjustments upon 
                distributions of property and modify basis 
                allocation rules.................................   231
            2. Modify structure of businesses indirectly 
                conducted by REITs...............................   239
            3. Modify treatment of closely-held REITs............   241
            4. Repeal tax-free conversion of large C corporations 
                to S corporations................................   244
        E. Tax Accounting Provisions.............................   248
            1. Require IRS permission to change accounting 
                methods..........................................   248
            2. Repeal installment method for most accrual basis 
                taxpayers........................................   253
            3. Deny deduction for punitive damages...............   255
            4. Apply uniform capitalization rules to certain 
                contract manufacturers...........................   257
            5. Repeal the lower of cost or market inventory 
                accounting method................................   258
            6. Repeal the non-accrual experience method of 
                accounting.......................................   260
            7. Disallow interest on debt allocable to tax-exempt 
                obligations......................................   262
        F. Cost Recovery Provisions..............................   265
            1. Modify treatment of start-up and organizational 
                expenditures.....................................   265
            2. Establish specific class lives for utility grading 
                costs............................................   266
        G. Insurance Provisions..................................   268
            1. Require recapture of policyholder surplus accounts   268
            2. Modify rules for capitalizing policy acquisition 
                costs of insurance companies.....................   270
            3. Increase the proration percentage for property and 
                casualty insurance companies.....................   274
        H. Exempt Organizations..................................   277
            1. Subject investment income of trade associations to 
                tax..............................................   277
        I. Estate and Gift Tax Provisions........................   282
            1. Restore phase-out of unified credit for large 
                estates..........................................   282
            2. Require consistent valuation for estate and income 
                tax purposes.....................................   283
            3. Require basis allocation for part-sale, part-gift 
                transactions.....................................   285
            4. Eliminate the stepped-up basis in community 
                property owned by surviving spouse...............   287
            5. Require that qualified terminable interest 
                property for which a marital deduction is allowed 
                be includable in the surviving spouse's estate...   289
            6. Eliminate non-business valuation discounts........   291
            7. Eliminate gift tax exemption for personal 
                residence trusts.................................   294
        J. International Provisions..............................   296
            1. Treat certain foreign-source interest and dividend 
                equivalents as U.S.-effectively connected income.   296
            2. Recapture overall foreign losses when controlled 
                foreign corporation stock is disposed............   299
            3. Amend 80/20 company rules.........................   301
            4. Modify foreign office material participation 
                exception applicable to certain inventory sales..   303
            5. Modify controlled foreign corporation exemption 
                from U.S. tax on transportation income...........   304
            6. Replace sales-source rules with activity-based 
                rules............................................   306
            7. Modify rules relating to foreign oil and gas 
                extraction income................................   308
        K. Pension Provisions....................................   311
            1. Increase elective withholding rate for nonperiodic 
                distributions from deferred compensation plans...   311
            2. Increase section 4973 excise tax on excess IRA 
                contributions....................................   313
            3. Impose limitation on prefunding of welfare 
                benefits.........................................   315
            4. Subject signing bonuses to employment taxes.......   317
        L. Compliance Provisions.................................   319
            1. Expand reporting of cancellation of indebtedness 
                income...........................................   319
            2. Modify the substantial understatement penalty for 
                large corporations...............................   320
            3. Repeal exemption for withholding on certain 
                gambling winnings................................   321
            4. Increase penalties for failure to file correct 
                information returns..............................   322
        M. Miscellaneous Revenue-Increase Provisions.............   323
            1. Modify deposit requirement for Federal 
                unemployment (FUTA) taxes........................   323
            2. Reinstate Oil Spill Liability Trust Fund excise 
                tax..............................................   324
            3. Simplify foster child definition under the earned 
                income credit....................................   325
            4. Repeal percentage depletion for non-fuel minerals 
                mined on Federal and formerly Federal lands......   326
            5. Impose excise tax on purchase of structured 
                settlements......................................   328
            6. Require taxpayers to include rental income of 
                residence in income without regard to period of 
                rental...........................................   330

III. Other Provisions That Affect Receipts.......................   332

        A. Reinstate Superfund Excise Taxes and Corporate 
            Environmental Income Tax.............................   332
        B. Convert a Portion of the Excise Taxes Deposited in the 
            Airport and Airway Trust Fund to Cost-Based User Fees 
            Assessed for Federal Aviation Administration Services   333
        C. Increase Excise Taxes on Tobacco Products.............   338
        D. Change Harbor Maintenance Excise Tax to Cost-Based 
            User Fee.............................................   340
        E. Additional Provisions Requiring Amendment of the 
            Internal Revenue Code................................   341
            1. Increase amount of rum excise tax that is covered 
                over to Puerto Rico and the U.S. Virgin Islands..   341
            2. Allow members of the clergy to revoke exemption 
                from Social Security and Medicare coverage.......   342
            3. Restore premiums for the United Mine Workers of 
                America Combined Benefit Fund....................   342
            4. Disclosure of tax return information for 
                administration of certain veterans programs......   342





                              INTRODUCTION

    This pamphlet,\1\ prepared by the staff of the Joint 
Committee on Taxation (``Joint Committee staff''), provides a 
description and analysis of the revenue provisions contained in 
the President's Fiscal Year 2000 Budget proposal, as submitted 
to the Congress on February 1, 1999.\2\ The pamphlet generally 
follows the order of the proposals as included in the 
Department of the Treasury's explanation.\3\ For the revenue 
provisions, there is a description of present law and the 
proposal (including effective date), a reference to any recent 
prior legislative action or budget proposal submission, and 
analysis of issues related to the proposal.
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    \1\ This pamphlet may be cited as follows: Joint Committee on 
Taxation, Description of Revenue Provisions Contained in the 
President's Fiscal Year 2000 Budget Proposal (JCS-1-99), February 22, 
1999.
    \2\ See Office of Management and Budget, Budget of the United 
States Government, Fiscal Year 2000: Analytical Perspectives (H. Doc. 
106-3, Vol. III), pp. 47-92.
    \3\ See Department of the Treasury, General Explanations of the 
Administration's Revenue Proposals, February 1999.
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    This pamphlet does not contain a description of certain 
proposed user fees (other than the proposed user fees 
associated with the financing of the Airport and Airway Trust 
Fund and the Harbor Maintenance Trust Fund) or other fees 
included in the President's Fiscal Year 2000 Budget.\4\ Also, 
this pamphlet does not contain a description of the Social 
Security and Universal Savings Account Provisions of the 
President's Fiscal Year 2000 Budget.\5\
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    \4\ See Budget of the United States Government, Fiscal Year 2000: 
Analytical Perspectives, pp. 93-104.
    \5\ See Budget of the United States Government, Fiscal Year 2000 
(H. Doc. 106-3, Vol. I), pp. 35-41 and 253-255.
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                    I. PROVISIONS REDUCING REVENUES

                     A. Health Care Tax Provisions

1. Long-term care tax credit

                              Present Law

    Present law contains a number of provisions relating to 
taxpayers with a disabled family member or with long-term care 
needs. A taxpayer can receive a child and dependent care tax 
credit for expenses incurred to care for a disabled spouse or 
dependent so the taxpayer can work. A low-income working 
taxpayer can qualify for the earned income tax credit if he or 
she resides with a disabled child (of any age). A taxpayer who 
itemizes can deduct expenses for qualified long-term care 
services or insurance if he or she is chronically ill or such 
expenses were incurred on behalf of a chronically ill spouse or 
dependent, provided that such expenses, together with other 
medical expenses of the taxpayer, exceed 7.5 percent of 
adjusted gross income (``AGI''). An additional standard 
deduction is available for taxpayers who do not itemize 
deductions if they (or their spouse) are over age 65 and/or 
blind. A credit is available for certain low income taxpayers 
who are elderly or disabled. The impairment-related work 
expenses of a handicapped individual are classified as a 
miscellaneous itemized deduction not subject to the 2-percent 
floor.
    To qualify as a dependent under present law, an individual 
must: (1) be a specified relative or member of the taxpayer's 
household; (2) be a citizen or resident of the U.S. or resident 
of Canada or Mexico; (3) not be required to file a joint tax 
return with his or her spouse; (4) have gross income below the 
dependent exemption amount ($2,750 in 1999) if not the 
taxpayer's child; and (5) receive over half of his or her 
support from the taxpayer. If no one person contributes over 
half the support of an individual, the taxpayer is treated as 
meeting the support requirement if: (a) over half the support 
is received from persons each of whom, but for the fact that he 
or she did not provide over half such support, could claim the 
individual as a dependent; (b) the taxpayer contributes over 10 
percent of such support; and (c) the other caregivers who 
provide over 10 percent of the support file written 
declarations stating that they will not claim the individual as 
a dependent.

                        Description of Proposal

    A taxpayer would be allowed to claim a $1,000 credit if he 
or she has long-term care needs. A taxpayer also would be 
allowed to claim the credit with respect to a spouse or each 
qualifying dependent who has long-term care needs. The credit 
(aggregated with the child credit and the proposed disabled 
worker credit) would be phased out for taxpayers with modified 
AGI above certain thresholds. Under the proposal, the sum of 
the otherwise allowable present-law child credit, the proposed 
disabled workers credit, and the proposed long-term care credit 
would be phased out at a rate of $50 for each $1,000 (or 
fraction thereof) of modified AGI above the threshold amount. 
Modified AGI and the threshold amounts would be the same as 
under the present-law phaseout of the child tax credit. Thus, 
modified AGI would be AGI plus the amount otherwise excluded 
from gross income under Code sections 911, 931, or 933 
(relating to the exclusion of income of U.S. citizens or 
residents living abroad; residents of Guam, American Samoa, and 
the Northern Mariana Islands; and residents of Puerto Rico, 
respectively). The threshold amount would be $110,000 for 
married individuals filing a joint return, $75,000 for 
unmarried taxpayers, and $55,000 for married taxpayers filing 
separate returns. These threshold amounts would not be indexed 
for inflation. An individual may be able to claim both this 
credit and the proposed disabled workers tax credit.
    For purposes of the proposed tax credit only, the 
definition of a dependent would be modified in two ways. First, 
the gross income threshold would increase to the sum of the 
personal exemption amount, the standard deduction, and the 
additional deduction for the elderly and blind (if applicable). 
In 1999, the gross income threshold would generally be $7,050 
for a non-elderly single dependent and $8,100 for an elderly 
single dependent.
    Second, the present-law support test would be deemed to be 
met if the taxpayer and an individual with long-term care needs 
reside together for a specified period. The length of the 
specified period would depend on the relationship between the 
taxpayer and the individual with long-term care needs. The 
specified period would be over half the year if the individual 
is the parent (including stepparents and in-laws), or ancestor 
of the parent, or child, or descendant of the child, of the 
taxpayer. Otherwise, the specified period would be the full 
year. If more than one taxpayer resides with the person with 
long-term care needs and would be eligible to claim the credit 
for that person, then those taxpayers generally must designate 
the taxpayer who will claim the credit. If the taxpayers fail 
to do so or if they are married to each other and filing 
separate returns, then only the taxpayer with the highest AGI 
would be eligible to claim the credit.
    An individual age 6 or older would be considered to have 
long-term care needs if he or she were certified by a licensed 
physician (prior to the filing of a return claiming the credit) 
as being unable for at least 6 months to perform at least 3 
activities of daily living (``ADLs'') without substantial 
assistance from another individual, due to a loss of functional 
capacity (including individuals born with a condition that is 
comparable to a loss of functional capacity).\6\ As under the 
present-law rules relating to long-term care, ADLs would be 
eating, toileting, transferring, bathing, dressing, and 
continence. Substantial assistance would include both hands-on 
assistance (that is, the physical assistance of another person 
without which the individual would be unable to perform the 
ADL) and stand-by assistance (that is, the presence of another 
person within arm's reach of the individual that is necessary 
to prevent, by physical intervention, injury to the individual 
when performing the ADL).
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    \6\ A portion of the period certified by the physician would have 
to occur within the taxable year for which the credit is claimed. After 
the initial certification, individuals would have to be recertified by 
their physician within 3 years or such other period as the Secretary 
prescribes.
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    As an alternative to the 3-ADL test described above, an 
individual would be considered to have long-term care needs if 
he or she were certified by a licensed physician as (a) 
requiring substantial supervision for at least 6 months to be 
protected from threats to health and safety due to severe 
cognitive impairment and (b) being unable for at least 6 months 
to perform at least one or more ADLs or to engage in age 
appropriate activities as determined under regulations 
prescribed by the Secretary of the Treasury in consultation 
with the Secretary of Health and Human Services.
    A child between the ages of 2 and 6 would be considered to 
have long-term care needs if he or she were certified by a 
licensed physician as requiring substantial assistance for at 
least 6 months with at least 2 of the following activities: 
eating, transferring, and mobility. A child under the age of 2 
would be considered to have long-term care needs if he or she 
were certified by a licensed doctor as requiring for at least 6 
months specific durable medical equipment (for example, a 
respirator) by reason of a severe health condition or requiring 
a skilled practitioner trained to address the child's condition 
when the parents are absent. The Department of the Treasury and 
the Department of Health and Human Services would be directed 
to report to Congress within 5 years of the date of enactment 
on the effectiveness of the definition of disability for 
children and recommend, if necessary, modifications to the 
definition.
    The taxpayer would be required to provide a correct 
taxpayer identification number for the individual with long-
term care needs, as well as a correct physician identification 
number (e.g., the Unique Physician Identification Number that 
is currently required for Medicare billing) for the certifying 
physician. Failure to provide correct taxpayer and physician 
identification numbers would be subject to the mathematical 
error rule. Under that rule, the IRS may summarily assess 
additonal tax due without sending the individual a notice of 
deficiency and giving the taxpayer an opportunity to petition 
the Tax Court. Further, the taxpayer could be required to 
provide other proof of the existence of long-term care needs in 
such form and manner, and at such times, as the Secretary 
requires.
    The long-term care credit would generally be nonrefundable, 
which means that the credit generally would be allowed only to 
the extent that the individual's regular tax liability exceeds 
the individual's tentative minimum tax, determined without 
regard to the alternative minimum tax foreign tax credit (the 
``tax liability limitation''). However, the credit would be 
coordinated with the present-law child credit and the proposed 
disabled workers credit so that the credits would be refundable 
for a taxpayer claiming three or more credit amounts under the 
credits. More than one credit amount could be attributable to a 
single individual. For example, a disabled worker with long-
term care needs would have two credit amounts, a disabled 
workers credit and a long-term care credit. Similarly, a 
taxpayer with two children under age 17, one of whom has long-
term care needs, would have three credit amounts: two child 
credit amounts and one long-term care credit amount. As under 
the present-law child credit, the amount of refundable credit 
would be the amount that the nonrefundable personal credits 
would increase if the tax liability limitation were increased 
by the excess of the taxpayer's social security taxes over the 
taxpayer's earned income credit (if any).

                             Effective Date

    The proposal would be effective for taxable years beginning 
after December 31, 1999.

                              Prior Action

    No prior action.

                                Analysis

    The proposal is intended to provide assistance to 
individuals who have long-term care needs or who care for 
others with such needs. Those in favor of the proposal argue 
that the credit is appropriate because such individuals have 
additional costs and do not have the same ability to pay as 
other taxpayers. Some also argue that the present-law favorable 
tax treatment for long-term care services and expenses are not 
sufficient to provide relief to all individuals with long-term 
care needs. For example, present-law does not provide relief 
for family members who provide care for an individual with 
long-term care needs because they cannot afford to hire 
assistance. Present-law also provides relief only to 
individuals with substantial expenses (i.e., in excess of the 
7.5 percent of AGI threshold).
    Some argue that the proposal should be expanded to apply to 
long-term care insurance expenses, even if the taxpayer 
currently does not have long-term care needs, in order to make 
more long-term care insurance more affordable.
    On the other hand, some argue that the proposal is unfair 
to taxpayers not eligible for the credit who also might have 
reduced ability to pay. For example, the credit would not be 
available for individuals who have significant medical expenses 
during a year due to an illness that does not qualify the 
individual for the credit. As another example, the credit would 
not apply to individuals with extraordinary losses, such as the 
destruction of a home. Some argue that the present-law tax 
benefits for long-term care expenses and insurance already 
provide sufficient benefits for individuals with long-term care 
needs.
    The proposal would create new complexities in the Code. 
Taxpayers would need to keep records to demonstrate eligibility 
for the credit. In addition, the provision could cause 
confusion among some taxpayers because it modifies for credit 
purposes only the dependency tests used elsewhere in the Code.
    It could further be argued that phaseouts are inequitable 
because they increase marginal tax rates for taxpayers in the 
phaseout range.\7\ On the other hand, it could be argued that a 
phaseout is needed if the proposal is to be targeted to 
individuals with limited ability to pay.
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    \7\ For a more complete discussion of these issues, see Joint 
Committee on Taxation, Present Law and Analysis Relating to Individual 
Effective Marginal Tax Rates (JCS-3-98), February 3, 1998.
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2. Disabled workers tax credit

                              Present Law

Tax credit for elderly and disabled individuals
    Certain low-income individuals who are age 65 or older may 
claim a nonrefundable income tax credit. The credit also is 
available to an individual, regardless of age, who is retired 
on disability and who was permanently and totally disabled at 
retirement. For this purpose, an individual is considered 
permanently and totally disabled if he or she is unable to 
engage in any substantial gainful activity by reason of any 
medically determinable physical or mental impairment that can 
be expected to result in death, or that has lasted or can be 
expected to last for a continuous period of not less than 12 
months. The individual must furnish proof of disability to the 
Internal Revenue Service (``IRS''). The maximum credit is $750 
for unmarried elderly or disabled individuals and for married 
couples filing a joint return if only one spouse is eligible; 
$1,125 for married couples filing a joint return with both 
spouses eligible; or $562.50 each, for married couples with 
both spouses eligible who are filing separate returns. The 
credit is phased out for individuals with middle- and higher-
income levels.
Deduction for impairment-related work expenses
    Under present law, the impairment-related work expenses of 
a handicapped individual are classified as miscellaneous 
itemized deductions not subject to the two-percent adjusted 
gross income (``AGI'') floor. Impairment-related work expenses 
are expenses for attendant care services at an individual's 
place of employment and other expenses (but not depreciation 
expenses) in connection with such place of employment which are 
necessary for the individual to work and which are deductible 
as a necessary business expense. For purposes of this 
deduction, a handicapped individual is someone with a physical 
or mental disability which results in a functional limitation 
to employment, or who has any physical or mental impairment 
which substantially limits at least one major life activity.

                        Description of Proposal

In general
    The proposal would provide a tax credit to disabled 
individuals, not to exceed the lesser of $1,000 or the 
individual's earned income for the taxable year. The credit 
(aggregated with the child credit and the proposed long-term 
care credit) would be phased out for taxpayers with modified 
AGI above certain thresholds. Under the proposal, the sum of 
the otherwise allowable present-law child tax credit, the 
proposed disabled workers credit, and the proposed long-term 
care credit would be phased out at a rate of $50 for every 
$1,000 (or fraction thereof) of modified AGI above the 
threshold amount. Modified AGI and the threshold amounts would 
be the same as under the present-law phaseout of the child tax 
credit. Thus, modified AGI would be AGI plus the amount 
otherwise excluded from gross income under Code sections 911, 
931, or 933 (relating to the exclusion of income of U.S. 
citizens or residents living abroad; residents of Guam, 
American Samoa, and the Northern Mariana Islands; and residents 
of Puerto Rico, respectively). The threshold amount would be 
$110,000 for married individuals filing a joint return, $75,000 
for unmarried taxpayers, and $55,000 for married individuals 
filing separately. These threshold amounts would not be indexed 
for inflation. An individual may be able to claim both this 
credit and the proposed long-term care credit.
Disability rules
    An individual would qualify as a disabled individual if the 
individual is certified by a licensed physician as being unable 
for a period of at least one year to perform at least one 
activity of daily living (``ADL'') without substantial 
assistance from another person, due to a loss of functional 
capacity. As under the present-law rules relating to long-term 
care, ADLs would be eating, toileting, transferring, bathing, 
dressing, and continence. Substantial assistance would include 
both hands-on assistance (that is, the physical assistance of 
another person without which the individual would be unable to 
perform the ADL) and stand-by assistance (that is, the presence 
of another person within arm's reach of the individual that is 
necessary to prevent, by physical intervention, injury to the 
individual when performing the ADL). The initial certification 
by a licensed physician would be required prior to the filing 
of the tax return in which the individual initially claims the 
disabled workers credit. A portion of the period certified by 
the physician would have to occur within the taxable year for 
which the credit is claimed. After the initial certification, 
the individual would have to be recertified by a licensed 
physician every three years or such other period as the 
Secretary prescribes.
    The individual would be required to provide a correct 
physician identification number (e.g., the Unique Physician 
Identification Number that is currently required for Medicare 
billing) for the physician making the certification. Failure to 
provide a correct physician identification number would be 
subject to the mathematical error rule (sec. 6213). Under that 
rule, the IRS may summarily assess additional tax due without 
sending the individual a notice of deficiency and giving the 
taxpayer an opportunity to petition the Tax Court. The taxpayer 
could be required to provide other proof of the existence of 
disability in such form and manner, and at such times, as the 
Secretary requires.
Tax liability limitation; refundable credits
    The disabled workers credit would generally be 
nonrefundable, which means that the credit generally would be 
allowed only to the extent that the individual's regular tax 
liability exceeds the individual's tentative minimum tax, 
determined without regard to the alternative minimum tax 
foreign tax credit (the ``tax liability limitation''). However, 
the credit would be coordinated with the present-law child 
credit and the proposed long-term care credit so that the 
credits would be refundable for a taxpayer claiming three or 
more credit amounts under the credits. More than one credit 
amount could be attributable to a single individual. For 
example, a disabled worker with long-term care needs would have 
two credit amounts, a disabled workers credit and a long-term 
care credit. Similarly, a taxpayer with two children under age 
17, one of whom has long-term care needs, would have three 
credit amounts: two child care credit amounts and one long-term 
care credit amount. As under the present-law child credit, the 
amount of refundable credit would be the amount that the 
nonrefundable personal credits would increase if the tax 
liability limitation were increased by the excess of the 
taxpayer's social security taxes over the taxpayer's earned 
income credit (if any).

                             Effective Date

    The proposal would be effective for taxable years beginning 
after December 31, 1999.

                              Prior Action

    No prior action.

                                Analysis

    Proponents of the proposal argue that a disabled worker's 
ability to pay tax may be limited compared to an identical 
worker who is not disabled, because the disabled worker incurs 
additional costs in order to work and earn income. The 
proposal, however, allows disabled workers to claim the credit 
regardless of whether they actually incur any such additional 
expenses. If the purpose of the proposal is to subsidize these 
additional expenses, it may be more efficient to condition the 
credit on the worker actually incurring the expenses. This, 
however, would entail more record keeping.
    Proponents of the proposed credit argue that it is intended 
to provide a tax benefit for lower and middle income disabled 
taxpayers. While present law provides some relief to such 
taxpayers, it is argued that some disabled taxpayers may not 
benefit from the present-law provisions because they have 
insufficient expenses to benefit from itemizing deductions, 
have expenses that do not qualify under present law, or rely on 
unpaid assistance. Opponents respond that the present-law 
benefits are sufficient. They also argue that the proposal is 
poorly targeted. For example, it does not provide relief to 
other individuals who have reduced ability to pay, such as 
individuals with significant medical expenses.
    Some argue that it is appropriate to extend the credit to 
all disabled taxpayers, irrespective of their earned income or 
AGI. A taxpayer's ability to pay tax is reduced by the costs of 
being disabled regardless of the taxpayer's income level. 
Nevertheless, it could be said that additional costs associated 
with disability reduce a higher-income taxpayer's ability to 
pay tax proportionately less than the same amount of costs 
reduce a lower-income taxpayer's ability to pay.
    The proposal also may be criticized for increasing the 
effective marginal tax rates with their inherent efficiency, 
equity, and complexity questions for taxpayers in the phase-out 
ranges.\8\ Proponents may respond, however, that phase-outs are 
necessary to appropriately target the benefits of the proposal 
to lower- and middle-income taxpayers. Others may argue that 
the proposal is inequitable, because it gives a $1,000 tax 
credit to a disabled worker with a modified AGI of $100,000 who 
files a joint return, but no tax credit to an unmarried worker 
with an equivalent modified AGI.
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    \8\ For a more complete discussion of these issues, see Joint 
Committee on Taxation, Present Law and Analysis Relating to Individual 
Effective Marginal Tax Rates (JCS-3-98), February 3, 1998.
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    Another issue presented by the proposal is its efficiency. 
For example, a direct expenditure program could be designed to 
subsidize all disabled workers, even if the disabled workers 
had no tax liability. Such an approach would provide a benefit 
to a broader category of disabled workers than the tax credit 
structure of the proposal, because some workers are not 
eligible for the refundable credit under the proposal. It could 
also be argued that the refundable aspect of the credit adds 
complexity to the tax law. One response to this criticism is 
that the present-law child tax credit has similar rules, which 
may already be familiar to taxpayers and tax practitioners. 
Finally, some might question whether the IRS is the government 
agency best suited to the responsibility for verifying the 
disability of each worker and the identification numbers of 
each physician making disability certifications.
3. Provide tax relief for small business health plans

                              Present Law

    Under present law, the tax treatment of health insurance 
expenses depends on the individual circumstances. Employer 
contributions toward employee accident or health insurance are 
generally deductible by employers and excludable from income 
and wages by employees. An individual who itemizes may deduct 
his or her health insurance premiums to the extent that such 
premiums, together with the individual's other medical expenses 
exceed 7.5 percent of the individual's AGI.
    A self-employed individual may deduct a percentage of 
premiums for health insurance covering the individual and his 
or her spouse and dependents, but only if the individual is not 
eligible to participate in a subsidized health plan maintained 
by any employer of the individual or the individual's spouse. 
The deduction is limited by the self-employed individual's 
earned income derived from the relevant trade or business. The 
deduction is equal to 60 percent of health insurance expenses 
for 1999-2000, 70 percent for 2002, and 100 percent for 2003 
and thereafter.
    A multiple employer welfare arrangement (``MEWA'') is an 
employee benefit plan or other arrangement that provides 
medical or certain other benefits to employees of two or more 
employers. MEWAs are generally subject to applicable State 
insurance laws, including provisions of State insurance law 
that generally comply with requirements imposed on insurance 
issuers under the Health Insurance Portability and 
Accountability Act of 1996 (``HIPAA'') and other Federal laws. 
MEWAs (whether or not funded through insurance) are also 
regulated under the Employee Retirement Income Security Act of 
1974, as amended (``ERISA'') with respect to reporting, 
disclosure, fiduciary, and claims procedures.
    Private foundation grants (including loans) must be used by 
the recipient for charitable purposes. To ensure that 
foundation grants are used for the intended charitable purpose, 
so-called ``expenditure responsibility'' requirements apply 
whenever such grants are made to noncharitable organizations 
for exclusively charitable purposes. These requirements involve 
certain recordkeeping and reporting requirements. Among other 
things, there must be a written agreement between the 
foundation and the grantee that specifies clearly how the grant 
funds will be expended, the grantee's books and records must 
account separately for the grant funds, and the grantee must 
report annually to the foundation on the use of the grant funds 
and the progress made in accomplishing the purposes of the 
grant.

                        Description of Proposal

In general
    The proposal has two parts. First, it would provide that a 
grant or loan made by a private foundation to a qualified 
health purchasing coalition (``qualified coalition'') would be 
treated as a grant or loan made for charitable purposes. 
Second, it would create a new income tax credit for the 
purchase of certain health insurance through a qualified 
coalition by small businesses that currently do not provide 
health insurance to their employees. Both provisions would be 
temporary.
Foundation grants to qualified health benefit purchasing coalitions
    Under the proposal, any grant or loan made by a private 
foundation to a qualified coalition to support the coalition's 
initial operating expenses would be treated as a grant or loan 
made for charitable purposes. As with any other grant or loan 
to a noncharitable organization for exclusively charitable 
purposes, private foundations would be required to comply with 
the ``expenditure responsibility'' recordkeeping and reporting 
requirements under present law.
    Initial operating expenses of a qualified coalition would 
include all ordinary and necessary expenses incurred in 
connection with the establishment of the qualified coalition 
and its initial operations, including the payment of reasonable 
compensation for services provided to the qualified coalition 
and rental payments. In addition, initial operating expenses 
would include the cost of tangible personal property purchased 
by the qualified coalition for its own use. Initial operating 
expenses would not include (1) the purchase of real property, 
(2) any payment made to, or for the benefit of, members (or 
employees or affiliates of members) of the qualified coalition, 
such as any payment of insurance premiums on policies insuring 
members (or their employees or affiliates), or (3) any expense 
incurred more than 24 months after the date of formation of the 
qualified coalition.
Small business health plan tax credit
    The proposal also would create a temporary tax credit for 
small businesses that purchase employee health insurance 
through qualified coalitions. The credit would be available to 
employers with at least 2, but not more than 50, employees, 
counting only employees with annual compensation (including 
401(k) and SIMPLE employer contributions) of at least $10,000 
in the prior calendar year. Eligible employers could not have 
had an employee health plan during any part of 1997 or 1998. 
The credit would be available only with respect to insurance 
purchased through a qualified coalition. The credit would equal 
10 percent of employer contributions to employee health plans. 
The maximum credit amount per policy would be $200 per year for 
individual coverage and $500 per year for family coverage (to 
be ratably reduced if coverage is provided for less than 12 
months during the employer's taxable year). The credit would be 
allowed to a qualifying small employer only with respect to 
contributions made during the first 24 months that the employer 
purchases health insurance through a qualified coalition. For 
employers that begin to purchase health insurance in 1999, this 
24-month limit would not include months beginning before 
January 1, 2000. As a condition of qualifying for the credit, 
employers would need to cover at least 70 percent of those 
workers who have compensation (including 401(k) and SIMPLE 
employer contributions) of at least $10,000 and who are not 
covered elsewhere by an employer health plan.\9\ A self-
employed individual who is eligible to take a deduction for 
health insurance premiums would not be allowed to include any 
of the premiums eligible for the deduction in the calculation 
of the credit amount. The small business health plan credit 
would be treated as a component of the general business credit, 
and would be subject to the limitations of that credit. The 
amount of the credit would reduce the employer's deduction for 
employee health care expenses.
---------------------------------------------------------------------------
    \9\ This rule applies whether or not the plan is subsidized by the 
employer.
---------------------------------------------------------------------------
Requirements imposed on qualified health benefit purchasing coalitions
    A qualified coalition would be required to operate on a 
non-profit basis and to be formed as a separate legal entity 
whose objective is to negotiate with health insurers for the 
purpose of providing health insurance benefits to the employees 
of its small business members. A qualified coalition would be 
authorized to collect and distribute health insurance premiums 
and provide related administrative services. It would need to 
be certified annually by an appropriate State or Federal agency 
as being in compliance with the following requirements. Its 
board would be required to have both employer and employee 
representatives of its small business members, but could not 
include service providers, health insurers, insurance agents or 
brokers, and others who might have a conflict of interest with 
the coalition's objectives. The qualified coalition could not 
bear insurance or financial risk, or perform any activity 
relating to the licensing of health plan issuers. Where 
feasible, the coalition would have to enter into agreements 
with three or more unaffiliated, licensed health plans, and 
would be required to offer at least one open enrollment period 
per calendar year. The qualified coalition would have to 
service a significant geographic area, but would not be 
required to cross State boundaries. It would be required to 
accept as members all eligible employers on a first-come, 
first-served basis, and would need to market its services to 
all eligible employers within its designated area. An eligible 
employer would be defined as any small employer, as defined 
under HIPAA (generally, businesses that employ an average of at 
least 2, but not more than 50, employees).
    Qualified coalitions would be subject to HIPAA and other 
Federal health laws, including participant nondiscrimination 
rules and provisions applicable to MEWAs under ERISA and the 
Code. Thus, coalition health plans could not discriminate 
against any individual participant as regards enrollment 
eligibility or premiums on the basis of his or her health 
status or claims experience. In addition, employers would have 
guaranteed renewability of health plan access. Health plans 
sold through qualified coalitions would also be required to 
meet State laws concerning health insurance premiums and 
minimum benefits. State ``fictitious group'' laws would be 
preempted, and States would be required to permit an insurer to 
reduce premiums negotiated with a qualified coalition in order 
to reflect administrative and other cost savings or lower 
profit margins. Health plans sold through qualified coalitions 
would not be considered to be 10-or-more employer plans for 
purposes of the welfare benefit fund rules. Accordingly, 
participating employers would be subject to the welfare benefit 
fund contribution limits.

                             Effective Date

    The proposal would be effective for taxable years beginning 
after December 31, 1999. The special foundation rule would 
apply to grants and loans made prior to January 1, 2004, for 
initial operating expenses incurred prior to January 1, 2006. 
The small business tax credit would be available only for 
health plans established before January 1, 2004. No carrybacks 
of the credit would be allowed to taxable years beginning 
before January 1, 2000.

                                Analysis

    The proposal is intended to encourage small employers to 
purchase health insurance for their employees. Health insurance 
coverage of employees of small businesses is significantly 
lower than that of larger employers. One possible reason for 
this lower coverage is that the costs of setting up and 
operating health plans in the current small business insurance 
market can be higher than those for larger employers. 
Consequently, small employers may pay more for similar employee 
health insurance benefits than do larger employers. In 
addition, insurance companies may need a minimum number of 
covered employees in order to be able to provide insurance to a 
group. This makes it difficult for small employers to offer 
multiple health plans to their employees. Most small businesses 
that offer health insurance benefits do not provide their 
workers with a choice of health plans.
    Providing a tax credit for the purchase of health insurance 
may lead to larger expenditures on health insurance than might 
otherwise be the case. This extra incentive for health 
insurance may be desirable if some of the benefits of an 
individual's having health insurance accrue to society at large 
(e.g., through a healthier, more productive workforce, or a 
reduction in health expenditures for uninsured individuals). In 
that case, absent the subsidy, individuals would underinvest in 
health insurance (relative to the socially desirable level) 
because they would not take into account the benefits that 
others receive. To the extent that expenditures on health 
insurance represent purely personal consumption, a subsidy 
would lead to overconsumption of health insurance.
    Health benefit purchasing coalitions pool employer 
workforces, negotiate with insurers over health plan benefits 
and premiums, provide comparative information about available 
health plans to participating employees, and may administer 
premium payments made by employers and their participating 
employees. Such coalitions may provide an opportunity for small 
employers to purchase health insurance for their workers at 
reduced cost and to offer a greater choice of health plans than 
is currently available to employees of small businesses. 
However, some small businesses that want to take advantage of 
the credit may not be able to do so because qualified 
coalitions may not operate in all areas, or may operate 
differently in some areas than others.
    It is unclear whether coalitions will operate as intended. 
Under present law, in some cases MEWAs have proved unsuccessful 
in reducing costs, and have in some cases failed to provide the 
promised coverage. In some cases this has been due to fraud, 
while in other cases simply to mismanagement. The requirements 
imposed on purchasing coalitions under the proposal may reduce 
the likelihood of such occurrences under the proposal.
    Proponents of the proposal relating to private foundations 
argue that the formation of health benefit purchasing 
coalitions has been hindered by their limited access to 
capital. Some private foundations have indicated a willingness 
to fund coalition start-up expenses, however, private 
foundations are prohibited under the Internal Revenue Code from 
making grants for other than charitable purposes. Present law 
provides no assurance that the funding of start-up expenses of 
health benefit purchasing coalitions would qualify as a 
``charitable purpose.'' Consequently, private foundations are 
reluctant to make grants to fund coalition start-up expenses.

                      B. Education Tax Provisions

1. Tax credits for holders of qualified school modernization bonds and 
        qualified zone academy bonds

                              Present Law

Tax-exempt bonds
    Interest on State and local governmental bonds generally is 
excluded from gross income for Federal income tax purposes if 
the proceeds of the bonds are used to finance direct activities 
of these governmental units, including the financing of public 
schools (sec. 103).
Qualified zone academy bonds
    As an alternative to traditional tax-exempt bonds, certain 
States and local governments are given the authority to issue 
``qualified zone academy bonds.'' A total of $400 million of 
qualified zone academy bonds may be issued in each of 1998 and 
1999. The $400 million aggregate bond cap is allocated each 
year to the States according to their respective populations of 
individuals below the poverty line.\10\ Each State, in turn, 
allocates the credit to qualified zone academies within such 
State. A State may carry over any unused allocation into 
subsequent years.
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    \10\ See Rev. Proc. 98-9, which sets forth the maximum face amount 
of qualified zone academy bonds that may be issued for each State 
during 1998; IRS Proposed Rules (REG-119449-97), which provides 
guidance to holders and issuers of qualified zone academy bonds.
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    Certain financial institutions (i.e., banks, insurance 
companies, and corporations actively engaged in the business of 
lending money) that hold qualified zone academy bonds are 
entitled to a nonrefundable tax credit in an amount equal to a 
credit rate (set monthly by Treasury Department regulation at 
110 percent of the applicable federal rate for the month in 
which the bond is issued) multiplied by the face amount of the 
bond (sec. 1397E). The credit rate applies to all such bonds 
issued in each month. A taxpayer holding a qualified zone 
academy bond on the credit allowance date (i.e., each one-year 
anniversary of the issuance of the bond) is entitled to a 
credit. The credit is includable in gross income (as if it were 
a taxable interest payment on the bond), and may be claimed 
against regular income tax and AMT liability.
    The Treasury Department sets the credit rate each month at 
a rate estimated to allow issuance of qualified zone academy 
bonds without discount and without interest cost to the issuer. 
The maximum term of the bond issued in a given month also is 
determined by the Treasury Department, so that the present 
value of the obligation to repay the bond is 50 percent of the 
face value of the bond. Such present value is determined using 
as a discount rate of the average annual interest rate of tax-
exempt obligations with a term of 10 years or more issued 
during the month.
    ``Qualified zone academy bonds'' are defined as any bond 
issued by a State or local government, provided that (1) at 
least 95 percent of the proceeds are used for the purpose of 
renovating, providing equipment to, developing course materials 
for use at, or training teachers and other school personnel in 
a ``qualified zone academy'' and (2) private entities have 
promised to contribute to the qualified zone academy certain 
equipment, technical assistance or training, employee services, 
or other property or services with a value equal to at least 10 
percent of the bond proceeds.
    A school is a ``qualified zone academy'' if (1) the school 
is a public school that provides education and training below 
the college level, (2) the school operates a special academic 
program in cooperation with businesses to enhance the academic 
curriculum and increase graduation and employment rates, and 
(3) either (a) the school is located in one of the 31 
designated empowerment zones or one of the 95 designated 
enterprise communities,\11\ or (b) it is reasonably expected 
that at least 35 percent of the students at the school will be 
eligible for free or reduced-cost lunches under the school 
lunch program established under the National School Lunch Act.
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    \11\ Pursuant to the Omnibus Budget Reconciliation Act of 1993, the 
Secretaries of the Department of Housing and Urban Development and the 
Department of Agriculture designated a total of nine empowerment zones 
and 95 enterprise communities on December 21, 1994 (sec. 1391). In 
addition, the Taxpayer Relief Act of 1997 provided for the designation 
of 22 additional empowerment zones (secs. 1391(b)(2) and 1391(g)). 
Designated empowerment zones and enterprise communities were required 
to satisfy certain eligibility criteria, including specified poverty 
rates and population and geographic size limitations (sec. 1392). The 
Code provides special tax incentives for certain business activities 
conducted in empowerment zones and enterprise communities (secs. 1394, 
1396, and 1397A).
---------------------------------------------------------------------------
    Because 1998 was the first year of the qualified zone 
academy bond program, very little of the applicable bond cap 
has been issued. According to one report, less than $30 million 
of the 1998 cap had been issued by November, 1998.\12\ 
Accordingly, most of the 1998 allocation was carried forward 
into 1999.
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    \12\ The Bond Buyer (Nov. 16, 1998).
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                        Description of Proposal

In general
    The proposal would authorize the issuance of additional 
qualified zone academy bonds and of qualified school 
modernization bonds. It also would establish new requirements 
applicable to qualified zone academy bonds, qualified school 
modernization bonds, and so-called ``Better America Bonds'' 
(described in Part I.D.2., below). All of these bonds are 
generally referred to as ``tax credit bonds.'' The new 
requirements would apply to tax credit bonds issued after 
January 1, 2000.
Rules generally applicable to tax credit bonds
    The proposal sets forth certain rules that would apply to 
any ``tax credit bond'' (i.e., qualified zone academy bonds, 
qualified school modernization bonds, and so-called ``Better 
America Bonds'').
    Similar to the tax benefits available to holders of 
present-law qualified zone academy bonds, the holders of tax 
credit bonds would receive annual Federal income tax credits in 
lieu of interest payments. Because the proposed credits would 
compensate the holder for lending money, such credits would be 
treated as payments of interest for Federal income tax purposes 
and, accordingly, would be included in the holder's gross 
income and could be claimed against regular income tax 
liability and alternative minimum tax liability. As with 
present-law qualified zone academy bonds, the ``credit rate'' 
for tax credit bonds would be set by the Secretary of the 
Treasury so that, on average, such bonds would be issued 
without interest, discount, or premium.\13\ The maximum term of 
the tax credit bonds would be 15 years.
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    \13\ To this end, the credit rate would be set equal to a measure 
of the yield on outstanding corporate bonds, as specified in Treasury 
regulations, for the business day prior to the date of issue. It is 
anticipated that the credit rate would be set with reference to a 
corporate AA bond rate which could be published daily by the Federal 
Reserve Board or otherwise determined under Treasury regulations. This 
measure for setting the credit rate for the tax credit bonds is 
different from the measure currently used to set the credit rate for 
qualified zone academy bonds.
---------------------------------------------------------------------------
    Any taxpayer would be able to hold a tax credit bond and 
thereby claim the tax credit.\14\ Treasury would provide 
regulations regarding the treatment of credits that flow 
through from a mutual fund to the holder of mutual fund shares. 
Unused credits could not be carried back, but could be carried 
forward for 5 years. The proposal would grant regulatory 
authority to the Treasury to require information returns to be 
provided with respect to holders (including corporations) that 
are entitled to credits.
---------------------------------------------------------------------------
    \14\ Accordingly, the present-law restriction on eligible holders 
of qualified zone academy bonds would not apply to bonds issued after 
December 31, 1999.
---------------------------------------------------------------------------
    Under the proposal, issuers of tax credit bonds must 
reasonably expect, on the date of issue, that 95 percent of the 
proceeds of the bonds (including any investment earnings on 
such proceeds) would be spent on qualifying purposes within 
three years. In addition, the issuer must incur a binding 
obligation with a third party to spend at least 10 percent of 
proceeds of the issue within 6 months of the date of issue.
    During the 3-year period after the date of issue, 
unexpended proceeds must be invested only in bank accounts or 
U.S. Treasury securities with a maturity of three years or 
less. If the issuer established a sinking fund for the 
repayment of the principal, all sinking fund assets would be 
required to be held in State and Local Government Securities 
(SLGS) issued by the Treasury. Any proceeds of the bonds 
(including any investment earnings on those proceeds) not 
expended for qualifying purposes at the end of the 3-year 
period would be required to be used to redeem a pro rata 
portion of the bonds within 90 days.
    Any property financed with tax credit bond proceeds must be 
used for a qualifying purpose for at least a 15-year period 
after the date of issuance. If the use of a bond-financed 
facility changes to a non-qualifying use within that 15-year 
period, the bonds would cease to be qualifying bonds and would 
accrue no further tax credits. Further, the issuer would be 
required to reimburse the Treasury for all tax credits 
(including interest) which accrued within three years of the 
date of noncompliance. If the issuer failed to make a full and 
timely reimbursement of tax credits, the Federal Government 
could proceed to collect against current holders of the bond 
for any remaining amounts. Similar recapture rules would apply 
in the case of violations of other tax-related requirements of 
tax credit bonds.
Qualified zone academy bonds
    The proposal would authorize the issuance of an additional 
$1 billion of qualified zone academy bonds in 2000 and $1.4 
billion in 2001. As under present law, the aggregate bond cap 
would be allocated to the States according to their respective 
populations of individuals below the poverty line, and States 
could carry over unused allocations until the end of the third 
succeeding year.
    The proposal would expand the list of permissible uses of 
proceeds of qualified zone academy bonds to include school 
construction. In addition, the proposal would clarify that 
property financed with the sale proceeds of qualified school 
zone academy bonds must be owned by a State or local 
government.
Qualified school modernization bonds
    Under the proposal, State and local governments would be 
able to issue ``qualified school modernization bonds'' to fund 
the construction, rehabilitation, or repair of public 
elementary and secondary schools.\15\ Property financed with 
the sale proceeds of qualified school modernization bonds would 
be required to be owned by a State or local government.
---------------------------------------------------------------------------
    \15\ For this purpose, the term construction includes land upon 
which a school facility is to be constructed.
---------------------------------------------------------------------------
    A total of $11 billion of qualified school modernization 
bonds could be issued in each of 2000 and 2001, with this 
amount to be allocated among the States and certain school 
districts. One half of this annual $11 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 that the Secretary of Education determined to 
be in particular need of assistance.\16\ The remaining half of 
the annual cap would be divided among the States and Puerto 
Rico.\17\
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    \16\ The cap would be allocated among the school districts and 
among States based on the amounts of Federal assistance received under 
the Basic Grant Formula for Title I of the Elementary and Secondary 
Education Act of 1965. This assistance is based primarily upon the 
number of low-income children residing in the district, with an 
adjustment for differences in per-pupil expenditures. States would not 
be restricted to using the Title I Basic Grant Formula to allocate the 
cap among school districts, but could use any appropriate mechanism.
    \17\ A small portion of the total cap would be set aside for each 
U.S. possession (other than Puerto Rico) based on its share of the 
total U.S. poverty population.
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    An additional $200 million of bonds in each of 2000 and 
2001 would be allocated by the Secretary of the Interior for 
the construction, rehabilitation, and repair of the Bureau of 
Indian Affairs-funded elementary and secondary schools.
    Allocated amounts unissued in the year of allocation could 
be issued up until the end of the third following year. A 
qualifying school district could transfer any unused portion of 
its allocation to the State in which it is located at any time 
prior to that date.
    Under the proposal, a bond would be treated as a qualified 
school modernization bond only if the following three 
requirements were satisfied: (1) the Department of Education 
approved the modernization plan of the State or eligible school 
district, which plan must (a) demonstrate that a comprehensive 
survey had been undertaken of the construction and renovation 
needs in the jurisdiction, and (b) describe how the 
jurisdiction would assure that bond proceeds were used as 
proposed; \18\ (2) the State or local governmental entity 
issuing the bond received an allocation for the bond from the 
appropriate entity; and (3) at least 95 percent of the bond 
proceeds were used to construct, rehabilitate, or repair 
elementary or secondary school facilities. In contrast to 
qualified zone academy bonds, the proposed qualified school 
modernization bonds would not be conditioned on contributions 
from private businesses.
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    \18\ Modernization plans for Bureau of Indian Affairs-funded 
schools would be approved by the Department of the Interior.
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                             Effective Date

    The proposal would be effective for bonds issued on or 
after January 1, 2000.

                              Prior Action

    A similar proposal was included in the President's fiscal 
year 1999 budget proposal.

                                Analysis

    The Administration's proposals to expand the allocation for 
(and permissible uses of) zone academy bonds and to establish 
school modernization bonds would subsidize a portion of the 
costs of new investment in public school infrastructure and, in 
certain qualified areas, equipment and teacher training. By 
subsidizing such costs, it is possible that additional 
investment will take place relative to investment that would 
take place in the absence of the subsidy. If no additional 
investment takes place than would otherwise, the subsidy would 
merely represent a transfer of funds from the Federal 
Government to States and local governments. This would enable 
States and local governments to spend the savings on other 
government functions or to reduce taxes.\19\ In this event, the 
stated objective of the proposals would not be achieved.
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    \19\ Most economic studies have found that when additional funding 
is made available to localities from outside sources, there is indeed 
an increase in public spending (this is known as the ``fly-paper'' 
effect, as the funding tends to ``stick'' where it is applied). The 
additional spending is not dollar for dollar, however, implying that 
there is some reduction of local taxes to offset the outside funding. 
See Harvey Rosen, Public Finance, Second Ed., 1988, p. 530 for a 
discussion of this issue.
---------------------------------------------------------------------------
    Though called a tax credit, the Federal subsidy for tax 
credit bonds is equivalent to the Federal Government directly 
paying the interest on a taxable bond issue on behalf of the 
State or local government that benefits from the bond 
proceeds.\20\ To see this, consider any taxable bond that bears 
an interest rate of 10 percent. A thousand dollar bond would 
thus produce an interest payment of $100 annually. The owner of 
the bond that receives this payment would receive a net payment 
of $100 less the taxes owed on that interest. If the taxpayer 
were in the 28-percent Federal tax bracket, such taxpayer would 
receive $72 after Federal taxes. Regardless of whether the 
State government or the Federal Government pays the interest, 
the taxpayer receives the same net of tax return of $72. In the 
case of tax credit bonds, no formal interest is paid by the 
Federal Government. Rather, a tax credit of $100 is allowed to 
be taken by the holder of the bond. In general, a $100 tax 
credit would be worth $100 to a taxpayer, provided that the 
taxpayer had at least $100 in tax liability. However, for tax 
credit bonds, the $100 credit also has to be claimed as income. 
Claiming an additional $100 in income costs a taxpayer in the 
28-percent tax bracket an additional $28 in income taxes, 
payable to the Federal Government. With the $100 tax credit 
that is ultimately claimed, the taxpayer nets $72 on the bond. 
The Federal Government loses $100 on the credit, but recoups 
$28 of that by the requirement that it be included in income, 
for a net cost of $72, which is exactly the net return to the 
taxpayer. If the Federal Government had simply agreed to pay 
the interest on behalf of the State or local government, both 
the Federal Government and the bondholder/taxpayer would be in 
the same situation. The Federal Government would make outlays 
of $100 in interest payments, but would recoup $28 of that in 
tax receipts, for a net budgetary cost of $72, as before. 
Similarly, the bondholder/taxpayer would receive a taxable $100 
in interest, and would owe $28 in taxes, for a net gain of $72, 
as before. The State or local government also would be in the 
same situation in both cases.
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    \20\ This is true provided that the taxpayer faces tax liability of 
at least the amount of the credit. Without sufficient tax liability, 
the proposed tax credit arrangement would not be as advantageous. 
Presumably, only taxpayers who anticipate having sufficient tax 
liability to be offset by the proposed credit would hold these bonds.
---------------------------------------------------------------------------
    The proposed tax credit regime to subsidize public school 
investment raises some questions of administrative efficiencies 
and tax complexity. Because potential purchasers of the zone 
academy bonds and school modernization bonds must educate 
themselves as to whether the bonds qualify for the credit, 
certain ``information costs'' are imposed on the buyer. 
Additionally, since the determination as to whether the bond is 
qualified for the credit ultimately rests with the Federal 
Government, further risk is imposed on the investor. These 
information costs and other risks serve to increase the credit 
rate and hence the costs to the Federal Government for a given 
level of support to the zone academies or school modernization 
efforts. For these reasons, and the fact that tax credit bonds 
will be less liquid than Treasury Securities, the bonds would 
bear a credit rate that is equal to a measure of the yield on 
outstanding corporate bonds.\21\
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    \21\ The proposed school modernization bonds credit rate would be 
set by the Secretary of the Treasury so that, on average, the bonds 
could be issued without interest, discount, or premium.
---------------------------------------------------------------------------
    The direct payment of interest by the Federal Government on 
behalf of States or localities, which was discussed above as 
being economically the equivalent of the credit proposal, would 
involve less complexity in administering the income tax, as the 
interest could simply be reported as any other taxable 
interest. Additionally, the tax credit approach implies that 
non-taxable entities would not invest in the bonds to assist 
school investment. In the case of a direct payment of interest, 
by contrast, tax-exempt organizations would be able to enjoy 
such benefits.
2. Exclusion for employer-provided educational assistance

                              Present Law

    Educational expenses paid by an employer for its employees 
are generally deductible to the employer.
    Employer-paid educational expenses are excludable from the 
gross income and wages of an employee if provided under a 
section 127 educational assistance plan or if the expenses 
qualify as a working condition fringe benefit under section 
132. Section 127 provides an exclusion of $5,250 annually for 
employer-provided educational assistance. The exclusion does 
not apply to graduate courses. The exclusion for employer-
provided educational assistance expires with respect to courses 
beginning on or after June 1, 2000.
    In order for the exclusion to apply, certain requirements 
must be satisfied. The educational assistance must be provided 
pursuant to a separate written plan of the employer. The 
educational assistance program must not discriminate in favor 
of highly compensated employees. In addition, not more than 5 
percent of the amounts paid or incurred by the employer during 
the year for educational assistance under a qualified 
educational assistance plan can be provided for the class of 
individuals consisting of more than 5-percent owners of the 
employer (and their spouses and dependents).
    Educational expenses that do not qualify for the section 
127 exclusion may be excludable from income as a working 
condition fringe benefit.\22\ In general, education qualifies 
as a working condition fringe benefit if the employee could 
have deducted the education expenses under section 162 if the 
employee paid for the education. In general, education expenses 
are deductible by an individual under section 162 if the 
education (1) maintains or improves a skill required in a trade 
or business currently engaged in by the taxpayer, or (2) meets 
the express requirements of the taxpayer's employer, applicable 
law or regulations imposed as a condition of continued 
employment. However, education expenses are generally not 
deductible if they relate to certain minimum educational 
requirements or to education or training that enables a 
taxpayer to begin working in a new trade or business.\23\
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    \22\ These rules also apply in the event that section 127 expires 
and is not reinstated.
    \23\ In the case of an employee, education expenses (if not 
reimbursed by the employer) may be claimed as an itemized deduction 
only if such expenses, along with other miscellaneous deductions, 
exceed 2 percent of the taxpayer's AGI. The 2-percent floor limitation 
is disregarded in determining whether an item is excludable as a 
working condition fringe benefit.
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                        Description of Proposal

    The proposal would extend the present-law exclusion for 
employer-provided educational assistance to undergraduate 
courses beginning before January 1, 2002. The proposal would 
also extend the exclusion to graduate education, effective for 
courses beginning after June 30, 1999, and before January 1, 
2002.

                             Effective Date

    The proposal to extend the exclusion for undergraduate 
courses would be effective for courses beginning before January 
1, 2002. The exclusion with respect to graduate-level courses 
would be effective for courses beginning after June 30, 1999 
and before June 1, 2002.

                              Prior Action

    A similar proposal to extend the exclusion to graduate-
level courses was included in the President's fiscal year 1997 
and 1999 budget proposals and in the Senate version of the 
Taxpayer Relief Act of 1997. An extension of the exclusion to 
graduate-level courses also was included in the Senate version 
of H.R. 2646 (105th Cong.) (the Education Savings and School 
Excellence Act of 1998); H.R. 2646 was vetoed by the President 
on July 21, 1998.
    The Senate version of the Taxpayer Relief Act of 1997 would 
have permanently extended the exclusion.

                                Analysis

    The exclusion for employer-provided educational assistance 
programs is aimed at increasing the levels of education and 
training in the workforce. The exclusion also reduces 
complexity in the tax laws. Employer-provided educational 
assistance benefits may serve as a substitute for cash wages 
(or other types of fringe benefits) in the overall employment 
compensation package. Because of their favorable tax treatment, 
benefits received in this form are less costly than cash wages 
in terms of the after-tax cost of compensation to the employee.
    Present-law section 127 serves to subsidize the provision 
of education and could lead to larger expenditures on education 
for workers than would otherwise occur. This extra incentive 
for education may be desirable if some of the benefits of an 
individual's education accrue to society at large through the 
creation of a better-educated populace or workforce, i.e., 
assuming that education creates ``positive externalities.'' In 
that case, absent the subsidy, individuals would underinvest in 
education (relative to the socially desirable level) because 
they would not take into account the benefits that others 
indirectly receive. To the extent that expenditures on 
education represent purely personal consumption, a subsidy 
would lead to over consumption of education.\24\
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    \24\ For a broader discussion of social and private benefits from 
education and an analysis of subsidies to education, see Joint 
Committee on Taxation, Analysis of Proposed Tax Incentives for Higher 
Education (JCS-3-97), March 4, 1997, pp. 19-23.
---------------------------------------------------------------------------
    Proponents of extending and expanding the benefits provided 
by section 127 observe that more education generally leads to 
higher future wages for the individuals who receive the 
education. Thus, proponents argue that higher future tax 
payments by these individuals will compensate for the tax 
expenditure today. While empirical evidence does indicate that 
more education leads to higher wages, whether the government is 
made whole on the tax expenditure depends upon to which 
alternative uses the forgone government funds may have been 
put. For example, proponents of increased government 
expenditures on research and development point to evidence that 
such expenditures earn rates of return far in excess of those 
on most private investments.\25\ If such returns exceed the 
financial returns to education, reducing such expenditures to 
fund education benefits may reduce future tax revenues.
---------------------------------------------------------------------------
    \25\ For a discussion of the returns to expenditures on research 
and development see Part I.G.4 of this pamphlet.
---------------------------------------------------------------------------
    Because present-law section 127 provides an exclusion from 
gross income for certain employer-provided education benefits, 
the value of this exclusion in terms of tax savings is greater 
for those taxpayers with higher marginal tax rates. Thus, 
higher-paid individuals, individuals with working spouses, or 
individuals with other sources of income may be able to receive 
larger tax benefits than their fellow workers. Section 127 does 
not apply, however, to programs under which educational 
benefits are provided only to highly compensated employees.
    In general, in the absence of section 127, the value of 
employer-provided education is excludable from income only if 
the education relates directly to the taxpayer's current job. 
If the education would qualify the taxpayer for a new trade or 
business, however, then the value of the education generally 
would be treated as part of the employee's taxable 
compensation. Under this rule, higher-income, higher-skilled 
individuals may be more able to justify education as related to 
their current job because of the breadth of their current 
training and responsibilities. For example, a lawyer or 
professor may find more courses of study directly related to 
his or her current job and not qualifying him or her for a new 
trade than would a clerk.
    The section 127 exclusion for employer-provided educational 
assistance may counteract this effect by making the exclusion 
widely available regardless of the employee's current job 
status or job description. Proponents argue that the exclusion 
is primarily useful to nonhighly compensated employees to 
improve their competitive position in the work force. In 
practice, however, the scant evidence available seems to 
indicate that those individuals receiving employer-provided 
educational assistance are somewhat more likely to be higher-
paid workers, particularly if the exclusion is extended to 
graduate level courses.\26\ The amount of the education 
benefits provided by an employer also appears to be positively 
correlated with the income of the recipient worker. Such 
evidence is consistent with the observation that, in practice, 
the exclusion is more valuable to those individuals in higher 
marginal tax brackets. A reformulation of the incentive as an 
inclusion of the value of benefits into income in conjunction 
with a tax credit could make the value of the benefit more even 
across recipients subject to different marginal tax 
brackets.\27\
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    \26\ See, for example, The National Association of Independent 
Colleges and Universities, ``Who Benefits from Section 127,'' December 
1995; Coopers & Lybrand, ``Section 127 Employee Educational Assistance: 
Who Benefits? At What Cost?,'' June 1989, p. 15; and Steven R. Aleman, 
``Employer Education Assistance: A Profile of Recipients, Their 
Educational Pursuits, and Employers,'' CRS Report, 89-33 EPW, January 
10, 1989, p. 9.
    \27\ If the credit were nonrefundable, then to the extent that a 
taxpayer reduces his or her tax liability to zero, he or she might not 
be able to receive the full value of the credit.
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    Reinstating the exclusion for graduate-level employer-
provided educational assistance may enable more individuals to 
seek higher education. Some argue that greater levels of higher 
education are important to having a highly trained and 
competitive workforce, and may be important in retraining 
workers who seek new employment. Others argue that the tax 
benefits from extending the exclusion to graduate-level 
education will accrue mainly to higher-paid workers. Others 
would argue that it would be desirable to extend the exclusion 
to graduate-level education, but that limiting the exclusion in 
this manner is appropriate given budgetary constraints.
    In addition to furthering education objectives, the 
exclusion for employer-provided educational assistance may 
reduce tax-law complexity. In the absence of the exclusion, 
employers and employees must make a determination of whether 
the exclusion is job-related. This determination is highly 
factual in nature, and can lead to disputes between taxpayers 
and the IRS, who may come to different conclusions based on the 
same facts. The exclusion eliminates the need to make this 
determination.
    The exclusion for employer-provided education has always 
been enacted on a temporary basis. It has been extended 
frequently, and often retroactively. The past experience of 
allowing the exclusion to expire and subsequently retroactively 
extending it has created burdens for employers and employees. 
Employees may have difficulty planning for their educational 
goals if they do not know whether their tax bills will 
increase. Employers have administrative problems determining 
the appropriate way to report and withhold on educational 
benefits each time the exclusion expires before it is extended. 
Providing greater certainty by further extending the exclusion 
may reduce administrative burdens and complexity, as well as 
enable individuals to better plan for their educational costs.
3. Tax credit for employer-provided workplace literacy and basic 
        education programs

                              Present Law

    Educational expenses paid by an employer for its employees 
are deductible to the employer.
    Employer-paid educational expenses are excludable from the 
gross income of an employee if provided under a section 127 
educational assistance plan or if the expenses qualify as a 
working condition fringe benefit under section 132. Section 127 
provides an exclusion of $5,250 annually for employer-provided 
educational assistance. The exclusion does not apply to 
graduate courses. The exclusion for employer-provided 
educational assistance expires with respect to courses 
beginning on or after June 1, 2000.
    In order for the exclusion to apply, certain requirements 
must be satisfied. The educational assistance must be provided 
pursuant to a separate written plan of the employer. The 
educational assistance program must not discriminate in favor 
of highly compensated employees. In addition, not more than 5 
percent of the amounts paid or incurred by the employer during 
the year for educational assistance under a qualified 
educational assistance plan can be provided for the class of 
individuals consisting of more than 5-percent owners of the 
employer (and their spouses and dependents).
    Educational expenses that do not qualify for the section 
127 exclusion may be excludable from income as a working 
condition fringe benefit.\28\ In general, education qualifies 
as a working condition fringe benefit if the employee could 
have deducted the education expenses under section 162 if the 
employee paid for the education. In general, education expenses 
are deductible by an individual under section 162 if the 
education (1) maintains or improves a skill required in a trade 
or business currently engaged in by the taxpayer, or (2) meets 
the express requirements of the taxpayer's employer, applicable 
law or regulations imposed as a condition of continued 
employment. However, education expenses are generally not 
deductible if they relate to certain minimum educational 
requirements or to education or training that enables a 
taxpayer to begin working in a new trade or business.\29\
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    \28\ These rules also apply in the event that section 127 expires 
and is not reinstated.
    \29\ In the case of an employee, education expenses (if not 
reimbursed by the employer) may be claimed as an itemized deduction 
only if such expenses, along with other miscellaneous deductions, 
exceed 2 percent of the taxpayer's AGI. The 2-percent floor limitation 
is disregarded in determining whether an item is excludable as a 
working condition fringe benefit.
---------------------------------------------------------------------------

                        Description of Proposal

    Employers who provide certain literacy, English literacy, 
and basic education programs for their eligible employees would 
be allowed to claim a credit against the employer's Federal 
income taxes. The amount of the credit would equal 10 percent 
of the employer's eligible expenses incurred with respect to 
qualified education programs, with a maximum credit of $525 per 
eligible employee. The credit would be treated as a component 
of the general business credit, and would be subject to the 
limitations of that credit.
    Qualified education would be limited to (1) basic skills 
instruction at or below the level of a high school degree, and 
(2) English literacy instruction. In general, the credit could 
not be claimed with respect to an employee who has received a 
high school degree or its equivalent. The employer could claim 
a credit with respect to employees with high school degrees but 
who lack sufficient mastery of basic educational skills to 
function effectively in the workplace only if an eligible 
provider both assesses the educational level of the employees 
and provides the instructional program for the employer. With 
respect to English literacy instruction, eligible employees 
would be employees with limited English proficiency. Eligible 
employees must be citizens or resident aliens aged 18 or older 
who are employed by the taxpayer in the United States for at 
least six months.
    To be eligible for the credit, the provision of literacy or 
basic education by an employer must meet the nondiscrimination 
requirements for educational assistance programs under present-
law section 127. Expenses eligible for the credit (up to 
$5,250) would be excludable from income and wages as a working 
condition fringe benefit if not otherwise excludable under 
section 127.\30\
---------------------------------------------------------------------------
    \30\ Present-law rules would apply in determining whether expenses 
in excess of this amount are excludable from income and wages.
---------------------------------------------------------------------------
    Expenses eligible for the credit would include payments to 
third parties and payments made directly to cover instructional 
costs, including but not limited to salaries of instructors, 
curriculum development, textbooks, and instructional technology 
used exclusively to support basic skills instruction. Wages 
paid to workers while they participate as students in the 
literacy or basic education program would not be eligible for 
the credit. The amount of the credit claimed would reduce, 
dollar for dollar, the amount of education expenses that the 
employer could otherwise deduct in computing its taxable 
income.
    Unless the employer provides basic skills instruction 
through an eligible provider, the curriculum must be approved 
by a State adult education authority, defined as an ``eligible 
agency'' in section 203(4) of the Adult Education and Family 
Literacy Act. An ``eligible provider'' would be an entity that 
is receiving Federal funding for adult education and literacy 
services or English literacy programs under the Adult Education 
and Family Literacy Act, Title II of the Workforce Investment 
Act of 1998. Eligible providers include local education 
agencies, certain community-based or volunteer literacy 
organizations, institutions of higher education, and other 
public or private nonprofit agencies.

                             Effective Date

    The proposal would be effective for taxable years beginning 
after December 31, 1999.

                              Prior Action

    No prior action.

                                Analysis

    The proposal is intended to provide employers with an 
additional incentive to provide literacy and basic education 
programs to their employees. The proposal focuses on this type 
of education due to concern that low-skilled workers may not 
undertake needed education because they lack resources to 
overcome barriers such as cost, child care, and transportation. 
It is argued that present law (i.e., the section 127 exclusion) 
does not provide sufficient incentive because employers of low-
skilled workers may hesitate to provide general education; the 
benefits of basic skills and literacy education may be more 
difficult for employers to capture through increased 
productivity than the benefits of more job-specific education.
    Providing additional tax benefits for certain educational 
expenses could lead to larger expenditures on education for 
workers that would otherwise occur. This extra incentive for 
education may be desirable if some of the benefits of an 
individual's education accrue to society at large (through the 
creation of a better-educated populace or workforce). In that 
case, absent the subsidy, individuals would under invest in 
education (relative to the socially desirable level) because 
they would not take into account the benefits that others 
indirectly receive. To the extent that expenditures on 
education represent purely personal consumption, a subsidy 
would lead to over-consumption of education. Some argue that 
concerns about over-consumption of education are reduced under 
the proposal because it targets basic skills and literacy 
training for individuals who, for the most part, lack a high 
school degree.
    The requirements with respect to eligible providers may 
increase the cost of education that would otherwise be provided 
under the proposal. On the other hand, providing the credit 
without limitations on the provider or curriculum could create 
potentially difficult issues of expense allocation, compliance, 
and tax administration.
4. Tax credit for contributions to qualified zone academies

                              Present Law

Qualified zone academy bonds
    As an alternative to traditional tax-exempt bonds, certain 
States and local governments are given the authority to issue 
``qualified zone academy bonds.'' A total of $400 million of 
qualified zone academy bonds may be issued in each of 1998 and 
1999. The $400 million aggregate bond cap is allocated each 
year to the States according to their respective populations of 
individuals below the poverty line.\31\ Each State, in turn, 
allocates the credit to qualified zone academies within such 
State. A State may carry over any unused allocation into 
subsequent years.
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    \31\ See Rev. Proc. 98-9, which sets forth the maximum face amount 
of qualified zone academy bonds that may be issued for each State 
during 1998; IRS Proposed Rules (REG-119449-97), which provides 
guidance to holders and issuers of qualified zone academy bonds.
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    Certain financial institutions (i.e., banks, insurance 
companies, and corporations actively engaged in the business of 
lending money) that hold qualified zone academy bonds are 
entitled to a nonrefundable tax credit in an amount equal to a 
credit rate (set monthly by Treasury Department regulation at 
110 percent of the applicable federal rate for the month in 
which the bond is issued) multiplied by the face amount of the 
bond (sec. 1397E). The credit rate applies to all such bonds 
issued in each month. A taxpayer holding a qualified zone 
academy bond on the credit allowance date (i.e., each one-year 
anniversary of the issuance of the bond) is entitled to a 
credit. The credit is includable in gross income (as if it were 
a taxable interest payment on the bond), and may be claimed 
against regular income tax and AMT liability.
    The Treasury Department sets the credit rate each month at 
a rate estimated to allow issuance of qualified zone academy 
bonds without discount and without interest cost to the issuer. 
The maximum term of the bond issued in a given month also is 
determined by the Treasury Department, so that the present 
value of the obligation to repay the bond is 50 percent of the 
face value of the bond. Such present value will be determined 
using as a discount rate the average annual interest rate of 
tax-exempt obligations with a term of 10 years or more issued 
during the month.
    ``Qualified zone academy bonds'' are defined as any bond 
issued by a State or local government, provided that (1) at 
least 95 percent of the proceeds are used for the purpose of 
renovating, providing equipment to, developing course materials 
for use at, or training teachers and other school personnel in 
a ``qualified zone academy'' and (2) private entities have 
promised to contribute to the qualified zone academy certain 
equipment, technical assistance or training, employee services, 
or other property or services with a value equal to at least 10 
percent of the bond proceeds.
    A school is a ``qualified zone academy'' if (1) the school 
is a public school that provides education and training below 
the college level, (2) the school operates a special academic 
program in cooperation with businesses to enhance the academic 
curriculum and increase graduation and employment rates, and 
(3) either (a) the school is located in one of the 31 
designated empowerment zones or one of the 95 designated 
enterprise communities,\32\ or (b) it is reasonably expected 
that at least 35 percent of the students at the school will be 
eligible for free or reduced-cost lunches under the school 
lunch program established under the National School Lunch Act.
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    \32\ Pursuant to the Omnibus Budget Reconciliation Act of 1993, the 
Secretaries of the Department of Housing and Urban Development and the 
Department of Agriculture designated a total of nine empowerment zones 
and 95 enterprise communities on December 21, 1994 (sec. 1391). In 
addition, the Taxpayer Relief Act of 1997 provided for the designation 
of 22 additional empowerment zones (secs. 1391(b)(2) and 1391(g)). 
Designated empowerment zones and enterprise communities were required 
to satisfy certain eligibility criteria, including specified poverty 
rates and population and geographic size limitations (sec. 1392). The 
Code provides special tax incentives for certain business activities 
conducted in empowerment zones and enterprise communities (secs. 1394, 
1396, and 1397A).
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Rules applicable to corporate contributions
    The maximum charitable contribution deduction that may be 
claimed by a corporation for any one taxable year is limited to 
10 percent of the corporation's taxable income for that year 
(disregarding charitable contributions and with certain other 
modifications) (sec. 170(b)(2)). Corporations also are subject 
to certain limitations based on the type of property 
contributed. In the case of a charitable contribution of short-
term gain property, inventory, or other ordinary income 
property, the amount of the deduction generally is limited to 
the taxpayer's basis (generally, cost) in the property. 
However, special rules in the Code provide augmented deductions 
for certain corporate \33\ contributions of inventory property 
for the care of the ill, the needy, or infants \34\ (sec. 
170(e)(3)), certain corporate contributions of scientific 
equipment constructed by the taxpayer, provided the original 
use of such donated equipment is by the donee for research or 
research training in the United States in physical or 
biological sciences (sec. 170(e)(4)),\35\ and certain 
contributions of computer technology and equipment to eligible 
donees to be used for the benefit of elementary and secondary 
school children (sec. 170(e)(6)). Under these special rules, 
the amount of the augmented deduction available to a 
corporation making a qualified contribution generally is equal 
to its basis in the donated property plus one-half of the 
amount of ordinary income that would have been realized if the 
property had been sold. However, the augmented deduction cannot 
exceed twice the basis of the donated property.
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    \33\ S corporations are not eligible donors for purposes of section 
170(e)(3) or section 170(e)(4).
    \34\ Treas. Reg. sec. 1.170A-4(b)(2)(ii)(F) defines an ``infant'' 
as a minor child (as determined under the laws of the jurisdiction in 
which the child resides). Treas. Reg. sec. 1.170A-4(b)(2)(ii)(G) 
provides that the ``care of an infant'' means performance of parental 
functions and provision for the physical, mental, and emotional needs 
of the infant.
    \35\ Eligible donees under section 170(e)(3) are public charities 
(but not governmental units) and private operating foundations. 
Eligible donees under section 170(e)(4) are limited to post-secondary 
educational institutions, scientific research organizations, and 
certain other organizations that support scientific research. Eligible 
donees under section 170(e)(6) are (1) any educational organization 
that normally maintains a regular faculty and curriculum and has a 
regularly enrolled body of pupils in attendance at the place where its 
educational activities are regularly carried on, and (2) Code section 
501(c)(3) entities that are organized primarily for purposes of 
supporting elementary and secondary education. Under section 
170(e)(6)(C), a private foundation also is an eligible donee, provided 
that, within 30 days after receipt of the contribution, the private 
foundation contributes the property to an eligible donee described 
above.
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                        Description of Proposal

    A credit against Federal income taxes would be allowed for 
certain corporate sponsorship payments made to a qualified zone 
academy located in a designated empowerment zone or enterprise 
community. The credit would equal 50 percent of cash 
contributions, plus 50 percent of the fair market value of 
certain in-kind contributions made to a qualified zone academy. 
For purposes of the credit, a qualified zone academy located 
outside of a designated empowerment zone or enterprise 
community would be treated as located within such a zone or 
community if a significant percentage of the academy's students 
reside in the zone or community.
    The credit would be available only if a credit allocation 
has been made with respect to the corporate sponsorship payment 
by the local governmental agency with responsibility for 
implementing the strategic plan of the empowerment zone or 
enterprise community under section 1391(f)(2), in consultation 
with the local educational agency with jurisdiction over public 
schools in the zone or community. The local governmental agency 
for each of the 31 designated empowerment zones would be 
allowed to designate up to $8 million of sponsorship payments 
to qualified zone academies as eligible for the 50-percent 
credit (that is, up to $4 million of credits). The local 
governmental agency for each of the 95 designated enterprise 
communities would be allowed to designate up to $2 million of 
contributions to qualified zone academies as eligible for the 
50-percent credit (that is, up to $1 million of credits). There 
is no limit on the amount of allocated credits that could be 
claimed by any one corporate sponsor; thus one sponsor could 
claim all the credits available in a particular zone or 
community. The deduction otherwise allowed for a corporate 
sponsorship payment would be reduced by the amount of the 
credit claimed with respect to such payment by the corporate 
sponsor. The proposed credit would be subject to the general 
business credit rules under present-law section 38.

                             Effective Date

    The proposal would be effective for corporate sponsorship 
payments made after December 31, 1999.

                              Prior Action

    No prior action.

                                Analysis

    The proposal's objective is to encourage private sector 
support of and participation in educational programs conducted 
at certain qualified zone academies located in empowerment 
zones and enterprise communities. By offering a tax credit to 
participating corporations, the proposal would lower the after-
tax cost of a corporate contribution beyond that currently 
provided by the deduction for charitable contributions. 
Specifically, under present law, a corporate taxpayer in the 
35-percent bracket faces an after-tax cost of only 65 cents for 
each dollar of charitable contributions, since the dollar 
deduction yields a tax saving of 35 cents. With the proposed 
50-percent credit, this same taxpayer would have more than half 
of its contribution, in effect, subsidized by the federal 
government. In addition to the 50-cent credit per dollar of 
contribution, the taxpayer would still be permitted to deduct 
from taxable income 50 cents of that dollar (the contribution 
amount minus the credit). Such 50-cent deduction would be worth 
17.5 cents to a corporate taxpayer in the 35-percent tax 
bracket. Thus, the total after-tax cost of a dollar 
contribution under the proposal is only 32.5 cents (1 dollar 
less the 50-cent credit less the 17.5-cent value of the 50-cent 
deduction), as compared to 65 cents under present-law rules. 
The effect of the credit cuts the taxpayer's cost of giving in 
half compared to present law.\36\
---------------------------------------------------------------------------
    \36\ This same result follows regardless of the effective tax rate 
of the corporate donor.
---------------------------------------------------------------------------
    The purpose of the present-law charitable deduction, and 
the proposed credit, is to encourage charitable giving by 
making giving less expensive. Economic studies have generally 
found that, at least with respect to individual donors, the 
charitable contribution deduction \37\ has both encouraged 
giving, and done so efficiently in that the additional 
charitable contributions that the deduction encourages exceed 
the revenue cost to the federal government of the deduction. 
Thus, to the extent that the charitable contribution serves a 
useful public service, it is argued that the deduction is 
cheaper than appropriating the funds that would be necessary to 
achieve the same public service. At the same time, it is also 
argued that private organizations can in many instances perform 
a charitable function more efficiently than a government 
agency. Others argue that not all activities subsidized by the 
deduction serve a truly public purpose, and thus would prefer 
to see the deduction eliminated and replaced with greater 
direct public spending. However, since the proposed credit is 
restricted to certain purposes, the latter objection is not 
relevant provided a true public service is promoted by the 
credit.
---------------------------------------------------------------------------
    \37\ The proposed credit has an effect similar to the effect of a 
deduction in lowering the cost of giving, and thus the economic studies 
focusing on the deduction are relevant to the credit as well.
---------------------------------------------------------------------------
    The proposal does not clarify what types of goods or 
services (e.g., inventory, used property, services) would 
qualify for purposes of the credit for certain in-kind 
contributions. In particular, the possibility of donated 
services raises valuation and compliance concerns. For example, 
the proposal does not address whether it would be appropriate 
to value donated services performed by a high-level corporate 
executive by reference to the executive's salary.
    The proposal defines qualified zone academies for purposes 
of the proposed tax credit differently than under current law. 
Specifically, the proposal would limit eligible qualified zone 
academies to those schools that are located in an empowerment 
zone or enterprise community, or that have a ``significant'' 
percentage of their students residing in an empowerment zone or 
enterprise community. The proposal does not define the term 
``significant'' for purposes of the residency requirement. In 
contrast to present law, the proposal would exclude from the 
definition of qualified zone academy those schools located 
outside a zone or community at which at least 35 percent of the 
students are eligible for free or reduced-cost lunches, but 
which do not meet the proposal's student residency requirement. 
In addition, under the proposal's definition, those schools 
located outside a zone or community that fail the present-law 
subsidized lunch qualification, but that meet the proposal's 
student residency requirement, would qualify as qualified zone 
academies for purposes of the proposed tax credit, although 
they are not qualified zone academies under present law. 
Presumably, the objective of the proposal's different 
definition of qualified zone academy is to ensure that 
allocated tax credits reach only those schools with a 
relatively high percentage of students who are residents of an 
empowerment zone or enterprise community. However, the 
differing definitions of qualified zone academies for purposes 
of the proposed tax credit and for other purposes may cause 
some confusion on the part of affected schools.
5. Eliminate 60-month limit on student loan interest deduction

                              Present Law

    Present law provides an above-the-line deduction for 
certain interest paid on qualified education loans. The 
deduction is limited to interest paid on a qualified education 
loan during the first 60 months in which interest payments are 
required. Months during which the qualified education loan is 
in deferral or forbearance do not count against the 60-month 
period.
    The maximum allowable deduction is $1,500 in 1999, $2,000 
in 2000, and $2,500 in 2001 and thereafter. The deduction is 
phased out ratably for individual taxpayers with modified 
adjusted gross income (``AGI'') of $40,000-$55,000 and $60,000-
$75,000 for joint returns. The income ranges will be indexed 
for inflation after 2002.

                        Description of Proposal

    The proposal would eliminate the limit on the number of 
months during which interest paid on a qualified education loan 
is deductible.

                             Effective Date

    The proposal would generally be effective for interest paid 
on qualified education loans after December 31, 1999.

                              Prior Action

    No prior action.

                                Analysis

    The 60-month rule serves in place of an overall limit on 
the amount of interest that may be deducted with respect to 
qualified education loans. Lengthening the time period over 
which taxpayers may deduct student loan interest expense would 
lead to a lower after-tax cost of financing education for those 
who have used large loans to finance their education and/or who 
do not repay the loans within five years (e.g., because of 
insufficient resources). As a consequence, lowering the after-
tax cost of financing education could encourage those students 
that need large loans in order to finance their education to 
pursue more education than they would have otherwise. On the 
other hand, lengthening the time period over which taxpayers 
may deduct student loan interest expense could encourage some 
taxpayers to take on more debt for a given level of education 
expenses in order to finance a greater level of current 
consumption. This additional debt assumed would not be 
associated with a greater educational attainment, but instead 
could serve as a way to effectively make some consumer interest 
expense deductible.
    The 60-month rule creates administrative burdens and 
complexities for individuals. For example, an individual with 
more than one student loan may have to keep track of different 
60-month periods for each loan. Issues may arise as to the 
proper application of the 60-month rule in the event that an 
individual consolidates student loans. Special rules are needed 
to apply the 60-month rule in common situations, such as 
periods of loan deferment or forbearance and refinancings. 
Eliminating the 60-month rule would simplify the student loan 
interest deduction.
    Other rules could be adopted to serve the purpose of the 
60-month rule, but such rules also would be likely to add 
complexity. For example, some have suggested that the 60-month 
rule be replaced with a lifetime limit on the amount of 
deductible interest. Such a rule would require individuals to 
keep track of the total amount of interest they have deducted. 
Such records would need to be kept longer than under the 60-
month rule as interest payments may be made over a longer 
period of time. Additional complexities would have to be 
addressed, such as how the lifetime limit would be allocated 
when there is a change in status of the taxpayer, such as 
through marriage or divorce. A lifetime limit would could also 
alter the class of taxpayers who benefit from the deduction and 
could create winners and losers relative to present law.
    Some have argued that the 60-month rule (or an alternative) 
is unnecessary, because there are already sufficient limits on 
the amount of the deduction. For example, it is argued that the 
AGI limits may effectively limit the number of years over which 
an individual can deduct student loan interest, if AGI 
increases over time. It if further argued that the additional 
limitation of the 60-month rule is not justified given its 
complexity.
    In addition to simplifying the student loan interest 
deduction, the proposal would eliminate possible inconsistent 
treatment of taxpayers based on how a lender structures the 
interest payments on a qualified loan and when a taxpayer 
chooses to make payments. For example, a taxpayer who elects to 
capitalize interest that accrues on a loan while the taxpayer 
is enrolled in college (and the loan is in deferment) may be 
able to deduct more total interest payments than a taxpayer 
(with the same size qualified education loan) who elects to pay 
the interest currently during college. This is because the 60-
month rule is suspended during the deferment, but would 
continue to elapse in the latter case while payments are being 
made.
6. Eliminate tax on forgiveness of direct student loans subject to 
        income contingent repayment

                              Present Law

Tax treatment of student loan forgiveness
    In the case of an individual, gross income subject to 
Federal income tax does not include any amount from the 
forgiveness (in whole or in part) of certain student loans, 
provided that the forgiveness is contingent on the student's 
working for a certain period of time in certain professions for 
any of a broad class of employers (sec. 108(f)).
    Student loans eligible for this special rule must be made 
to an individual to assist the individual in attending an 
educational institution that normally maintains a regular 
faculty and curriculum and normally has a regularly enrolled 
body of students in attendance at the place where its education 
activities are regularly carried on. Loan proceeds may be used 
not only for tuition and required fees, but also to cover room 
and board expenses (in contrast to tax free scholarships under 
section 117, which are limited to tuition and required fees).
    The loan must be made by (1) the United States (or an 
instrumentality or agency thereof), (2) a State (or any 
political subdivision thereof), (3) certain tax-exempt public 
benefit corporations that control a State, county, or municipal 
hospital and whose employees have been deemed to be public 
employees under State law, or (4) an educational organization 
that originally received the funds from which the loan was made 
from the United States, a State, or a tax-exempt public benefit 
corporation. In addition, an individual's gross income does not 
include amounts from the forgiveness of loans made by 
educational organizations (and certain tax-exempt organizations 
in the case of refinancing loans) out of private, 
nongovernmental funds if the proceeds of such loans are used to 
pay costs of attendance at an educational institution or to 
refinance any outstanding student loans (not just loans made by 
educational organizations) and the student is not employed by 
the lender organization. In the case of loans made or 
refinanced by educational organizations (as well as refinancing 
loans made by certain tax-exempt organizations) out of private 
funds, the student's work must fulfill a public service 
requirement. The student must work in an occupation or area 
with unmet needs and such work must be performed for or under 
the direction of a tax-exempt charitable organization or a 
governmental entity.
Federal Direct Loan Program; income-contingent repayment option
    A major change in the delivery of Federal student loans 
occurred in 1993. The Student Loan Reform Act (``SLRA''), part 
of the Omnibus Budget Reconciliation Act of 1993, converted the 
Federal Family Education Loans (``FFEL''), which were made by 
private lenders and guaranteed by the Federal Government, into 
direct loans made by the Federal Government to students through 
their schools (the William D. Ford Direct Loan Program).\38\ 
The Direct Loan Program began in academic year 1994-95 and was 
to be phased in, with at least 60 percent of all student loan 
volume to be direct loans by the 1998-1999 academic year.
---------------------------------------------------------------------------
    \38\ For a comprehensive description of the Federal Direct Loan 
program, see U.S. Library of Congress, Congressional Research Service, 
The Federal Direct Student Loan Program, CRS Report for Congress No. 
95-110 EPW, by Margot A. Schenet (Washington, D.C.), updated October 
16, 1996.
---------------------------------------------------------------------------
    Federal Direct Loans include Federal Direct Stafford/Ford 
Loans (subsidized and unsubsidized), Federal Direct PLUS loans, 
and Federal Direct Consolidation loans. The SLRA requires that 
the Secretary of Education offer four alternative repayment 
options for direct loan borrowers: standard, graduated, 
extended, and income-contingent. However, the income-contingent 
option is not available to Direct PLUS borrowers. If the 
borrower does not choose a repayment plan, the Secretary may 
choose one, but may not choose the income-contingent repayment 
option.\39\ Borrowers are allowed to change repayment plans at 
any time.
---------------------------------------------------------------------------
    \39\ Defaulted borrowers of direct or guaranteed loans may also be 
required to repay through an income-contingent plan for a minimum 
period.
---------------------------------------------------------------------------
    Under the income-contingent repayment option, a borrower 
must make annual payments for a period of up to 25 years based 
on the amount of the borrower's Direct Loan (or Direct 
Consolidated Loan), AGI during the repayment period, and family 
size.\40\ Generally, a borrower's monthly loan payment is 
capped at 20 percent of discretionary income (AGI minus the 
poverty level adjusted for family size).\41\ If the loan is not 
repaid in full at the end of a 25-year period, the remaining 
debt is canceled by the Secretary of Education. There is no 
community or public service requirement.
---------------------------------------------------------------------------
    \40\ The Department of Education revised the regulations governing 
the income-contingent repayment option, effective July 1, 1996. See 
Federal Register, December 1, 1995, pp. 61819-61828.
    \41\ If the monthly amount paid by a borrower does not equal the 
accrued interest on the loan, the unpaid interest is added to the 
principal amount. This is called ``negative amortization.'' Under the 
income-contingent repayment plan, the principal amount cannot increase 
to more than 110 percent of the original loan; additional unpaid 
interest continues to accrue, but is not capitalized.
---------------------------------------------------------------------------

                        Description of Proposal

    The exclusion from income for amounts from forgiveness of 
certain student loans would be expanded to cover forgiveness of 
direct student loans made through the William D. Ford Federal 
Direct Loan Program, if loan repayment and forgiveness are 
contingent on the borrower's income level.

                             Effective Date

    The proposal would be effective for loan cancellations 
after December 31, 1999.

                              Prior Action

    The proposal was included in the President's fiscal year 
1998 and 1999 budget proposals, as well as in the House and 
Senate versions of the Taxpayer Relief Act of 1997. The 
proposal was not included in the conference agreement on the 
Taxpayer Relief Act of 1997.

                                Analysis

    There are three types of expenditures incurred by students 
in connection with their education: (1) direct payment of 
tuition and other education-related expenses; (2) payment via 
implicit transfers received from governments or private 
persons; and (3) forgone wages. The present-law income tax 
generally treats direct payments of tuition as consumption, 
neither deductible nor amortizable. By not including the 
implicit transfers from governments or private persons in the 
income of the student, present law offers the equivalent of 
expensing of those expenditures undertaken on behalf of the 
student by governments and private persons. This expensing-like 
treatment also is provided for direct transfers to students in 
the form of qualified scholarships excludable from income. 
Similarly, because forgone wages are never earned, the implicit 
expenditure incurred by students forgoing present earnings also 
receives expensing-like treatment under the present-law income 
tax.\42\
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    \42\ For a more complete discussion of education expenses under a 
theoretical income tax and the present-law income tax prior to changes 
made in the 1997 Act, see Joint Committee on Taxation, Analysis of 
Proposed Tax Incentives for Higher Education (JCS-3-97), March 4, 1997, 
pp. 19-23.
---------------------------------------------------------------------------
    The Federal Government could help a student finance his or 
her tuition and fees by making a loan to the student or 
granting a scholarship to the student. In neither case are the 
funds received by the student includable in taxable income. 
Economically, a subsequent forgiveness of the loan converts the 
original loan into a scholarship. Thus, as noted above, 
excluding a scholarship from income or not including a forgiven 
loan in income is equivalent to permitting a deduction for 
tuition paid.
    While present-law section 117 generally excludes 
scholarships from income, regardless of the recipient's income 
level, to the extent they are used for qualified tuition and 
related expenses, certain other education tax benefits are 
subject to expenditure and income limitations. For example, the 
HOPE credit limits expenditures that qualify for tax benefit to 
$2,000 annually (indexed for inflation after the year 2000) and 
the Lifetime Learning credit limits expenditures that qualify 
for tax benefit to $5,000 annually ($10,000 beginning in 
2003).\43\ In addition, the HOPE and Lifetime Learning credits 
are limited to taxpayers with modified adjusted gross incomes 
of $50,000 ($100,000 for joint filers) or less. No comparable 
expenditure or income limitations would apply to individuals 
who benefit from loan forgiveness under the proposal. For 
example, the expenditure limitation contained in section 117 
would not apply; thus, the provision could permit students to 
exclude from income amounts in excess of the qualified tuition 
and related expenses that would have been excludable under 
section 117 had the loan constituted a scholarship when 
initially made. However, it could be argued that expenditure 
limits are not necessary because the Federal Direct Loan 
program includes restrictions on the annual amount that a 
student may borrow, and that income limitations are unnecessary 
because an individual who has not repaid an income contingent 
loan in full after 25 years generally would be a lower-income 
individual throughout most of that 25-year period.
---------------------------------------------------------------------------
    \43\ For a more complete description of the HOPE and Lifetime 
Learning credits, see Joint Committee on Taxation, General Explanation 
of Tax Legislation Enacted in 1997 (JCS-23-97), December 17, 1997, pp. 
11-20.
---------------------------------------------------------------------------
    In addition, it could be argued that expanding section 
108(f) to cover forgiveness of Federal Direct Loans for which 
the income-contingent repayment option is elected is 
inconsistent with the conceptual framework of 108(f). There is 
no explicit or implicit public service requirement for 
cancellation of a Federal Direct Loan under the income-
contingent repayment option. Rather, the only preconditions are 
a low AGI and the passage of 25 years.
    As of May 1, 1996, 15 percent of the Direct Loan borrowers 
in repayment had selected the income-contingent option.\44\ 
Among those who choose the income-contingent repayment option, 
the Department of Education has estimated that slightly less 
than 12 percent of borrowers will fail to repay their loans in 
full within 25 years and, consequently, will have the unpaid 
amount of their loans discharged at the end of the 25-year 
period.\45\ Thus, the primary revenue effects associated with 
this provision would not commence until 2019--25 years after 
the program originated in 1994.
---------------------------------------------------------------------------
    \44\ CRS, The Federal Direct Student Loan Program, p.12. The 
Department of Education estimates that approximately 60 percent of 
borrowers will be in a repayment plan other than the standard 10-year 
repayment plan.
    \45\ See Federal Register, September 20, 1995, p. 48849.
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7. Tax treatment of education awards under certain Federal programs
            a. Eliminate tax on awards under National Health Corps 
                    Scholarship Program and F. Edward Hebert Armed 
                    Forces Health Professions Scholarship and Financial 
                    Assistance Program

                              Present Law

    Section 117 excludes from gross income amounts received as 
a qualified scholarship by an individual who is a candidate for 
a degree and used for tuition and fees required for the 
enrollment or attendance (or for fees, books, supplies, and 
equipment required for courses of instruction) at a primary, 
secondary, or post-secondary educational institution. The tax-
free treatment provided by section 117 does not extend to 
scholarship amounts covering regular living expenses, such as 
room and board. In addition to the exclusion for qualified 
scholarships, section 117 provides an exclusion from gross 
income for qualified tuition reductions for certain education 
provided to employees (and their spouses and dependents) of 
certain educational organizations.
    Section 117(c) specifically provides that the exclusion for 
qualified scholarships and qualified tuition reductions does 
not apply to any amount received by a student that represents 
payment for teaching, research, or other services by the 
student required as a condition for receiving the scholarship 
or tuition reduction.
    Section 134 provides that any ``qualified military 
benefit,'' which includes any allowance, is excluded from gross 
income if received by a member or former member of the 
uniformed services if such benefit was excludable from gross 
income on September 9, 1986.
    The National Health Service Corps Scholarship Program (the 
``NHSC Scholarship Program'') and the F. Edward Hebert Armed 
Forces Health Professions Scholarship and Financial Assistance 
Program (the ``Armed Forces Scholarship Program'') provide 
education awards to participants on condition that the 
participants provide certain services. In the case of the NHSC 
Program, the recipient of the scholarship is obligated to 
provide medical services in a geographic area (or to an 
underserved population group or designated facility) identified 
by the Public Health Service as having a shortage of health-
care professionals. In the case of the Armed Forces Scholarship 
Program, the recipient of the scholarship is obligated to serve 
a certain number of years in the military at an armed forces 
medical facility. These education awards generally involve the 
payment of higher education expenses (under the NHSC Program, 
the awards may be also used for the repayment or cancellation 
of existing or future student loans). Because the recipients 
are required to perform services in exchange for the education 
awards, the awards used to pay higher education expenses are 
taxable income to the recipient.

                        Description of Proposal

    The proposal would provide that amounts received by an 
individual under the NHSC Scholarship Program or the Armed 
Forces Scholarship Program are eligible for tax-free treatment 
as qualified scholarships under section 117, without regard to 
any service obligation by the recipient.

                             Effective Date

    The proposal would be effective for education awards 
received after December 31, 1999.

                              Prior Action

    A similar provision was included in H.R. 2646 (105th Cong.) 
(the Education Savings and School Excellence Act of 1998), as 
passed by the Congress on June 15, 1998. The President vetoed 
H.R. 2646 on July 21, 1998.
            b. Eliminate tax on repayment or cancellation of student 
                    loans under NHSC Scholarship Program, Americorps 
                    Education Award Program, and Armed Forces Health 
                    Professions Loan Repayment Program

                              Present Law

    In the case of an individual, gross income subject to 
Federal income tax does not include any amount from the 
forgiveness (in whole or in part) of certain student loans, 
provided that the forgiveness is contingent on the student's 
working for a certain period of time in certain professions for 
any of a broad class of employers (sec. 108(f)).
    Student loans eligible for this special rule must be made 
to an individual to assist the individual in attending an 
educational institution that normally maintains a regular 
faculty and curriculum and normally has a regularly enrolled 
body of students in attendance at the place where its education 
activities are regularly carried on. Loan proceeds may be used 
not only for tuition and required fees, but also to cover room 
and board expenses (in contrast to tax free scholarships under 
section 117, which are limited to tuition and required fees).
    The loan must be made by (1) the United States (or an 
instrumentality or agency thereof), (2) a State (or any 
political subdivision thereof), (3) certain tax-exempt public 
benefit corporations that control a State, county, or municipal 
hospital and whose employees have been deemed to be public 
employees under State law, or (4) an educational organization 
that originally received the funds from which the loan was made 
from the United States, a State, or a tax-exempt public benefit 
corporation. In addition, an individual's gross income does not 
include amounts from the forgiveness of loans made by 
educational organizations (and certain tax-exempt organizations 
in the case of refinancing loans) out of private, 
nongovernmental funds if the proceeds of such loans are used to 
pay costs of attendance at an educational institution or to 
refinance any outstanding student loans (not just loans made by 
educational organizations) and the student is not employed by 
the lender organization. In the case of loans made or 
refinanced by educational organizations (as well as refinancing 
loans made by certain tax-exempt organizations) out of private 
funds, the student's work must fulfill a public service 
requirement. The student must work in an occupation or area 
with unmet needs and such work must be performed for or under 
the direction of a tax-exempt charitable organization or a 
governmental entity.
    The NHSC Scholarship Program, the Americorps Education 
Award Program, and the Armed Forces Health Professions Loan 
Repayment Program provide education awards to participants that 
may be used for the repayment or cancellation of existing or 
future student loans. However, the repayment or cancellation of 
student loans under these programs appears not to meet the 
requirements for exclusion under current-law section 108(f), 
because the repayment or cancellation of student loans in some 
instances is not contingent on the participant's working for 
any of a broad class of employers.

                        Description of Proposal

    The proposal would provide that any repayment or 
cancellation of a student loan under the NHSC Scholarship 
Program, the Americorps Education Award Program, or the Armed 
Forces Health Professions Loan Repayment Program is excludable 
from income. The tax-free treatment would apply only to the 
extent that the student incurred qualified tuition and related 
expenses in excess of those which were taken into account in 
determining the amount of any education credit claimed during 
academic periods when the student loans were incurred.\46\
---------------------------------------------------------------------------
    \46\ For this purpose, qualified expenses were not taken into 
account to the extent that the otherwise allowable credit was reduced 
due to the taxpayer's AGI.
---------------------------------------------------------------------------

                             Effective Date

    The proposal would be effective for repayments or 
cancellations of student loans received after December 31, 
1999.

                              Prior Action

    No prior action.

                         Analysis for a. and b.

    Proponents of the proposed exclusions assert that the 
current imposition of tax liability on awards, repayments, or 
cancellations under the NHSC Scholarship Program, the Armed 
Forces Scholarship and Loan Repayment Programs, and the 
Americorps Education Award Program undermines the objective of 
providing incentives for individuals to serve as health 
professionals and teachers in underserved areas or as health 
professionals in the Armed Forces. There are, however, a number 
of similar federal (e.g., National Institutes of Health 
Undergraduate Scholarship Program) and state (e.g., Illinois 
Department of Public Health State Scholarships) programs that 
are in the same position as the programs that would be assisted 
by the proposal. Consequently, the proposals would result in 
unequal treatment of similarly situated taxpayers under various 
education award programs.
    While the Department of Defense takes the position that 
section 134 applies to awards made under the Armed Forces 
Health Professions Scholarship and Loan Repayment Programs, it 
has requested that the programs be included in the proposals.

                        C. Child Care Provisions

1. Expand the dependent care credit

                              Present Law

In general
    A taxpayer who maintains a household which includes one or 
more qualifying individuals may claim a nonrefundable credit 
against income tax liability for up to 30 percent of a limited 
amount of employment-related dependent care expenses (sec. 21). 
Eligible employment-related expenses are limited to $2,400 if 
there is one qualifying individual or $4,800 if there are two 
or more qualifying individuals. Generally, a qualifying 
individual is a dependent under the age of 13 or a physically 
or mentally incapacitated dependent or spouse. No credit is 
allowed for any qualifying individual unless a valid taxpayer 
identification number (``TIN'') has been provided for that 
individual. A taxpayer is treated as maintaining a household 
for a period if the taxpayer (or the taxpayer's spouse, if 
married) provides more than one-half the cost of maintaining 
the household for that period. In the case of married 
taxpayers, the credit is not available unless they file a joint 
return.
    Employment-related dependent care expenses are expenses for 
the care of a qualifying individual incurred to enable the 
taxpayer to be gainfully employed, other than expenses incurred 
for an overnight camp. For example, amounts paid for the 
services of a housekeeper generally qualify if such services 
are performed at least partly for the benefit of a qualifying 
individual; amounts paid for a chauffeur or gardener do not 
qualify.
    Expenses that may be taken into account in computing the 
credit generally may not exceed an individual's earned income 
or, in the case of married taxpayers, the earned income of the 
spouse with the lesser earnings. Thus, if one spouse has no 
earned income, generally no credit is allowed.
    The 30-percent credit rate is reduced, but not below 20 
percent, by 1 percentage point for each $2,000 (or fraction 
thereof) of adjusted gross income (``AGI'') above $10,000.
Interaction with employer-provided dependent care assistance
    For purposes of the dependent care credit, the maximum 
amounts of employment-related expenses ($2,400/$4,800) are 
reduced to the extent that the taxpayer has received employer- 
provided dependent care assistance that is excludable from 
gross income (sec. 129). The exclusion for dependent care 
assistance is limited to $5,000 per year and does not vary with 
the number of children.
Additional credit for taxpayers with dependents under the age of one
    There is no additional credit for taxpayers with dependents 
under the age of one.

                        Description of Proposal

    The proposal would make several changes to the dependent 
care tax credit. First, the credit percentage would be 
increased to 50 percent for taxpayers with AGI of $30,000 or 
less. For taxpayers with AGI between $30,001 and $59,000, the 
credit percentage would be decreased by 1 percent for each 
$1,000 of AGI, or fraction thereof, in excess of $30,000. The 
credit percentage would be 20 percent for taxpayers with AGI of 
$59,001 or greater. Second, under the proposal, an otherwise 
qualifying taxpayer would generally qualify for the dependent 
care tax credit if the taxpayer resided in the same household 
as the qualifying child regardless of whether the taxpayer 
contributed over one-half the cost of maintaining the 
household. However, in the case of a married couple filing 
separately, while the credit would be extended to one 
qualifying spouse filing a separate return, the spouse claiming 
the dependent care tax credit would have to satisfy the 
present-law household maintenance test to receive the credit. 
Third, the dollar amounts of the starting point of the new 
phase-down range and the maximum amount of eligible employment-
related expenses would be indexed for inflation beginning in 
2001. Finally, the proposal would extend up to $250 of 
additional credit ($500 for two or more qualifying dependents) 
to taxpayers with a qualifying dependent under the age of one 
at the end of the taxable year. This additional credit, 
computed as the applicable credit rate times $500 ($1,000 for 
two or more qualifying dependents), would be available 
regardless of whether the taxpayer actually incurred any out-
of-pocket child care expenses.
    The present-law reduction of the dependent care credit for 
employer-provided dependent care assistance would not be 
changed.

                             Effective Date

    Generally, the proposal would be effective for taxable 
years beginning after December 31, 1999. The starting point of 
the phase-down range and the maximum amounts of eligible 
employment-related expenses generally would be indexed for 
inflation for taxable years beginning after December 31, 2000. 
The maximum amount of the additional credit for taxpayers with 
infant dependents would be indexed for inflation for taxable 
years beginning after December 31, 2000.

                              Prior Action

    A substantially similar proposal (not including the 
additional credit for taxpayers with qualifying dependents 
under the age of one) was included in the President's fiscal 
year 1999 budget proposal.

                                Analysis

Overview
    The proposed expansion of the dependent care tax credit 
involves several issues. One issue is the government's role in 
encouraging parents to work in the formal workplace versus in 
the home. A second issue is the appropriate role of government 
in providing financial support for child care. A third issue 
involves the increased complexity added by this proposal and 
the effect of the phaseout provisions on marginal tax rates. 
Each of these issues are discussed in further detail below.
Work outside of the home
    One of the many factors influencing the decision as to 
whether the second parent in a two-parent household works 
outside the home is the tax law.\47\ The basic structure of the 
graduated income tax may act as a deterrent to work outside of 
the home. The reason for this is that the income tax taxes only 
labor whose value is formally recognized through the payment of 
wages.\48\ Work in the home, though clearly valuable, is not 
taxed. One way to see the potential impact of this bias is to 
consider the case of a parent who could work outside the home 
and earn $10,000. Assume that in so doing the family would 
incur $10,000 in child care expenses. Thus, in this example, 
the value of the parent's work inside or outside the home is 
recognized by the market to have equal value.\49\ From a purely 
monetary perspective (ignoring any work-related costs such as 
getting to work, or buying clothes for work), this individual 
should be indifferent as between working inside or outside the 
home. The government also should be indifferent to the choice 
of where this parent expends the parent's labor effort, as the 
economic value is judged to be the same inside or outside the 
home. However, the income tax system taxes the labor of this 
person in the formal marketplace, but not the value of the 
labor if performed in the home. Thus, of the $10,000 earned in 
the market place, some portion would be taxed away, leaving a 
net wage of less than $10,000.\50\ This parent would be better 
off by staying at home and enjoying the full $10,000 value of 
home labor without taxation.\51\
---------------------------------------------------------------------------
    \47\ This discussion applies to childless couples as well.
    \48\ Barter transactions involving labor services would generally 
be subject to income taxation as well.
    \49\ A neutral position is taken in this analysis as to whether 
actual parents can provide better care for their own children than can 
other providers. Thus, since the child care can be obtained in the 
marketplace for $10,000 in this example, it is assumed that this is the 
economic value of the actual parent doing the same work.
    \50\ The tax on ``secondary'' earners may be quite high, as the 
first dollar of their earnings are taxed at the highest Federal 
marginal tax rate applicable to the earnings of the ``primary'' earning 
spouse. Additionally, the earnings will face social security payroll 
taxes, and may bear State and local income taxes as well. For further 
discussion of this issue, see Joint Committee on Taxation, Present Law 
and Background Relating to Proposals to Reduce the Marriage Tax Penalty 
(JCX-1-98), January 27, 1998.
    \51\ Even with the present lower child care credit, the net wage 
would still be lower because of the social security taxes and any 
income taxes for which the taxpayer would be liable.
---------------------------------------------------------------------------
    Because labor in the home is not taxed, most economists 
view the income tax as being biased towards the provision of 
home labor, resulting in inefficient distribution of labor 
resources. For example, if the person in the above example 
could earn $12,000 in work outside the home and pay $10,000 in 
child care, work outside the home would be the efficient choice 
in the sense that the labor would be applied where its value is 
greatest. However, if the $12,000 in labor resulted in $2,000 
or more in additional tax burden, this individual would be 
better off by working in the home. The government could 
eliminate or reduce this bias in several ways. First, it could 
consider taxing the value of ``home production.'' Most would 
consider this unfair and not feasible for administrative 
reasons. The second alternative would be to eliminate or reduce 
the burden of taxation on ``secondary'' earners when they do 
enter the formal labor force. This approach was implemented 
through the two-earner deduction (from 1982-1986), which 
allowed a deduction for some portion of the earnings of the 
lesser-earning spouse.\52\ Another approach, and part of 
present law, is to allow a tax credit for child care expenses, 
provided both parents (or if unmarried, a single parent) work 
outside the home. This latter approach is targeted to single 
working parents and two-earner families with children, whereas 
the two-earner deduction applied to all two-earner couples 
regardless of child care expenses.
---------------------------------------------------------------------------
    \52\ Joint Committee on Taxation, Present Law and Background 
Relating to Proposals to Reduce the Marriage Tax Penalty (JCX-1-98), 
January 27, 1998, p. 6.
---------------------------------------------------------------------------
    The proposal to expand the dependent care credit would 
reduce the tax burden on families that pay for child care 
relative to all other taxpayers. Alternatives such as expanding 
the child tax credit or the value of personal exemptions for 
dependents would target tax relief to all families with 
children regardless of the labor choices of the parents. 
However, families without sufficient income to owe taxes would 
not benefit. If the objective were to further assist all 
families with children, including those with insufficient 
income to owe taxes, one would need to make the child credit 
refundable.
    Proponents of the proposal argue that child care costs have 
risen substantially, and the dependent care credit needs to be 
expanded to reflect this and ensure that children are given 
quality care. Opponents would argue that the current credit is 
a percentage of expenses, and thus as costs rise so does the 
credit. However, to the extent one has reached the cap on 
eligible expenses, this would not be true. Furthermore, the 
maximum eligible employment-related expenses and the income 
levels for the phaseout have not been adjusted for inflation 
since 1982, when the amounts of maximum eligible employment-
related expenses were increased. It also could be argued that 
the increase is needed to lessen the income tax's bias against 
work outside of the home. However, the increase in the number 
of two-parent families where both parents work might suggest 
that any bias against work outside of the home must have been 
mitigated by other forces, such as perhaps increased wages 
available for work outside of the home. Others would argue that 
the increasing number of two-earner couples with children is 
not the result of any reduction in the income tax's bias 
against work outside of the home, but rather reflects economic 
necessity in many cases.
    Opponents of the proposal contend that all families with 
children should be given any available tax breaks aimed at 
children, regardless of whether they qualify for the dependent 
care tax credit. In this regard, they may support the element 
of the proposal extending a tax benefit to all taxpayers with 
dependents under the age of one. This latter group may cite as 
support for their position that the size of the personal 
exemption for each dependent is much smaller than it would have 
been had it been indexed for inflation in recent decades. In 
their view, even with the addition of the child tax credit, the 
current tax Code does not adequately account for a family with 
children's decreased ability to pay taxes.
    It is not clear whether opponents of the proposal also 
believe that there should be biases in the income tax in favor 
of a parent staying at home with the children. It should be 
noted that married couples with children in which both parents 
work are often affected by the so-called marriage penalty.\53\ 
Conversely, those for whom one parent stays at home generally 
benefit from a ``marriage bonus.'' The proposal to increase the 
dependent care credit can be thought of as a proposal to 
decrease the marriage penalty for families with children.\54\
---------------------------------------------------------------------------
    \53\ See Joint Committee on Taxation, Present Law and Background 
Relating to Proposals to Reduce the Marriage Tax Penalty (JCX-1-98), 
January 27, 1998, p. 10.
    \54\ Married couples with children in which both spouses work and 
that receive a marriage bonus would also benefit from the dependent 
care proposal.
---------------------------------------------------------------------------
The appropriate role of government
    Another argument against the proposal is that, by giving an 
increased amount of credit based on money spent for child care, 
the proposal contributes to a distortion away from other forms 
of consumption and an incentive to overspend on child care. A 
counter-argument is that there are positive externalities to 
quality child care, and thus a distortion that encourages 
additional spending on child care is good for society. However, 
opponents would counter this argument with a similar argument 
that the best quality child care will come from the actual 
parents, and thus if there should be any bias in the provision 
of child care for reasons of quality it should be a bias 
towards parents providing their own child care. Such an 
argument is less tenable, however, for single parents for whom 
work outside of the home is a necessity. Another response is 
that, given the assumption that the government should subsidize 
child care, there are better ways to improve availability and 
affordability of adequate child care than through the tax code. 
It is possible that a direct spending initiative would be more 
efficient and administrable.
Complexity and marginal rate issues
    Some argue that the increased number (see the discussion of 
the employer tax credit for expenses of supporting employee 
child care in Part I.C.2., below of this pamphlet) and 
complexity of provisions in the tax code for social purposes 
(e.g., this proposal) complicates the tax system and undermines 
the public's confidence in the fairness of the income tax. 
Others respond that tax fairness should sometimes outweigh 
simplicity for purposes of the tax code.
    Some argue that the replacement of the maintenance of 
household test with a residency test is a significant 
simplification. Others respond that taxpayers' compliance 
burden will not be significantly reduced because the dependency 
requirement which is retained under the proposal requires the 
application of a set of rules with a compliance burden similar 
to that of the maintenance of household test.
    The proposal's modifications relating to the phase-out of 
the credit raise the tax policy issue of complexity. By phasing 
out the dependent care credit over the $30,000 to $60,000 
income range, many more families are likely to be in the phase-
out ranges. For those families the application of a phase-out 
is an increase in complexity. In contrast, families with income 
levels who would be subject to the present-law phase-down range 
but not the phase-out range under the proposal would enjoy a 
reduction in complexity.
    Additionally, the taxpayer's phaseout occurs at a steeper 
rate than under present law. Present law has a reduction in the 
credit rate of 1 percent for each additional $2,000 of AGI in 
the phase-out range. This proposal would reduce the credit rate 
by 1 percent for each $1,000 of AGI in the phase-out range. The 
marginal tax rate implied by the phaseout is thus twice as 
great as the marginal tax rate under present law. Under present 
law, a taxpayer with maximum eligible expenses of $4,800 will 
thus lose $48 in credits for each $2,000 of income in the 
phase-out range, which is equivalent to a marginal tax rate 
increase of 2.4 percentage points ($48/$2,000). Under the 
proposal, marginal tax rates would be increased by 4.8 
percentage points ($48/$1,000) for those in the phase-out 
range. Thus, the dependent care credit could decrease work 
effort for two reasons. By increasing marginal tax rates for 
those in the phase-out range, the benefit from working is 
reduced. Additionally, for most recipients of the credit, 
after-tax incomes will have been increased, which would enable 
the taxpayer to consume more of all goods, including leisure. A 
positive effect on labor supply will exist for those currently 
not working, for whom the increased credit might be an 
incentive to decide to work outside of the home.\55\
---------------------------------------------------------------------------
    \55\ For further discussion of the impact of this provision on 
marginal tax rates and labor supply, see Joint Committee on Taxation, 
Present Law and Analysis Relating to Individual Effective Marginal Tax 
Rates (JCS-3-98), February 3, 1998.
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2. Tax credit for employer-provided child care facilities

                              Present Law

    Generally, present law does not provide a tax credit to 
employers for supporting child care or child care resource and 
referral services.\56\ An employer, however, may be able to 
claim such expenses as deductions for ordinary and necessary 
business expenses. Alternatively, the taxpayer may be required 
to capitalize the expenses and claim depreciation deductions 
over time.
---------------------------------------------------------------------------
    \56\ An employer may claim the welfare-to-work tax credit on the 
eligible wages of certain long-term family assistance recipients. For 
purposes of the welfare-to-work credit, eligible wages includes amounts 
paid by the employer for dependent care assistance.
---------------------------------------------------------------------------

                        Description of Proposal

Employer tax credit for supporting employee child care
    Under the proposal, taxpayers would receive a tax credit 
equal to 25 percent of qualified expenses for employee child 
care. These expenses would include costs incurred: (1) to 
acquire, construct, rehabilitate or expand property that is to 
be used as part of a taxpayer's qualified child care facility; 
(2) for the operation of a taxpayer's qualified child care 
facility, including the costs of training and continuing 
education for employees of the child care facility; or (3) 
under a contract with a qualified child care facility to 
provide child care services to employees of the taxpayer. To be 
a qualified child care facility, the principal use of the 
facility must be for child care, and the facility must be duly 
licensed by the State agency with jurisdiction over its 
operations. Also, if the facility is owned or operated by the 
taxpayer, at least 30 percent of the children enrolled in the 
center (based on an annual average or the enrollment measured 
at the beginning of each month) must be children of the 
taxpayer's employees. If a taxpayer opens a new facility, it 
must meet the 30-percent employee enrollment requirement within 
two years of commencing operations. If a new facility failed to 
meet this requirement, the credit would be subject to 
recapture.
    To qualify for the credit, the taxpayer must offer child 
care services, either at its own facility or through third 
parties, on a basis that does not discriminate in favor of 
highly compensated employees.
Employer tax credit for child care resource and referral services
    Under the proposal, a taxpayer would be entitled to a tax 
credit equal to 10 percent of expenses incurred to provide 
employees with child care resource and referral services.
Other rules
    A taxpayer's total of these credits would be limited to 
$150,000 per year. Any amounts for which the taxpayer may 
otherwise claim a tax deduction would be reduced by the amount 
of these credits. Similarly, if the credits are taken for 
expenses of acquiring, constructing, rehabilitating, or 
expanding a facility, the taxpayer's basis in the facility 
would be reduced by the amount of the credits.

                             Effective Date

    The credits would be effective for taxable years beginning 
after December 31, 1999.

                              Prior Action

    The proposal was included in the President's fiscal year 
1999 budget proposal.
    The Senate version of the Taxpayer Relief Act of 1997 would 
have provided a temporary tax credit (taxable years 1998 
through 2000) equal to 50 percent of an employer's qualified 
child care expenses for each taxable year. The maximum credit 
allowable would not have exceeded $150,000 per year. This 
provision was not included in the final conference agreement on 
the Taxpayer Relief Act of 1997.

                                Analysis

    It is argued that providing these tax benefits may 
encourage employers to spend more money on child care services 
for their employees and that increased quality and quantity of 
these services will be the result. On the other hand, less 
desirable results may include a windfall tax benefit to 
employers who would have engaged in this behavior without 
provision of these tax benefits, and a competitive disadvantage 
in the hiring and retaining of workers for nonprofit 
organizations who cannot take advantage of these new tax 
benefits.
    Opponents of the proposal argue that adding complexity to 
the tax law can undermine the public's confidence in the 
fairness of the tax law, and that the country's child care 
problems and other social policy concerns can be more 
efficiently addressed through a spending program than through a 
tax credit. Proponents argue that any additional complexity in 
the tax law is outweighed by increased fairness. They contend 
that present law has not taken into account the changing 
demographics of the American workforce and the need to provide 
improved child care for the ever increasing numbers of two-
earner families.

              D. Tax Incentives to Revitalize Communities

1. Increase low-income housing tax credit per capita cap

                              Present Law

    A tax credit, claimed over a 10-year period is allowed for 
the cost of rental housing occupied by tenants having incomes 
below specified levels. The credit percentage for newly 
constructed or substantially rehabilitated housing that is not 
Federally subsidized is adjusted monthly by the Internal 
Revenue Service so that the 10 annual installments have a 
present value of 70 percent of the total qualified 
expenditures. The credit percentage for new substantially 
rehabilitated housing that is Federally subsidized and for 
existing housing that is substantially rehabilitated is 
calculated to have a present value of 30 percent qualified 
expenditures.
    Except in the case of projects that also receive financing 
with proceeds of tax-exempt bonds issued subject to the private 
activity bond volume limit and certain carry-over amounts the 
aggregate credit authority provided annually to each State is 
$1.25 per resident. Credits that remain unallocated by States 
after prescribed periods are reallocated to other States 
through a ``national pool.''

                        Description of Proposal

    The $1.25 per capita cap would be increased to $1.75 per 
capita.

                             Effective Date

    The proposal would be effective for calendar years 
beginning after December 31, 1999.

                              Prior Action

    A substantially similar proposal was included in the 
President's fiscal year 1999 budget proposal.

                                Analysis

Demand subsidies versus supply subsidies

    As is the case with direct expenditures, the tax system may 
be used to improve housing opportunities for low-income 
families either by subsidizing rental payments (increasing 
demand) or by subsidizing construction and rehabilitation of 
low-income housing units (increasing supply).
    The provision of Federal Section 8 housing vouchers is an 
example of a demand subsidy. The exclusion of the value of such 
vouchers from taxable income is an example of a demand subsidy 
in the Internal Revenue Code. By subsidizing a portion of rent 
payments, these vouchers may enable beneficiaries to rent more 
or better housing than they might otherwise be able to afford. 
The low-income housing credit is an example of a supply 
subsidy. By offering a subsidy worth 70 percent (in present 
value) of construction costs, the credit is designed to induce 
investors to provide housing to low-income tenants, or a better 
quality of housing, than otherwise would be available.
    A demand subsidy can improve the housing opportunities of a 
low-income family by increasing the family's ability to pay for 
more or higher quality housing. In the short run, an increase 
in the demand for housing, however, may increase rents as 
families bid against one another for available housing. 
Consequently, while a family who receives the subsidy may 
benefit by being able to afford more or better housing, the 
resulting increase in market rents may reduce the well-being of 
other families. In the long run, investors should supply 
additional housing because higher rents increase the income of 
owners of existing rental housing, and therefore may be 
expected to make rental housing a more attractive investment. 
This should ameliorate the short-term increase in market rents 
and expand availability of low-income housing.
    A supply subsidy can improve the housing opportunities of a 
low-income family by increasing the available supply of housing 
from which the family may choose. Generally, a supply subsidy 
increases the investor's return to investment in rental 
housing. An increased after-tax return should induce investors 
to provide more rental housing. As the supply of rental housing 
increases, the market rents investors charge should decline as 
investors compete to attract tenants to their properties. 
Consequently, not only could qualifying low-income families 
benefit from an increased supply of housing, but other renters 
could also benefit. In addition, owners of existing housing may 
experience declines in income or declines in property values as 
rents fall.

Efficiency of demand and supply subsidies

    In principle, demand and supply subsidies of equal size 
should lead to equal changes in improved housing opportunities. 
There is debate as to the accuracy of this theory in practice. 
Some argue that both direct expenditures and tax subsidies for 
rental payments may not increase housing consumption dollar for 
dollar. One study of the Federal Section 8 Existing Housing 
Program suggests that, for every $100 of rent subsidy, a 
typical family increases its expenditure on housing by $22 and 
increases its expenditure on other goods by $78.\57\ While the 
additional $78 spent on other goods certainly benefits the 
family receiving the voucher, the $100 rent subsidy does not 
increase their housing expenditures by $100.
---------------------------------------------------------------------------
    \57\ See, W. Reeder, ``The Benefits and Costs of the Section 8 
Existing Housing Program,'' Journal of Public Economics, 26, 1985.
---------------------------------------------------------------------------
    Also, one study of government-subsidized housing starts 
between 1961 and 1977 suggests that as many as 85 percent of 
the government-subsidized housing starts may have merely 
displaced unsubsidized housing starts.\58\ This figure is based 
on both moderate- and low-income housing starts, and therefore 
may overstate the potential inefficiency of tax subsidies 
solely for low-income housing. Displacement is more likely to 
occur when the subsidy is directed at projects the private 
market would have produced anyway. Thus, if relatively small 
private market activity exists for low-income housing, a supply 
subsidy is more likely to produce a net gain in available low-
income housing units because the subsidy is less likely to 
displace otherwise planned activity.
---------------------------------------------------------------------------
    \58\ M. Murray, ``Subsidized and Unsubsidized Housing Starts: 1961-
1977,'' The Review of Economics and Statistics, 65, November 1983.
---------------------------------------------------------------------------
    The theory of subsidizing demand assumes that, by providing 
low-income families with more spending power, their increase in 
demand for housing will ultimately lead to more or better 
housing being available in the market. However, if the supply 
of housing to these families does not respond to the higher 
market prices that rent subsidies ultimately cause, the result 
will be that all existing housing costs more, the low-income 
tenants will have no better living conditions than before, and 
other tenants will face higher rents.\59\ The benefit of the 
subsidy will accrue primarily to the property owners because of 
the higher rents.
---------------------------------------------------------------------------
    \59\ For example, supply may not respond to price changes if there 
exist construction, zoning, or other restrictions on the creation of 
additional housing units.
---------------------------------------------------------------------------
    Supply subsidy programs can suffer from similar 
inefficiencies. For example, some developers who built low-
income rental units before enactment of the low-income housing 
credit, may now find that the projects qualify for the credit. 
That is, the subsidized project may displace what otherwise 
would have been an unsubsidized project with no net gain in 
number of low-income housing units. If this is the case, the 
tax expenditure of the credit will result in little or no 
benefit except to the extent that the credit's targeting rules 
may force the developer to serve lower-income individuals than 
otherwise would have been the case. In addition, by depressing 
rents the supply subsidy may displace privately supplied 
housing.

Efficiency of tax subsidies

    Some believe that tax-based supply subsidies do not produce 
significant displacement within the low-income housing market 
because low-income housing is unprofitable and the private 
market would not otherwise build new housing for low-income 
individuals. In this view, tax-subsidized low-income housing 
starts would not displace unsubsidized low-income housing 
starts. However, the bulk of the stock of low-income housing 
consists of older, physically depreciated properties which once 
may have served a different clientele. Subsidies to new 
construction could make it no longer economic to convert some 
of these older properties to low-income use, thereby displacing 
potential low-income units.
    The tax subsidy for low-income housing construction also 
could displace construction of other housing. Constructing 
rental housing requires specialized resources. A tax subsidy 
may induce these resources to be devoted to the construction of 
low-income housing rather than other housing. If most of the 
existing low-income housing stock had originally been built to 
serve non-low-income individuals, a tax subsidy to newly 
constructed low-income housing could displace some privately 
supplied low-income housing in the long run.
    Supply subsidies for low-income housing may be subject to 
some additional inefficiencies. Much of the low-income housing 
stock consists of older structures. Subsidies to new 
construction may provide for units with more amenities or units 
of a higher quality than low-income individuals would be 
willing to pay for if given an equivalent amount of funds. That 
is, rather than have $100 spent on a newly constructed 
apartment, a low-income family may prefer to have consumed part 
of that $100 in increased food and clothing. In this sense, the 
supply subsidy may provide an inefficiently large quantity of 
housing services from the point of view of how consumers would 
choose to allocate their resources. However, to the extent that 
maintenance of a certain standard of housing provides benefits 
to the community, the subsidy may enhance efficiency. If the 
supply subsidy involves fixed costs, such as the cost of 
obtaining a credit allocation under the low-income housing 
credit, a bias may be created towards large projects in order 
to amortize the fixed cost across a larger number of units. 
This may create an inefficient bias in favor of large projects. 
On the other hand, the construction and rehabilitation costs 
per unit may be less for large projects than for small 
projects. Lastly, unlike demand subsidies which permit the 
beneficiary to seek housing in any geographic location, supply 
subsidies may lead to housing being located in areas which, for 
example, are farther from places of employment than the 
beneficiary would otherwise choose. In this example, some of 
benefit of the supply subsidy may be dissipated through 
increased transportation cost.

Targeting the benefits of tax subsidies

    A supply subsidy to housing will be spent on housing; 
although, as discussed above, it may not result in a dollar-
for-dollar increase in total housing spending. To insure that 
the housing, once built, serves low-income families, income and 
rent limitations for tenants must be imposed as is the case for 
demand subsidies. While an income limit may be more effective 
in targeting the benefit of the housing to lower income levels 
than would an unrestricted market, it may best serve only those 
families at or near the income limit.
    If, as with the low-income housing credit, rents are 
restricted to a percentage of targeted income, the benefits of 
the subsidy may not accrue equally to all low-income families. 
Those with incomes beneath the target level may pay a greater 
proportion of their income in rent than does a family with a 
greater income. On the other hand, to the extent that any new, 
subsidy-induced housing draws in only the targeted low-income 
families with the highest qualifying incomes it should open 
units in the privately provided low-income housing stock for 
others.
    Even though the subsidy may be directly spent on housing, 
targeting the supply subsidy, unlike a demand subsidy, does not 
necessarily result in targeting the benefit of the subsidy to 
recipient tenants. Not all of the subsidy will result in net 
additions to the housing stock. The principle of a supply 
subsidy is to induce the producer to provide something he or 
she otherwise would not. Thus, to induce the producer to 
provide the benefit of improved housing to low-income families, 
the subsidy must provide benefit to the producer.
    Targeting tax incentives according to income can result in 
creating high implicit marginal tax rates. For example, if rent 
subsidies are limited to families below the poverty line, when 
a family is able to increase its income to the point of 
crossing the poverty threshold the family may lose its rent 
subsidy. The loss of rent subsidy is not unlike a high rate of 
taxation on the family's additional income. The same may occur 
with supply subsidies. With the low-income housing credit, the 
percentage of units serving low-income families is the criteria 
for receiving the credit. Again, the marginal tax rate on a 
dollar of income at the low-income threshold may be very high 
for prospective tenants.

Data relating to the low-income housing credit

    Comprehensive data from tax returns concerning the low-
income housing tax credit currently are unavailable. However, 
Table 1, below, presents data from a survey of State credit 
allocating agencies.

    Table 1.--Allocation of the Low-Income Housing Credit, 1987-1997
------------------------------------------------------------------------
                                                              Percentage
              Years                 Authority    Allocated    allocated
                                    (millions)   (millions)   (percent)
------------------------------------------------------------------------
1987.............................       $313.1        $62.9         20.1
1988.............................        311.5        209.8         67.4
1989.............................        314.2        307.2         97.8
1990.............................        317.7        213.1         67.0
1991 \1\.........................        497.3        400.6         80.6
1992 \1\.........................        488.5        337.0         69.0
1993 \1\.........................        546.4        424.7         78.0
1994 \1\.........................        523.7        494.9         95.5
1995 \1\.........................        432.6        420.9         97.0
1996 \1\.........................        391.6        378.9         97.0
1997 \1\.........................        387.3        382.9        99.0
------------------------------------------------------------------------
\1\ Increased authority includes credits unallocated from prior years
  carried over to the current year.
Source: Survey of State allocating agencies conducted by National
  Council of State Housing Associations (1998).

    Table 1 does not reflect actual units of low-income housing 
placed in service, but rather only allocations of the credit to 
proposed projects. Some of these allocations will be carried 
forward to projects placed in service in future years. As such, 
these data do not necessarily reflect the magnitude of the 
Federal tax expenditure from the low-income housing credit. The 
staff of the Joint Committee on Taxation (``Joint Committee 
staff'') estimates that the fiscal year 1999 tax expenditure 
resulting from the low-income credit will total $3.4 
billion.\60\ This estimate would include revenue lost to the 
Federal Government from buildings placed in service in the 10 
years prior to 1999. Table 1 shows a high rate of credit 
allocations in recent years.
---------------------------------------------------------------------------
    \60\ Joint Committee on Taxation, Estimates of Federal Tax 
Expenditures for Fiscal Years 1999-2003 (JCS-7-98), December 14, 1998, 
p. 18.
---------------------------------------------------------------------------
    A Department of Housing and Urban Development study has 
attempted to measure the costs and benefits of the low-income 
housing credit compared to that of the Federal Section 8 
housing voucher program.\61\ This study attempts to compare the 
costs of providing a family with an identical unit of housing, 
using either a voucher or the low-income housing credit. The 
study concludes that on average the low-income housing credit 
provides the same unit of housing as would the voucher at two 
and one half times greater cost than the voucher program. 
However, this study does not attempt to measure the effect of 
the voucher on raising the general level of rents, nor the 
effect of the low-income housing credit on lowering the general 
level of rents. The preceding analysis has suggested that both 
of these effects may be important. In addition, as utilization 
of the credit has risen, the capital raised per credit dollar 
has increased. This, too, would reduce the measured cost of 
providing housing using the low-income credit.
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    \61\ U.S. Department of Housing and Urban Development, Evaluation 
of the Low-Income Housing Tax Credit: Final Report, February 1991.
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Increasing State credit allocations

    The dollar value of the State allocation of $1.25 per 
capita was set in the 1986 Act and has not been revised. Low-
income housing advocates observe that because the credit amount 
is not indexed, inflation has reduced its real value since the 
dollar amounts were set in 1986. The Gross Domestic Product 
(``GDP'') price deflator for residential fixed investment 
measures 39.9 percent price inflation between 1986 and the 
third quarter of 1998. Had the per capita credit allocation 
been indexed for inflation, using this index to reflect 
increased construction costs, the value of the credit today 
would be approximately $1.75.\62\ While not indexing for 
inflation, present law does provide for annual adjustments to 
the State credit allocation authority based on current 
population estimates. Because the need for low-income housing 
can be expected to correlate with population, the annual credit 
limitation already is adjusted to reflect changing needs.
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    \62\ Most Code provisions are indexed to the Consumer Price Index 
(``CPI''). Over this same period, cumulative inflation as measured by 
the CPI was approximately 49.5 percent. Indexing the $1.25 to the CPI 
would have produced a value of approximately $1.87 today.
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    The revenue consequences estimated by the Joint Committee 
staff of increasing the per capita limitation understate the 
long-run revenue cost to the Federal Government. This occurs 
because the Joint Committee staff reports revenue effects only 
for the 10-year budget period. Because the credit for a project 
may be claimed for 10 years, only the total revenue loss 
related to those projects placed in service in the first year 
are reflected fully in the Joint Committee staff's 10-year 
estimate. The revenue loss increases geometrically throughout 
the budget period as additional credit authority is granted by 
the States and all projects placed in service after the first 
year of the budget period produce revenue losses in years 
beyond the 10-year budget period.

2. Tax credits for holders of Better America Bonds

                              Present Law

Tax-exempt bonds

    Interest on debt incurred by States or local governments is 
excluded from income if the proceeds of the borrowing are used 
to carry out governmental functions of those entities or the 
debt is repaid with governmental funds (``governmental 
bonds''). These bonds may include bonds used to finance the 
acquisition of land (or interests in land) and buildings. 
Interest on bonds that nominally are issued by States or local 
governments, but the proceeds of which are used (directly or 
indirectly) by a private person and payment of which is derived 
from funds of such a private person (``private activity 
bonds'') is taxable unless the purpose of the borrowing is 
approved specifically in the Code or in another provision of a 
revenue Act. These specified purposes include, but are not 
limited to, privately owned and/or operated: (1) sewage 
facilities; (2) solid waste disposal facilities; and (3) water 
systems. Issuance of most qualified private activity bonds is 
subject to annual state volume limits, currently the greater of 
$50 per resident, or $150 million if greater.

Tax credits for interest on bonds

    A nonrefundable tax credit in an amount equal to a credit 
rate (set monthly by the Treasury Department) multiplied by the 
face amount of certain qualified zone academy bonds is allowed 
to certain financial institutions (i.e., banks, insurance 
companies, and corporations actively engaged in the business of 
lending money). The credit rate applies to all bonds issued in 
a month. A taxpayer holding a qualified zone academy bond on 
the credit allowance date (i.e., the annual anniversary of the 
bond's issuance) is entitled to a credit. The credit is 
includible in gross income (as if it were an interest payment 
on the bond), and may be claimed against regular income tax 
liability and alternative minimum tax liability. A qualified 
zone academy bonds is defined as any bond issued by a State or 
local government, provided that (1) at least 95 percent of the 
proceeds are used for the purpose of renovating, providing 
equipment to, developing course materials for use at, or 
training teachers and other school personnel in a ``qualified 
zone academy'' and (2) private entities have promised to 
contribute to the qualified zone academy certain equipment, 
technical assistance or training, employee services, or other 
property or services with a value equal to at least 10 percent 
of the bond proceeds.

Expensing of certain environmental remediation expenses

    Taxpayers can elect to treat certain environmental 
remediation expenditures that would otherwise be chargeable to 
capital account as deductible in the year paid or incurred 
(sec. 198). The deduction applies for both regular and 
alternative minimum tax purposes. The expenditure must be 
incurred in connection with the abatement or control of 
hazardous substances at a qualified contaminated site. A 
qualified contaminated site generally is any property that: (1) 
is held for use in a trade or business, for the production of 
income, or as inventory; (2) is certified by the appropriate 
State environmental agency to be located within certain 
targeted areas; and (3) contains (or potentially contains) a 
hazardous substance (so-called ``brownfields''). In the case of 
property to which a qualified environmental remediation 
expenditure otherwise would have been capitalized, any 
qualified environmental remediation expenditure deductions are 
subject to recapture as ordinary income upon sale or other 
disposition of the property (sec. 1245). The provision applies 
only to eligible expenditures paid or incurred in taxable years 
ending after August 5, 1997, and before January 1, 2001.

                        Description of Proposal

In general

    The proposal would provide a tax credit to holders of a new 
category of bonds, Better America Bonds (``BABs''),\63\ issued 
by State or local governments for certain specified purposes. 
The taxpayer holding a BAB on the credit allowance date (i.e., 
the annual anniversary of the bond's issuance) would be 
entitled to the credit. The amount of the credit would 
determined by multiplying that BAB's credit rate (set by the 
Treasury Department when the BAB was issued) by the face amount 
of the holder's BAB. The credit would be includible in gross 
income (as if it were an interest payment on the bond), and 
could be claimed against regular income tax liability and 
alternative minimum tax liability.
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    \63\ The structure of BABs would be identical to the structure in 
the Administration's fiscal year 2000 budget proposal for qualified 
school modernization bonds and qualified zone academy bonds. (See 
discussion in Part I.B.1, above.)
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Authority to issue BABs

    The Administrator of the Environmental Protection Agency 
(``EPA'') would be given authority to allocate $1.9 billion 
dollars of BAB authority to eligible issuers (i.e., States and 
local governments, including tribal governments, U.S. 
Possessions) annually for five years beginning in the year 
2000. Any amounts unallocated for a year could be allocated in 
the following year. Any amounts allocated to an eligible issuer 
in any year could be used for bond issuance in that year or in 
any of the following three years.
    The EPA would be directed to publish guidelines, before 
January 1, 2000, establishing the criteria to be used in an 
annual competition for authority to issue the BABs. Eligible 
issuers would apply for an allocation of authority to issue the 
BABs and the EPA, in consultation with other Federal agencies, 
would review these applications and allocate authority to issue 
BABs in conjunction with the Community Empowerment Board.

Qualifying purposes for BABs

    The proposal would limit the purposes for which BABS could 
be issued by eligible issuers for: (1) acquisition of land for 
open space, wetland, public parks or green ways to be owned by 
the State or local government or 501(c)(3) entity whose exempt 
purpose includes environmental preservation; (2) construction 
of visitors' facilities to be owned by the State or local 
government or 501(c)(3) entity whose exempt purpose includes 
environmental preservation; (3) remediation of land, in order 
to improve water quality, acquired under (1) above, or of 
publicly owned open space, wetlands, or parks, by undertaking 
reasonable measures to control erosion and remediating 
conditions caused by prior disposal of toxic or other waste; 
(4) acquisition of easements on privately owned open land that 
prevent commercial development and any substantial change in 
the use or character of the land; or (5) environmental 
assessment and remediation of contaminated property owned by 
State or local governments because it was abandoned by the 
prior owner.

Other rules applicable to BABs

    No depreciation for tax purposes would be allowed with 
respect to property financed with BABs. Also, no expenditures 
financed with BAB proceeds would be eligible for expensing 
under the environmental remediation rules of section 198.
    Issuers of BABs would be required to allow eligible 
501(c)(3) organizations to purchase the credit financed 
property at any time after the end of its qualified use (e.g., 
at the end of the 15-year period beginning on the date of 
issuance of the BAB) before selling to another party. An 
eligible 501(c)(3) organization would have the right, but not 
the obligation to purchase the property at that time before the 
sale to another party. An eligible 501(c)(3) organization must: 
(1) have exempt purposes which include environmental 
protection; (2) covenant to maintain the property in qualifying 
use in perpetuity; and (3) hold an option to purchase the 
property. The purchase price to the 501(c)(3) under the option 
would be the price paid in conjunction with the expenditure of 
bond proceeds at the beginning of the 15-year period. This 
option would be created when the proceeds of the bond were are 
expended to purchase the property and recorded pursuant to 
State law as a restrictive covenant binding upon all 
successors. The actual option could be granted at any time 
during the 15-year period beginning on the date of issuance.

Rules generally applicable to tax credit bonds

    The proposal sets forth certain rules that would apply to 
any ``tax credit bond'' (i.e., BABs, qualified zone academy 
bonds, qualified school modernization bonds).
    Similar to the tax benefits available to holders of 
present-law qualified zone academy bonds, the holders of tax 
credit bonds would receive annual Federal income tax credits in 
lieu of interest payments. Because the proposed credits would 
compensate the holder for lending money, the credits would be 
treated as payments of interest for Federal income tax purposes 
and, accordingly, would be included in the holder's gross 
income. As with present-law qualified zone academy bonds, the 
``credit rate'' for tax credit bonds would be set by the 
Secretary of the Treasury so that, on average, the bonds would 
be issued without interest, discount, or premium.\64\ The 
maximum term of the tax credit bond would be 15 years.
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    \64\ To this end, the credit rate would be set equal to a measure 
of the yield on outstanding corporate bonds, as specified in Treasury 
regulations, for the business day prior to the date of issue. It is 
anticipated that the credit rate would be set with reference to a 
corporate AA bond rate which could be published daily by the Federal 
Reserve Board or otherwise determined under Treasury regulations.
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    Any taxpayer would be able to hold a tax credit bond and 
thereby claim the tax credit. The Treasury Department would 
provide regulations regarding the treatment of credits that 
flow through from a mutual fund to the holder of mutual fund 
shares. Unused credits could not be carried back, but could be 
carried forward for 5 years. The proposal would grant 
regulatory authority to the Secretary to require information 
returns to be provided with respect to holders (including 
corporations) that are entitled to credits.
    Under the proposal, issuers of tax credit bonds must 
reasonably expect that, on the date of issue, 95 percent of the 
proceeds of the bonds (including any investment earnings on 
such proceeds) would be spent on qualifying purposes within 
three years and that any property financed with bond proceeds 
would be used for a qualified purpose for at least a 15-year 
period. In addition, the issuer must incur a binding obligation 
with a third party to spend at least 10 percent of proceeds of 
the issue within 6 months of the date of issue.
    During the 3-year period after the date of issue, 
unexpended proceeds must be invested only in bank accounts or 
U.S. Treasury securities with a maturity of three years or 
less. If the issuer established a sinking fund for the 
repayment of the principal, all sinking fund assets would have 
to be held in State and Local Government Securities (SLGS) 
issued by the Treasury. Any proceeds of the bonds (including 
any investment earnings on those proceeds) not expended for 
qualifying purposes at the end of the 3-year period must be 
used to redeem a pro rata portion of the bonds within 90 days.
    Any property financed with tax credit bond proceeds must be 
used for a qualifying purpose for at least a 15-year period 
after the date of issuance. If the use of a bond-financed 
facility changed to a non-qualifying use within that 15-year 
period, the bonds would cease to be qualifying bonds and would 
accrue no further tax credits. Further, the issuer would be 
required to reimburse the Treasury for all tax credits 
(including interest) which accrued within three years of the 
date of noncompliance. If the issuer failed to make a full and 
timely reimbursement of tax credits, the Federal government 
could proceed to collect against current holder(s) of the bond 
for any remaining amounts.

                             Effective Date

    The proposal would apply to bonds issued on or after 
January 1, 2000.

                              Prior Action

    No prior action.

                                Analysis

    The proposal would subsidize a portion of the cost of new 
investment in ``green space'' land and facilities, as well as 
certain environmental remediation expenditures. Subsidizing 
such costs, it is argued, increases the level of investment in 
socially desirable assets over the level of investment that 
would take place in the absence of the subsidy. It is argued 
that significant public benefits will be result, in the form of 
more public green space and a cleaner environment.
    Though called a tax credit, the Federal subsidy for BABs 
would be economically equivalent to a direct payment by the 
Federal government of interest on taxable bonds, on behalf of 
the eligible issuers that benefits from the bond proceeds.\65\ 
To illustrate, consider any taxable bond that bears an interest 
rate of 10 percent. A $1,000 bond would produce an interest 
payment of $100 annually. The bondholder receiving this payment 
would have $100, less the tax owed on the interest income. If 
the taxpayer were in the 28-percent Federal tax bracket, 
taxpayer would have $72 after Federal tax. Regardless of 
whether the eligible issuer or the Federal Government pays the 
interest, the taxpayer receives the same net-of-tax return of 
$72. In the case of BABs, interest is not actually paid by the 
Federal Government, but rather, a tax credit of $100 is allowed 
to the holder of the bond. In general, a $100 tax credit would 
be worth $100 to a taxpayer, provided that the taxpayer had at 
least $100 in tax liability. However, the BABs proposal 
requires the amount of the $100 credit to be included in the 
taxpayer's income. The taxpayer in the 28-percent tax bracket 
nets $72 after Federal tax, just as on the bond. Similarly, the 
Federal Government would be in the same position under the BABs 
proposal as if it had paid the $100 interest on the bond. The 
Federal Government loses $100 on the credit, but recoups $28 of 
that by the requirement that it be included in income, for a 
net cost of $72. The State and local government would also be 
in the same situation in both cases.
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    \65\ This is true provided that the taxpayer faces tax liability of 
at least the amount of the credit. Without sufficient tax liability, 
the proposed tax credit arrangement would not be as advantageous. 
Presumably, only taxpayers who anticipate having sufficient tax 
liability to be offset by the proposed credit would hold these bonds.
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    The proposed tax credit arrangement to subsidize 
environmental preservation and remediation raises some 
questions of administrative efficiency and tax complexity. An 
alternative, direct expenditure program under the direct 
control of the EPA would avoid the involvement of the IRS in 
the administration of a program outside its traditional area of 
expertise. Because potential purchasers of the bonds must 
educate themselves as to whether the bonds qualify for the 
credit, certain ``information costs'' are imposed on the buyer. 
Additionally, since the determination as to whether the bond is 
qualified for the credit ultimately rests with the Federal 
Government, further risk is imposed on the investor. These 
information costs and other risks serve to increase the credit 
rate and hence the costs to the Federal Government for a given 
level of support for environmental improvements. For these 
reasons, and the fact that tax credit bonds will be less liquid 
than Treasury securities, the bonds would bear a credit rate 
that is equal to a measure of the yield on outstanding 
corporate bonds. The direct payment of interest by the Federal 
Government on behalf of eligible issuers, which was discussed 
above as being economically the equivalent of the credit 
proposal, would be less complex, both as to the substantive tax 
law, and as to the administration of the tax law, because the 
interest could simply be reported like any other taxable 
interest.
    Finally, the use of a tax credit has the effect that non-
taxable entities may not invest in these bonds to improve the 
environment because they are unable to use the tax benefits 
provided under the proposal. In the case of a direct payment of 
interest, by contrast, tax-exempt organizations would be able 
to enjoy such benefits.

3. New markets tax credit

                              Present Law

    A number of tax incentives are available for investments 
and loans in low-income communities. For example, tax 
incentives are available to taxpayers that invest in 
specialized small business investment companies licensed by the 
Small Business Administration (``SBA'') to make loans to, or 
equity investments in, small businesses owned by persons who 
are socially or economically disadvantaged. A tax credit is 
allowed over a 10-year period for qualified contributions to 
selected community development corporations that provide 
assistance in economically distressed areas. A tax credit is 
allowed over a 10-year period for rental housing occupied by 
tenants having incomes below specified levels. Certain 
businesses that are located in empowerment zones and enterprise 
communities designated by the Secretary of the Department of 
Housing and Urban Development and the Secretary of the 
Department of Agriculture also qualify for Federal tax 
incentives.

                        Description of Proposal

    The proposal would create a new tax credit for qualified 
investments made to acquire stock (or other equity interests) 
in selected community development entities (``CDE''). The 
credits would be allocated to CDEs pursuant to Treasury 
Department regulations. During the period 2000-2004, the 
maximum amount of investments that would qualify for the credit 
would be capped at an aggregate annual amount of $1.2 billion 
(a maximum of $6 billion for the entire period of the tax 
credit). If a CDE fails to sell equity interests to investors 
up to the amount authorized within five years of the 
authorization, then the remaining authorization would be 
canceled, and the Treasury Department would have up to two 
years to authorize another CDE to issue equity interests for 
the unused portion.
    The credit allowed to the investor (either the original 
purchaser or a subsequent holder) would be a six-percent credit 
for each year during the five-year period after the equity 
interest is purchased from the CDE. A taxpayer holding a 
qualified investment would be entitled to a credit on each 
anniversary date (for five years) of the original investment 
with the CDE. The taxpayer's basis in the investment would be 
reduced by the amount of the credit. The credit would be 
subject to the general business credit rules.
    A ``qualified investment'' refers to an equity interest 
acquired directly from a CDE in exchange for cash.\66\ The 
equity interest must not be redeemed (or otherwise cashed out) 
by the CDE for at least five years. Substantially all of the 
investment proceeds must be used by the CDE to make ``qualified 
low-income community investments,'' meaning equity investments 
in, or loans to, qualified active businesses located in low-
income communities.\67\ Qualified low-income community 
investments could be made directly by a CDE, or could be made 
indirectly through another CDE.\68\
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    \66\ To ensure that credits are available only for new equity 
investments in CDEs, the term ``qualified investment'' would not 
include any stock or other equity interest acquired from a CDE which 
made a substantial stock redemption or distribution (without a bona 
fide business purpose therefor) in an attempt to avoid the purposes of 
the proposal.
    \67\ If at least 85 percent of the aggregate gross assets of the 
CDE are invested (directly or indirectly) in equity interests in, or 
loans to, qualified active businesses located in low-income 
communities, then there would be no need to trace the use of the 
proceeds from the particular stock (or other equity ownership) issuance 
with respect to which the credit is claimed.
    \68\ A CDE would be treated as indirectly making ``qualified low-
income community investment'' when it purchases loans previously made 
by another CDE which, in turn, uses the proceeds to provide additional 
capital to qualified active businesses located in low-income 
communities.
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    A CDE would include (but would not be limited to) Community 
Development Financial Institutions, Community Development 
Corporations, Small Business Investment Corporations-LMIs, New 
Market Venture Capital Firms, America's Private Investment 
Corporations, or other investment funds (including for-profit 
subsidiaries of nonprofit organizations). To be selected for a 
credit allocation, the CDE's primary mission must be serving or 
providing investment capital for low-income communities or low-
income persons. The CDE also must maintain accountability to 
residents of low-income communities (through representation on 
governing or advisory boards, or otherwise), and at least 60 
percent of its gross assets must be invested in ``qualified 
low-income community investments'' or residential property 
located in low-income communities.\69\
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    \69\ Expenditures made by a CDE to provide financial counseling and 
certain other services to businesses located in, and residents of, low-
income communities would also be treated as ``qualified low-income 
community investment.''
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    As part of the credit allocation process, the Treasury 
Department would certify entities as eligible CDEs. Certified 
entities would be required to file annual reports demonstrating 
that they continue to meet the requirements for initial 
certification, and would be required to identify the amount 
(and purchasers) of equity interests with respect to which 
allocated credits may be claimed by the purchaser and to 
demonstrate that the entity monitors its investments to ensure 
that capital is used in low-income communities. If an entity 
fails to be a CDE during the five-year period following the 
taxpayer's purchase of an equity interest in the entity, or if 
the equity interest is redeemed by the issuing entity during 
that five-year period, then any credits claimed with respect to 
the equity interest would be recaptured and no further credits 
would be allowed.
    A ``low-income community'' would be defined as census 
tracts with either (1) poverty rates of at least 20 percent 
(based on the most recent census data), or (2) median family 
income which does not exceed 80 percent of metropolitan area 
income (or for a non-metropolitan census tract, 80 percent of 
non-metropolitan statewide median family income). A ``qualified 
active business'' generally would be defined as a business \70\ 
which satisfies the requirements of an ``enterprise zone 
business'' as defined in sec. 1397B(a) except that there is no 
requirement that the employees of the business be residents of 
the low-income community. Rental of improved commercial real 
estate located in a low-income community (e.g., an office 
building or shopping mall) would be a qualified active 
business, regardless of the characteristics of the commercial 
tenants of the property. In addition, a qualified active 
business that receives a loan from a CDE could include an 
organization that is organized and operated on a non-profit 
basis. The purchase and holding of unimproved real estate would 
not be a qualified active business. In addition, a qualified 
active business would not include (a) any business consisting 
predominantly of the development or holding of intangibles for 
sale or license; (b) operation of any facility described in 
sec. 144(c)(6)(B); or (c) any business if a significant equity 
interest in such business is held by a person who also holds a 
significant equity interest in the CDE.
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    \70\ As under current-law section 1394(b)(3)(D), the term 
``qualified active business'' would include any trade or business which 
would qualify as such a business if the trade or business were 
separately incorporated.
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    The Treasury Department would be granted authority to 
prescribe such regulations as may be necessary or appropriate 
to carry out the purposes of the proposal, including 
regulations limiting the benefit of the proposed tax credit in 
circumstances where investments are directly or indirectly 
being subsidized by other Federal programs (e.g., low-income 
housing credit and tax-exempt bonds), and regulations 
preventing abuse of the credit through the use of related 
parties. The Treasury Department would issue regulations 
describing the certification process for community development 
entities, annual reporting requirements for such entities, and 
application of the low-income community investment requirements 
to start-up entities.

                             Effective Date

    The proposal would be effective for qualified investments 
made after December 31, 1999.

                              Prior Action

    No prior action.

                                Analysis

    The Administration proposal would create a new incentive 
for taxpayers that make capital available for use in inner 
cities and isolated rural communities, in the form of a 
guaranteed return on an equity investment. Generally, a non-
preferred equity investment carries few or no guarantees of 
return. The incentive provided under the Administration 
proposal is a guarantee of a 6-percent return annually for five 
years (in the form of a tax credit). Hence, for taxpayers who 
can claim the new markets tax credit, their equity investment 
in the CDE is similar to owning preferred stock in the CDE 
which converts to common stock after five years, except that 
the preferred dividend (the tax credit) is guaranteed by the 
Federal government rather than backed by the revenue of the 
CDE. By guaranteeing a return, the proposal both reduces the 
aggregate return the CDE must hope to earn in order to attract 
investors to the CDE and reduces the risk of an investment in a 
CDE. Thus, the proposal should reduce the cost of raising 
capital to the CDE. The proposal requires the CDE to use the 
new capital to make equity investments or loans to certain 
qualified low-income investments.
    There may be a loss of efficiency from funneling a tax 
benefit to qualified low-income community businesses through 
CDEs. If the pool of potential qualifying investments is large 
relative to the pool of CDE funds, the competing businesses 
would bid up the returns they promise the CDE and, thereby, the 
tax benefit would remain with the CDE rather than the 
businesses. On the other hand, if the pool of potential 
qualifying investments is small relative to the pool of CDE 
funds, the CDEs would compete among themselves for qualifying 
investments and the businesses would receive the benefits of a 
lower cost of capital.
    Proponents would argue that capital markets are not fully 
efficient. In particular, a bias may exist against funding 
business ventures in low-income communities, with investors 
demanding a higher rate of return on such ventures than the 
proponents believe is justified by market conditions. The 
proposal attempts to influence investment decisions by 
increasing the net, after-tax, return to qualified low-income 
investments compared to other investments in order to reverse 
the effects of this bias. By reducing the cost of capital, the 
proposal could make location in a qualifying low-income 
community profitable.
    Opponents would argue that a higher cost of capital \71\ 
does not imply that markets are inefficient. The cost of 
capital reflects investors' perceptions of risk. Where a 
business locates may increase the probability of its failure 
and thereby increase its cost of capital. Artificially 
diverting investment funds in one direction results in certain 
investments that offer a lower rate of return being funded in 
lieu of other investments that offer a higher rate of return. 
Moreover, the proposal does not limit the CDE's investments to 
those investments that otherwise have a higher cost of capital. 
Loans to a Fortune 500 company would be permissible under the 
proposal.
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    \71\ A higher cost of capital may take the form of higher interest 
rates charged on business loans or a larger percentage of equity 
ownership per dollar invested.
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    Proponents would argue that, even if the higher cost of 
capital to such businesses is not the result of inefficiency of 
the capital market, an important social goal can be achieved by 
helping target investment to low-income communities. Opponents 
would argue that this objective could be addressed through 
existing programs, such as the community development 
corporations, the empowerment zones and enterprise communities, 
and by requirements of the Community Reinvestment Act and other 
similar legislation.\72\ The objective also is addressed, in 
part, by the SBA's subsidized loan program and present-law Code 
sections 1045 and 1202.\73\ They also would question whether 
the proposal is the most efficient means of achieving this 
objective. It will take time and resources to implement this 
proposal. By contrast, the SBA already has programs in place 
that are designed to achieve similar objectives.
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    \72\ The proposal does not specify any rule for coordination of tax 
benefits under the new markets tax credit with empowerment zone tax 
benefits, nor does it specify coordination with any appropriated funds 
that the taxpayer may receive as a result of undertaking a qualified 
investment.
    \73\ Small Business Investment Companies (``SBIC'') are similar in 
structure to the proposed CDEs. An SBIC receives a reduction in its 
cost of capital from the Federal government through loans from the SBA. 
The SBIC, in turn, uses this capital to make equity and debt 
investments in qualified enterprises.
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    The proposal is expected to result in the imposition of new 
recordkeeping and other administrative burdens on CDEs. Each 
CDE presumably would have to establish extensive procedures by 
which it evaluates, selects and monitors the businesses and 
residential properties in which it invests (and with its 
community accountability requirements) on an ongoing basis to 
ensure its continued qualification as a CDE. For example, a CDE 
that makes a loan to a qualified active business in the low-
income community would need to verify that the business 
satisfies the requirements of a ``qualified active business'' 
throughout the term of the loan. Each CDE also would need to 
develop a process by which it allocates the tax credit to 
investors, and keep sufficient records concerning its investors 
(and former investors) in the event it fails to maintain its 
CDE status (which would result in a recapture of any credits 
claimed by investors within the previous five years). The CDEs 
also would have additional reporting requirements for the 
Internal Revenue Service.
    The proposal provides that the Treasury Department allocate 
the tax credits among CDEs.\74\ In the absence of legislative 
criteria providing qualifications for the allocation of the 
credits among CDEs, some might question whether the proposal 
raises concerns regarding the delegation of such taxing power 
by the Congress to the Executive Branch.
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    \74\ The proposal is silent as to how the Treasury Department is 
expected to allocate the credits among the CDEs.
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4. Specialized small business investment companies

                              Present Law

    Under present law, a taxpayer may elect to roll over 
without payment of tax any capital gain realized upon the sale 
of publicly-traded securities where the taxpayer uses the 
proceeds from the sale to purchase common stock in a 
specialized small business investment company (``SSBIC'') 
within 60 days of the sale of the securities. The maximum 
amount of gain that an individual may roll over under this 
provision for a taxable year is limited to the lesser of (1) 
$50,000 or (2) $500,000 reduced by any gain previously excluded 
under this provision. For corporations, these limits are 
$250,000 and $1 million.
    In addition, under present law, an individual may exclude 
50 percent of the gain \75\ from the sale of qualifying small 
business stock held more than five years. An SSBIC is 
automatically deemed to satisfy the active business requirement 
which a corporation must satisfy to qualify its stock for the 
exclusion.
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    \75\ The portion of the capital gain included in income is subject 
to a maximum regular tax rate of 28 percent, and 42 percent of the 
excluded gain is a minimum tax preference.
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    Regulated investment companies (``RICs'') are entitled to 
deduct dividends paid to shareholders. To qualify for the 
deduction, 90 percent of the company's income must be derived 
from dividends, interest and other specified passive income, 
the company must distribute 90 percent of its investment 
income, and at least 50 percent of the value of its assets must 
be invested in certain diversified investments.
    For purposes of these provisions, an SSBIC means any 
partnership or corporation that is licensed by the Small 
Business Administration under section 301(d) of the Small 
Business Investment Act of 1958 (as in effect on May 13, 1993). 
SSBICs make long-term loans to, or equity investments in, small 
businesses owned by persons who are socially or economically 
disadvantaged.

                        Description of Proposal

    Under the proposal, the tax-free rollover provision would 
be expanded by (1) extending the 60-day period to 180 days, (2) 
making preferred stock (as well as common stock) in an SSBIC an 
eligible investment, and (3) increasing the lifetime caps to 
$750,000 in the case of an individual and to $2 million in the 
case of a corporation, and repealing the annual caps.
    The proposal also would provide that an SSBIC that is 
organized as a corporation may convert to a partnership without 
imposition of a tax to either the corporation or its 
shareholders, by transferring its assets to a partnership in 
which it holds at least an 80-percent interest and then 
liquidating. The corporation would be required to distribute 
all its earnings and profits before liquidating. The 
transaction must take place within 180 days of enactment of the 
proposal. The partnership would be liable for a tax on any 
``built-in'' gain in the assets transferred by the corporation 
at the time of the conversion.
    The 50-percent exclusion for gain on the sale of qualifying 
small business stock would be increased to 60 percent where the 
taxpayer, or a pass-through entity in which the taxpayer holds 
an interest, sells qualifying stock of an SSBIC.
    For purposes of determining status as a RIC eligible for 
the dividends received deduction, the proposal would treat 
income derived by a SSBIC from its limited partner interest in 
a partnership whose business operations the SSBIC does not 
actively manage as income qualifying for the 90-percent test; 
would deem the SSBIC to satisfy the 90-percent distribution 
requirement if it distributes all its income that it is 
permitted to distribute under the Small Business Investment Act 
of 1958; and would deem the RIC diversification of assets 
requirement to be met to the extent the SSBIC's investments are 
permitted under that Act.

                             Effective Date

    The rollover and small business stock provisions of the 
proposal would be effective for sales after date of enactment. 
The RIC provisions would be effective for taxable years 
beginning on or after date of enactment.

                              Prior Action

    A similar proposal was included in the President's fiscal 
year 1999 budget proposal.

                                Analysis

    The proposal would make investments in SSBICs more 
attractive by providing tax advantages of deferral and lower 
capital gains taxes. Present law, and the proposal, attempt to 
distort taxpayer investment decisions by increasing the net, 
after-tax, return to investments in SSBICs compared to other 
assets. Economists argue that distortions in capital markets 
lead to reduced economic growth. In an efficient capital 
market, market values indicate sectors of the economy where 
investment funds are most needed. Artificially diverting 
investment funds in one direction or another results in certain 
investments that offer a lower rate of return being funded in 
lieu of certain other investments that offer a higher rate of 
return. The net outcome is a reduction in national income below 
that which would otherwise be achieved. Proponents of the 
proposal argue that capital markets are not fully efficient. In 
particular, they argue that a bias exists against funding 
business ventures undertaken by persons who are socially or 
economically disadvantaged.
    Generally, the cost of capital is greater for small 
businesses than for larger businesses. That is, investors 
demand a greater rate of return on their investment in smaller 
businesses than in larger businesses. The higher cost of 
capital may take the form of higher interest rates charged on 
business loans or a larger percentage of equity ownership per 
dollar invested. A higher cost of capital does not imply that 
capital markets are inefficient. The cost of capital reflects 
investors' perceptions of risk and the higher failure rates 
among small business ventures. There has been little study of 
whether the cost of capital to small businesses, regardless of 
the economic or social background of the entrepreneur, is ``too 
high'' when the risk of business failure is taken into account.
    Proponents of the proposal argue that, even if the higher 
cost of capital to such businesses is not the result of 
inefficiency of the capital market, an important social goal 
can be achieved by helping more persons who are socially or 
economically disadvantaged gain entrepreneurial experience. 
Opponents observe that, under present law, that objective is 
addressed by the Small Business Administration's subsidized 
loan program and present-law Code sections 1045 and 1202. They 
note that the proposal would not lower the cost of capital for 
all small businesses or for all small businesses organized by 
persons who are socially or economically disadvantaged, only 
those businesses that receive some of their financing through 
an SSBIC. Other investors do not receive these tax benefits 
even if they make substantial investments in business ventures 
organized by persons who are socially or economically 
disadvantaged. They argue there is a loss of efficiency from 
funneling a tax benefit to entrepreneurs through only one type 
of investment fund pool. In the near term, some of the tax 
benefit may accrue to current owners of SSBICs rather than to 
entrepreneurs as taxpayers seeking to take advantage of the 
proposal bid up the price of shares of existing SSBICs. 
Proponents note that over the longer term, as more funds flow 
into SSBICs and as new SSBICs are formed, there will be a 
larger pool of funds available to qualified entrepreneurs and 
those entrepreneurs will receive the benefits of a lower cost 
of capital.

5. Extend wage credit for two new empowerment zones

                              Present Law

    Pursuant to the Omnibus Budget Reconciliation Act of 1993 
(``OBRA 1993''), the Secretaries of the Department of Housing 
and Urban Development and the Department of Agriculture 
designated a total of nine empowerment zones and 95 enterprise 
communities on December 21, 1994. Of the nine empowerment 
zones, six are located in urban areas and three are located in 
rural areas.\76\
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    \76\ The six urban empowerment zones are located in New York City, 
Chicago, Atlanta, Detroit, Baltimore, and Philadelphia-Camden (New 
Jersey). The three rural empowerment zones are located in the Kentucky 
Highlands (Clinton, Jackson and Wayne counties, Kentucky), Mid-Delta 
Mississippi (Bolivar, Holmes, Humphreys, Leflore counties, 
Mississippi), and Rio Grande Valley Texas (Cameron, Hidalgo, Starr, and 
Willacy counties, Texas).
---------------------------------------------------------------------------
    In general, businesses located in these empowerment zones 
qualify for the following tax incentives: (1) a 20-percent wage 
credit for the first $15,000 of wages paid to a zone resident 
who works in the empowerment zone (the ``wage credit'');\77\ an 
additional $20,000 of section 179 expensing for ``qualified 
zone property'' placed in service by an ``enterprise zone 
business''; and (3) special tax-exempt financing for certain 
zone facilities. Businesses located in enterprise communities 
are eligible for the special tax-exempt financing benefits but 
not the other tax incentives available in the empowerment 
zones. The tax incentives for empowerment zones and enterprise 
communities generally remain in effect 10 years.
---------------------------------------------------------------------------
    \77\ For wages paid in calendar years during the period 1994 
through 2001, the credit rate is 20 percent. The credit rate is reduced 
to 15 percent for calendar year 2002, 10 percent for calendar year 
2003, and 5 percent for calendar year 2004. No wage credit is available 
after 2004.
---------------------------------------------------------------------------
    The Taxpayer Relief Act of 1997 (``1997 Act'') authorized 
the designation of two additional urban empowerment zones (the 
``new urban empowerment zones''),\78\ and the designation of 20 
additional empowerment zones. The new urban empowerment zones, 
whose designations take effect on January 1, 2000, are eligible 
for substantially the same tax incentives as the nine 
empowerment zones authorized by OBRA 1993 except that the wage 
credit is phased down beginning in 2005 and expires after 2007. 
Thus, the wage credit rate for the two urban empowerment zones 
is 20 percent during the period 2000 to 2004, 15 percent for 
calendar year 2005, 10 percent for calendar year 2006, and 5 
percent for calendar year 2007. Businesses in the 20 additional 
empowerment zones are not eligible for the wage credit (but are 
eligible to receive up to $20,000 of additional section 179 
expensing and to utilize the special tax-exempt financing 
benefits).
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    \78\ The new urban empowerment zones are located in Los Angeles, 
California and Cleveland, Ohio.
---------------------------------------------------------------------------

                        Description of Proposal

    The proposal would provide that the wage credit for the new 
urban empowerment zones would remain in effect for a 10-year 
period. The wage credit would be phased down using the same 
percentages that apply to the empowerment zones designated 
under OBRA 1993. Thus, the wage credit rate for the new urban 
empowerment zones would be 20 percent during the period 2000 to 
2006, 15 percent for calendar year 2007, 10 percent for 
calendar year 2008, and 5 percent for calendar year 2009.

                             Effective Date

    The proposal would be effective as of January 1, 2000.

                              Prior Action

    No prior action.

                                Analysis

    The proposal would equalize the period during which the 
wage credit is available for businesses in the new urban 
empowerment zones with the other tax benefits (i.e., the 
additional section 179 expensing and special tax-exempt 
financing for certain zone facilities). Equalizing the period 
during which the wage credit is available with the period 
during which the other tax benefits are available may be 
appropriate if the tax benefits are viewed as mutually 
interdependent to entice economic development to the new urban 
empowerment zones. The proposal also would have the effect of 
providing the new urban empowerment zones with the same length 
of wage credit benefit as the nine original empowerment zones.
    Currently, the effect of the wage credit and the other 
empowerment zone tax benefits is unclear. According to a June 
1998 report by the General Accounting Office (GAO), the IRS did 
not have sufficient reliable data on the use of the wage credit 
(nor on the sec. 179 expensing benefit) in the nine original 
empowerment zones to determine how often these incentives were 
used.\79\ The GAO is in the process of collecting additional 
data from businesses within the nine original empowerment zones 
that should help Congress evaluate the effectiveness of the 
wage credit as a stimulus for economic development, as well as 
provide data on businesses' use of other Federal tax incentives 
targeted at these empowerment zones.
---------------------------------------------------------------------------
    \79\ GAO Report, Community Development Information on the Use of 
Empowerment Zone and Enterprise Community Tax Incentives (GAO/RCED-98-
203), June 1998.
---------------------------------------------------------------------------

               E. Energy and Environmental Tax Provisions

1. Tax credit for energy-efficient building equipment

                              Present Law

    No income tax credit is provided currently for investment 
in energy-efficient building equipment.
    A 10-percent energy credit is allowed for the cost of new 
property that is equipment (1) that uses solar energy to 
generate electricity, to heat or cool a structure, or to 
provide solar process heat, or (2) used to produce, distribute, 
or use energy derived from a geothermal deposit, but only, in 
the case of electricity generated by geothermal power, up to 
the electric transmission stage, and which meet performance and 
quality standards prescribed by the Secretary of the Treasury 
(after consultation with the Secretary of the Energy). Public 
utility property does not qualify for the credit (sec. 48(a)).
    A taxpayer may exclude from income the value of any subsidy 
provided by a public utility for the purchase or installation 
of an energy conservation measure. An energy conservation 
measure means any installation or modification primarily 
designed to reduce consumption of electricity or natural gas or 
to improve the management of energy demand with respect to a 
dwelling unit (sec. 136).

                        Description of Proposal

    A credit of either 10 or 20 percent would be provided for 
the purchase of certain types of highly energy-efficient 
building equipment: fuel cells, electric heat pumps, advanced 
natural gas water heaters, natural gas heat pumps, central air 
conditioners, electric heat pump hot water heaters and 
residential size electric heat pumps, and advanced central air 
conditioners. The credit would be nonrefundable and subject to 
the dollar caps as specified. For businesses, it would be 
subject to the limitations on the general business credit and 
would reduce the basis of the equipment.

10-percent credit

    A credit of 10 percent of the purchase price (up to a 
maximum of $250 per unit) would be allowed for the purchase of 
the following building equipment:
    Electric heat pumps (equipment using electrically powered 
vapor compression cycles to extract heat from air in one space 
and deliver it to air in another space) with a heating 
efficiency of at least 9 HSPF (Heating Seasonal Performance 
Factor) and a cooling efficiency of at least 13.5 SEER 
(Seasonal Energy Efficiency Rating).
    Central air conditioners with an efficiency of at least 
13.5 SEER.
    Advanced natural gas water heaters (equipment using a 
variety of mechanisms to increase steady-state efficiency and 
reduce standby and vent losses) with an Energy Factor of at 
least 0.65 in the standard Department of Energy (DOE) test 
procedure.

20-percent credit

    A credit of 20 percent of the purchase price would be 
allowed for the purchase of the following building equipment:
    Fuel cells (equipment using an electrochemical process to 
generate electricity and heat) with an electricity-only 
generation efficiency of at least 35 percent and a minimum 
generating capacity of 5 kilowatts. The maximum credit would be 
$500 per kilowatt of capacity.
    Electric heat pump hot water heaters (equipment using 
electrically powered vapor compression cycles to extract heat 
from air and deliver it to a hot water storage tank) with an 
Energy Factor of at least 1.7 in the standard DOE test 
procedure. The maximum credit would be $500 per unit.
    Electric heat pumps with a heating efficiency of at least 9 
HSPF and a cooling efficiency of at least 15 SEER. The maximum 
credit would be $500 per unit.
    Central air conditioners with an efficiency of at least 15 
SEER. The maximum credit would be $500 per unit.
    Advanced natural gas water heaters with an Energy Factor of 
at least 0.80 in the standard DOE test procedure. The maximum 
credit would be $500 per unit.
    Natural gas heat pumps (equipment using either a gas-
absorption cycle or a gas-driven engine to power the vapor 
compression cycle to extract heat from one source and deliver 
it to another) with a coefficient of performance for heating of 
at least 1.25 and for cooling of at least 0.70. The maximum 
credit would be $1,000 per unit.

                             Effective Date

    The 10-percent credit would be available for final 
purchases from unrelated third parties after December 31, 1999, 
and before January 1, 2002. The 20-percent credit would be 
available for final purchases from unrelated third parties 
after December 31, 1999, and before January 1, 2004.

                              Prior Action

    The proposal is similar to a proposal in the President's 
fiscal year 1999 budget proposal.

2. Tax credit for the purchase of energy-efficient new homes

                              Present Law

    No deductions or credits are provided currently for the 
purchase of energy-efficient new homes.
    A taxpayer may exclude from income the value of any subsidy 
provided by a public utility for the purchase or installation 
of an energy conservation measure. An energy conservation 
measure means any installation or modification primarily 
designed to reduce consumption of electricity or natural gas or 
to improve the management of energy demand with respect to a 
dwelling unit (sec. 136).

                        Description of Proposal

    A tax credit of up to $2,000 would be available to 
purchasers of highly energy-efficient new homes that meet 
energy-efficiency standards for heating, cooling and hot water 
that significantly exceed those of the IECC. A taxpayer may 
claim the credit only if the new home is the taxpayer's 
principal residence and reduces energy use by prescribed 
amounts as compared to the IECC for single family residences. 
The tax credit would be $1,000 for new homes that are at least 
30 percent more energy efficient than the IECC standard, $1,500 
for new homes that are at least 40 percent more energy 
efficient than the IECC standard, and $2,000 for new homes that 
are at least 50 percent more energy efficient than the IECC 
standard.

                             Effective Date

    The $1,000 credit would be available for final homes 
purchased after December 31, 1999, and before January 1, 2002. 
The $1,500 credit would be available for final homes purchased 
after December 31, 1999, and before January 1, 2003. The $2,000 
credit would be available for final homes purchased after 
December 31, 1999, and before January 1, 2005.

                              Prior Action

    The proposal is similar to a proposal in the President's 
fiscal year 1999 budget proposal.

3. Extend tax credit for high fuel-economy vehicles

                              Present Law

    A 10-percent tax credit is provided for the cost of a 
qualified electric vehicle, up to a maximum credit of $4,000 
(sec. 30). A qualified electric vehicle is a motor vehicle that 
is powered primarily by an electric motor drawing current from 
rechargeable batteries, fuel cells, or other portable sources 
of electrical current, the original use of which commences with 
the taxpayer, and that is acquired for the use by the taxpayer 
and not for resale. The full amount of the credit is available 
for purchases prior to 2002. The credit begins to phase down in 
2002 and phases out in 2005.
    Certain costs of qualified clean-fuel vehicle property may 
be expensed and deducted when such property is placed in 
service (sec. 179A). Qualified clean-fuel vehicle property 
includes motor vehicles that use certain clean-burning fuels 
(natural gas, liquefied natural gas, liquefied petroleum gas, 
hydrogen, electricity and any other fuel at least 85 percent of 
which methanol, ethanol, any other alcohol or ether. The 
maximum amount of the deduction is $50,000 for a truck or van 
with a gross vehicle weight over 26,000 pounds or a bus with 
seating capacities of at least 20 adults; $5,000 in the case of 
a truck or van with a gross vehicle weight between 10,000 and 
26,000 pounds; and $2,000 in the case of any other motor 
vehicle. Qualified electric vehicles do not qualify for the 
clean-fuel vehicle deduction. The deduction phases down in the 
years 2002 through 2004.

                        Description of Proposal

    The proposal would extend the present credit for qualified 
electric vehicles and provide temporary tax credits for fuel-
efficient hybrid vehicles:
    (1) Credit for electric vehicles.--The phase down of the 
credit for electric vehicles would be eliminated and the credit 
would be extended through 2006. Thus, the maximum $4,000 credit 
would be available for purchases before 2007.
    (2) Credit for fuel-efficient hybrid vehicles.--The credit 
would be: (a) $1,000 for each vehicle that is one-third more 
fuel efficient than a comparable vehicle in its class; (b) 
$2,000 for each vehicle that is two-thirds more fuel efficient 
than a comparable vehicle in its class; (c) $3,000 for each 
vehicle that is twice as fuel efficient as a comparable vehicle 
in its class; and (d) $4,000 for each vehicle that is three 
times as fuel efficient as a comparable vehicle in its class.
    A qualifying hybrid vehicle would be a vehicle powered by 
onboard fuel which uses regenerative braking and an energy 
storage system that will recover at least 60 percent of the 
energy in a typical 70-0 braking event. A qualifying vehicle 
would have to meet all emission requirements applicable to 
gasoline-powered automobiles.
    These credits would be available for all qualifying light 
vehicles including cars, minivans, sport utility vehicles, and 
light trucks. Taxpayers who claim one of these credits would 
not be able to claim the qualified electric vehicle credit or 
the deduction for clean-fuel vehicle property for the same 
vehicle.

                             Effective Date

    The $1,000 credit would be effective for purchases of 
qualifying vehicles after December 31, 2002 and before January 
1, 2005; the $2,000 credit would be effective for purchases of 
qualifying vehicles after December 31, 2002 and before January 
1, 2007; the $3,000 credit would be effective for purchases of 
qualifying vehicles after December 31, 2003 and before January 
1, 2007; and the $4,000 credit would be effective for purchases 
of qualifying vehicles after December 31, 2003 and before 
January 1, 2007.

                              Prior Action

    The proposal is similar to a proposal in the President's 
fiscal year 1999 budget proposal.

4. Tax credit for combined heat and power (``CHP'') systems

                              Present Law

    Combined heat and power (``CHP'') systems are used to 
produce electricity and process heat and/or mechanical power 
from a single primary energy source. A tax credit is currently 
not available for investments in CHP systems.
    Depreciation allowances for CHP property vary by asset use 
and capacity. Assets employed in the production of electricity 
with rated total capacity in excess of 500 kilowatts, or 
employed in the production of steam with rated total capacity 
in excess of 12,500 pounds per hour, and used by the taxpayer 
in an industrial manufacturing process or plant activity (and 
not ordinarily available for sale to others), have a general 
cost recovery period of 15 years. Electricity or steam 
production assets of lesser rated capacity generally are 
classified with other manufacturing assets and have cost 
recovery periods of 5 to 10 years. Assets used in the steam 
power production of electricity for sale, including combustion 
turbines operated in a combined cycle with a conventional steam 
unit, have a 20-year recovery period. Other turbines and 
engines used to produce electricity for sale have a 15-year 
recovery period. Assets that are structural components of 
buildings have a recovery period of either 39 years (if 
nonresidential) or 27.5 years (if residential). For assets with 
recovery periods of 10 years or less, the 200-percent declining 
balance method may be used to compute depreciation allowances. 
The 150-percent declining balance method may be used for assets 
with recovery periods of 15 or 20 years. The straight-line 
method must be used for buildings and their structural 
components.

                        Description of Proposal

    The proposal would establish an 8-percent investment credit 
for qualified CHP systems with an electrical capacity in excess 
of 50 kilowatts or with a capacity to produce mechanical power 
in excess of 67 horsepower (or an equivalent combination of 
electrical and mechanical energy capacities). CHP property 
would be defined as property comprising a system that uses the 
same energy source for the simultaneous or sequential 
generation of (1) electricity or mechanical shaft power (or 
both) and (2) steam or other forms of useful thermal energy 
(including heating and cooling applications). A qualified CHP 
system would be required to produce at least 20 percent of its 
total useful energy in the form of thermal energy and at least 
20 percent of its total useful energy in the form of electrical 
or mechanical power (or a combination thereof) and would also 
be required to satisfy an energy-efficiency standard. For CHP 
systems with an electrical capacity in excess of 50 megawatts 
(or a mechanical energy capacity in excess of 67,000 
horsepower), the total energy efficiency of the system would 
have to exceed 70 percent. For smaller systems, the total 
energy efficiency would have to exceed 60 percent. For this 
purpose, total energy efficiency would be calculated as the sum 
of the useful electrical, thermal, and mechanical power 
produced by the system at normal operating rates, measured on a 
Btu basis, divided by the lower heating value of the primary 
fuel source for the system supplied. The credit would be 
allowed with respect to qualified CHP property only if its 
eligibility is verified under regulations prescribed by the 
Secretary of the Treasury. The regulations would require 
taxpayers claiming the credit to obtain proper certification by 
qualified engineers that the system meets the energy-efficiency 
and percentage-of-energy tests.
    Investments in qualified CHP assets that are otherwise 
assigned cost recovery periods of less than 15 years would be 
eligible for the credit, provided that the taxpayer elected to 
treat such property as having a 22-year class life. Thus, 
regular tax depreciation allowances would be calculated using a 
15-year recovery period and the 150-percent declining balance 
method.
    The credit would be treated as energy property under the 
investment credit component of the section 38 general business 
credit, and would be subject to the rules and limitations 
governing such property. Thus, only property placed in service 
in the United States would be eligible for the credit, and the 
basis of qualified property would be reduced by the amount of 
the credit. Regulated public utilities claiming the credit 
would be required to use a normalization method of accounting 
with respect to the credit. Taxpayers using the credit for CHP 
equipment would not be entitled to any other tax credit for the 
same equipment.

                             Effective Date

    The credit would apply to investments in CHP equipment 
placed in service after December 31, 1999, but before January 
1, 2003.

                              Prior Action

    The proposal is similar to a proposal in the President's 
fiscal year 1999 budget proposal.

5. Tax credit for rooftop solar equipment

                              Present Law

    Nonrefundable business energy tax credits are allowed for 
10 percent of the cost of qualified solar and geothermal energy 
property (sec. 48(a)). Solar energy property that qualifies for 
the credit includes any equipment that uses solar energy to 
generate electricity, to heat or cool (or provide hot water for 
use in) a structure, or to provide solar process heat.
    The business energy tax credits are components of the 
general business credit (sec. 38(b)(1)). The business energy 
tax credits, when combined with all other components of the 
general business credit, generally may not exceed for any 
taxable year the excess of the taxpayer's net income tax over 
the greater of (1) 25 percent of net regular tax liability 
above $25,000 or (2) the tentative minimum tax. For credits 
arising in taxable years beginning after December 31, 1997, an 
unused general business credit generally may be carried back 
one year and carried forward 20 years (sec. 39).

                        Description of Proposal

    A tax credit would be available for purchasers of rooftop 
photovoltaic systems and solar water heating systems located on 
or adjacent to the building for uses other than heating 
swimming pools. The credit would be equal to 15 percent of 
qualified investment up to a maximum of $1,000 for solar water 
heating systems and $2,000 for rooftop photovoltaic systems. 
This credit would be nonrefundable. For businesses, this credit 
would be subject to the limitations of the general business 
credit. The depreciable basis of the qualified property would 
be reduced by the amount of the credit claimed. Taxpayers would 
have to choose between the proposed credit and the present 
business energy credit for each investment.

                             Effective Date

    The proposal would be effective for equipment placed in 
service after December 31, 1999 and before January 1, 2005 for 
solar water heating systems, and for equipment placed in 
service after December 31, 1999 and before January 1, 2007 for 
rooftop photovoltaic systems.

                              Prior Action

    Other than delaying the effective date for one year, the 
proposal is identical to a proposal in the President's fiscal 
year 1999 budget proposal.

6. Extend wind and biomass tax credit

                              Present Law

    An income tax credit is allowed for the production of 
electricity from either qualified wind energy or qualified 
``closed-loop'' biomass facilities (sec. 45). The credit is 
equal to 1.7 cents (1.5 cents plus adjustments for inflation 
since 1992) per kilowatt hour of electricity produced from 
these qualified sources during the 10-year period after the 
facility is placed in service.
    The credit applies to electricity produced by a qualified 
wind energy facility placed in service after December 31, 1993, 
and before July 1, 1999, and to electricity produced by a 
qualified closed-loop biomass facility placed in service after 
December 31, 1992, and before July 1, 1999. Closed-loop biomass 
is the use of plant matter, where the plants are grown for the 
sole purpose of being used to generate electricity. It does not 
apply to the use of waste materials (including, but not limited 
to, scrap wood, manure, and municipal or agricultural waste). 
It also does not apply to taxpayers who use standing timber to 
produce electricity. In order to claim the credit, a taxpayer 
must own the facility and sell the electricity produced by the 
facility to an unrelated party.
    The credit for electricity produced from wind or closed-
loop biomass is a component of the general business credit 
(sec. 38(b)(1)). This credit, when combined with all other 
components of the general business credit, generally may not 
exceed for any taxable year the excess of the taxpayer's net 
income tax over the greater of (1) 25 percent of net regular 
tax liability above $25,000 or (2) the tentative minimum tax. 
For credits arising in taxable years beginning after December 
31, 1997, an unused general business credit generally may be 
carried back one taxable year and carried forward 20 taxable 
years.

                        Description of Proposal

    The proposal would extend the current credit for 5 years, 
to facilities placed in service before July 1, 2004, and would 
expand eligible biomass sources for facilities placed in 
service before July 1, 2004. In addition, biomass that is co-
fired in coal plants to produce electricity would be eligible 
for the credit at a reduced rate (1.0 cent per kilowatt hour 
adjusted for inflation after 1999) through June 30, 2004. 
Biomass qualifying for the credit would include (in addition to 
closed-loop biomass) any solid, nonhazardous, cellulosic waste 
material, that is segregated from other waste materials, and 
that is derived from the following forest-related resources: 
mill residues, pre-commercial thinnings, slash and brush, but 
not including old growth timber, waste pallets, crates, and 
dunnage, and landscape or right-of-way tree trimmings, and 
biomass derived from agriculture sources, including orchard 
tree crops, vineyard grain, legumes, sugar, and other crop-by-
products or residues. Unsegregated municipal solid waste 
(garbage) would not qualify for the credit.

                             Effective Date

    The proposal would be effective on the date of enactment, 
for facilities placed in service prior to July 1, 2004.

                              Prior Action

    A proposal to extend the current credit for 5 years was 
included in the President's fiscal year 1999 budget proposal. A 
provision to extend this credit for two years (i.e., for 
facilities placed in service before July 1, 2001), was included 
in the Senate version of the Taxpayer Relief Act of 1997, but 
was not included in the final conference agreement. A provision 
to sunset the credit was included in the House version of the 
Balanced Budget Act of 1995.

                         Analysis for Items 1-6

General rationale for tax benefits for energy conservation and 
        pollution abatement

    The general rationale for providing tax benefits to energy 
conservation and pollution abatement is that there exist 
externalities in the consumption or production of certain 
goods. An externality exists when, in the consumption or 
production of a good, there is a difference between the cost or 
benefit to an individual and the cost or benefit to society as 
a whole.\80\ When the social costs of consumption exceed the 
private costs of consumption, a negative externality exists. 
When the social benefits from consumption or production exceed 
private benefits, a positive externality is said to exist. When 
negative externalities exist, there will be over consumption of 
the good causing the negative externality relative to what 
would be socially optimal. When positive externalities exist, 
there will be under consumption or production of the good 
producing the positive externality. The reason for the over 
consumption or under consumption is that private actors will in 
general not take into account the effect of their consumption 
on others, but only weigh their personal cost and benefits in 
their decisions. Thus, they will consume goods up to the point 
where their marginal benefit of more consumption is equal to 
the marginal cost that they face. But from a social 
perspective, consumption should occur up to the point where the 
marginal social cost is equal to the marginal social benefit. 
Only when there are no externalities will the private actions 
lead to the socially optimal level of consumption or 
production, because in this case private costs and benefits 
will be equal to social costs and benefits.
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    \80\ It should be noted that the social cost or benefit includes 
the cost or benefit to the individual actually doing the consuming or 
producing.
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    Pollution is an example of a negative externality, because 
the costs of pollution are borne by society as a whole rather 
than solely by the polluters themselves. In the case of 
pollution, there are two possible government interventions that 
could produce a more socially desirable level of pollution. One 
such approach would be to set a tax on the polluting activity 
that is equal to the social cost of the pollution. Thus, if 
burning a gallon of gasoline results in pollution that 
represents a cost to society as a whole of 20 cents, it would 
be economically efficient to tax gasoline at 20 cents a gallon. 
By so doing, the externality is said to be internalized, 
because now the private polluter faces a private cost equal to 
the social cost, and the socially optimal amount of consumption 
will take place. An alternative approach would be to employ a 
system of payments, such as perhaps tax credits, to essentially 
pay polluters to reduce pollution. If the payments can be set 
in such a way as to yield the right amount of reduction (that 
is, without paying for reduction more than the reduction is 
valued, or failing to pay for a reduction where the payment 
would be less than the value of the pollution reduction), the 
socially desirable level of pollution will result.\81\ The 
basic difference between these two approaches is a question of 
who pays for the pollution reduction. The tax approach suggests 
that the right to clean air is paramount to the right to 
pollute, as polluters would bear the social costs of their 
pollution. The alternative approach suggests that the pollution 
reduction costs should be borne by those who receive the 
benefit of the reduction.
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    \81\ It should be noted that this approach would be unwieldy to 
implement, as it would in general require case by case decisions as to 
the expenditure of funds to reduce pollution, rather than relying on 
market mechanisms once a socially efficient price has been set, as 
through the appropriate tax. Also, it can be difficult to measure 
pollution reduction, as the base from which the reduction is measured 
would necessarily be somewhat arbitrary. As a related matter, a general 
policy of paying for pollution reduction could, in theory, lead to 
threats to pollute in order to extract the payment.
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    In the case of a positive externality, the appropriate 
economic policy would be to impose a negative tax (i.e., a 
credit) on the consumption or production that produces the 
positive externality. By the same logic as above, the 
externality becomes internalized, and the private benefits from 
consumption become equal to the social benefits, leading to the 
socially optimal level of consumption or production.

Targeted investment tax credits

    Five of the President's revenue proposals related to energy 
and the environment are targeted investment tax credits 
designed to encourage investment in certain assets that reduce 
the emissions of gases related to atmospheric warming.\82\ The 
following general analysis of targeted investment tax credits 
is applicable to these proposals.
---------------------------------------------------------------------------
    \82\ Another credit proposal, a production credit for electricity 
produced from wind or biomass, is discussed below.
---------------------------------------------------------------------------
    As a general matter of economic efficiency, tax credits 
designed to influence investment choices should be used only 
when it is acknowledged that market-based pricing signals have 
led to a lower level of investment in a good than would be 
socially optimal. In general, this can occur in a market-based 
economy when private investors do not capture the full value of 
an investment--that is, when there are positive externalities 
to the investment that accrue to third parties who did not bear 
any of the costs of the investments.\83\ For example, if an 
individual or corporation can borrow funds at 10 percent and 
make an investment that will return 15 percent, they will 
generally make that investment. However, if the return were 15 
percent, but only 8 percent of that return went to the 
investor, and 7 percent to third parties, the investment will 
generally not take place, even though the social return (the 
sum of the return to the investor and other parties) would 
indicate that the investment should be made. In such a 
situation, it may be desirable to subsidize the return to the 
investor through tax credits or other mechanisms in order that 
the investor's return is sufficient to cause the socially 
desirable investment to be made. In this example, a credit that 
raised the return to the investor to at least 10 percent would 
be necessary. Even if the cost of the credit led to tax 
increases for the third parties, they would presumably be 
better off since they enjoy a 7-percent return from the 
investment, and the credit would only need to raise the return 
to the investor by 2 percent for him or her to break even. 
Thus, even if the third parties would bear the full cost of the 
credit, they would, on net, enjoy a 5-percent return to the 
investment (7 percent less 2 percent).\84\
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    \83\ Investment in education is often cited as an example where the 
social return may exceed the private return, i.e., there are positive 
externalities.
    \84\ The actual calculation as to whether the credit would improve 
economic efficiency should also consider the economic costs imposed to 
raise the necessary tax revenues to pay for the credit. Unless taxation 
is perfectly efficient (i.e., no distortions are imposed in raising tax 
revenue), the costs to society of raising a dollar in public funds will 
exceed a dollar. For a discussion of this issue, see Charles Ballard, 
John Shoven, and John Whalley, ``General Equilibrium Computations of 
the Marginal Welfare Costs of Taxes in the United States,'' American 
Economic Review, March 1985, pp. 128-38; and Charles Ballard, John 
Shoven, and John Whalley, ``The Total Welfare Cost of the United States 
Tax System: A General Equilibrium Approach,'' National Tax Journal, 
June 1985, pp. 125-40.
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    There are certain aspects of targeted tax credits that 
could impair the efficiency with which they achieve the desired 
goal of reduced atmospheric emissions. By targeting only 
certain investments, other more cost-effective means of 
pollution reduction may be overlooked. Many economists would 
argue that the most efficient means of addressing pollution 
would be through a direct tax on the pollution-causing 
activities, rather than through the indirect approach of 
targeted tax credits for certain technologies. By this 
approach, the establishment of the economically efficient 
prices on pollutants, through taxes, would result in the 
socially optimal level of pollution. This would indirectly lead 
to the adoption of the technologies favored in the President's 
budget, but only if they were in fact the most socially 
efficient technologies. In many cases, however, establishing 
the right prices on pollution-causing activities through taxes 
could be administratively infeasible, and other solutions such 
as targeted credits may be more appropriate.
    A second potential inefficiency of investment tax credits 
is one of budgetary inefficiency, in the sense that their 
budgetary costs could be large relative to the incremental 
investment in the targeted activities. The reason for this is 
that there will generally have been investment in the 
activities eligible for the credit even in the absence of the 
credit. Thus, for example, if investors planned to invest a 
million dollars in an activity before a 10-percent credit, and 
the credit caused the investment to rise $100,000 to $1.1 
million because of the credit, then only $100,000 in additional 
investment can be attributed to the credit. However, all $1.1 
million in investments will be eligible for the 10-percent 
credit, at a budgetary cost of $110,000 (10 percent of 1.1 
million). Thus, only $100,000 in additional investment would be 
undertaken, at a budgetary cost of $110,000. Because there is a 
large aggregate amount of investment undertaken without general 
investment credits, introducing a general credit would 
subsidize much activity that would have taken place anyway.\85\
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    \85\ For a general discussion of the effects of tax policy on 
business fixed investment, see Alan Auerbach and Kevin Hassett, ``Tax 
Policy and Business Fixed Investment in the United States,'' Journal of 
Public Economics, Vol. 47, No. 2, March 1992.
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    Targeted credits like the President's proposals, on the 
other hand, are likely to be more cost effective, from a budget 
perspective, in achieving the objective of increased 
investment, if only for the reason that a government would 
likely not consider their use if there were already extensive 
investment in a given area.\86\ Thus, investment that would 
take place anyhow is not subsidized, because there presumably 
is not much of such investment taking place. The presumption 
behind the targeted tax credits in the President's budget 
proposals is that there is not sufficient investment in the 
targeted areas because the alternative and more emissions-
producing investments are less costly to the investor. Hence, a 
tax credit would be necessary to reduce costs and encourage 
investment in the favored activity.
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    \86\ For example, there would be no need for a targeted tax credit 
for construction of coffee shops, as most would agree that the 
operation of the free market leads to a sufficient number of coffee 
shops.
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    A final limitation on the efficiency of the proposed 
credits is their restricted availability. The proposed tax 
credits come with several limitations beyond their stipulated 
dollar limitation. Specifically, they are all nonrefundable and 
cannot offset tax liability determined under the AMT. Certain 
of the proposals, such as the credit for rooftop solar 
equipment and the credits for certain energy-efficient building 
equipment, have a cap on the dollar amount of the credit, and 
thus after the cap is reached the marginal cost of further 
investment becomes equal to the market price again, which is 
presumed to be inefficient.\87\ The impact of these limitations 
is to make the credit less valuable to those without sufficient 
tax liability to claim the full credit, for those subject to 
the AMT, or those who have reached any cap on the credit. Given 
the arguments outlined above as to the rationale for targeted 
tax credits, it is not economically efficient to limit their 
availability based on the tax status of a possible user of the 
credit. It can be argued that, if such social benefits exist 
and are best achieved through the tax system, the credit should 
be both refundable and available to AMT taxpayers. Some would 
argue that making the credits refundable may introduce 
compliance problems that would exceed the benefits from 
encouraging the targeted activities for the populations lacking 
sufficient tax liability to make use of the credit. With 
respect to the AMT, the rationale for the limitation is to 
protect the objective of the AMT, which is to insure that all 
taxpayers pay a minimum (determined by the AMT) amount of tax. 
Two differing policy goals thus come in conflict in this 
instance. Similarly, caps on the aggregate amount of a credit 
that a taxpayer may claim are presumably designed to limit the 
credit's use out of some sense of fairness, but again, this 
conflicts with the goal of pollution reduction.
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    \87\ The cap on the credit for rooftop solar equipment is a per-
taxpayer cap. The cap for the energy efficient building equipment is a 
per-unit cap, which could encourage an economically inefficient 
proliferation of units, rather than use of a single larger unit, in 
order to take advantage of the credits.
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    A justification for targeted tax credits that has been 
offered with respect to some pollution abatement activities, 
such as home improvements that would produce energy savings 
(installation of energy saving light bulbs or attic insulation, 
for example), is that the investment is economically sound at 
unsubsidized prices, but that homeowners or business owners are 
unaware of the high returns to the investments.\88\ The 
argument for targeted tax credits in this case is that they are 
needed to raise the awareness of the homeowner, or to lower the 
price sufficiently to convince the homeowner that the 
investment is worthwhile, even though the investment is in 
their interest even without the subsidy. These arguments have 
been called into question recently on the grounds that the 
returns to the investments have been overstated by 
manufacturers, or are achievable only under ideal 
circumstances. This view holds that the returns to these 
investments are not dissimilar to other investments of similar 
risk profile, and that homeowners have not been economically 
irrational in their willingness to undertake certain energy 
saving investments.\89\ Of course, to the extent that there are 
negative externalities from the private energy consumption, 
these households, though making rational private choices, will 
not make the most socially beneficial choices without some form 
of subsidy.
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    \88\ See Jerry A. Hausman, ``Individual Discount Rates and the 
Purchase and Utilization of Energy-Using Durables,'' Bell Journal of 
Economics and Management Science, vol. 10, Spring 1979. Hausman's study 
concluded that the mean household discount rate for evaluating the 
purchase of a more efficient room air conditioner was between 15 and 25 
percent in 1975 to 1976. These discount rates generally exceeded 
consumer loan rates at that time. In addition, information about the 
relative efficiency of different models was available. During this time 
period, room air conditioners carried information tags reporting the 
energy efficiency and expected operating costs of various models.
    \89\ See Gilbert Metcalf and Kevin Hassett, ``Measuring the Energy 
Savings from Home Improvement Investments: Evidence from Monthly 
Billing Data'', Working paper No. 6074, National Bureau of Economic 
Research, June 1997.
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    A final justification offered for targeted tax credits in 
some instances is to ``jump start'' demand in certain infant 
industries in the hopes that over time the price of such goods 
will fall as the rewards from competition and scale economies 
in production are reaped. However, there is no guarantee that 
the infant industry would ultimately become viable without 
continued subsidies. This argument is often offered for 
production of electric cars--that if the demand is sufficient 
the production costs will fall enough to make them ultimately 
viable without subsidies. This justification is consistent with 
the current proposals in that the credits are available only 
for a limited period of time.

Production credit for wind and biomass

    The wind and biomass tax credit is different from the other 
tax credits in that the credit amount is based on production, 
rather than on investment. Some argue that a production credit 
provides for a stream of tax benefits, rather than an up-front 
lump sum, and that the stream of benefits can help provide 
financing for investment projects that would use wind or 
biomass facilities. On the other hand, an up-front tax credit 
provides more certainty, as the future production credits could 
possibly be curtailed by future Congresses. In general, 
investors prefer certainty to uncertainty, and thus may 
discount the value of future production credits. Another 
difference between a production credit and an investment credit 
is that the latter provides only a temporary distortion to the 
market--once the investment is made, normal competitive market 
conditions will prevail and the rational firm will only produce 
its end product if it can cover its variable costs. With a 
production credit, a firm may actually profitably produce even 
though it cannot cover its variable costs in the absence of the 
credit. This would generally be considered an economically 
inefficient outcome unless there are positive externalities to 
the production of the good that exceed the value of the 
credit.\90\ If it is presumed that the electricity produced 
from wind or biomass substitutes for electricity produced from 
the burning of fossil fuels, economic efficiency will be 
improved so long as the credit does not have to be set so high 
in order to encourage the alternative production that it 
exceeds the value of the positive externality. On the other 
hand, by making some production of electricity cheaper, it is 
possible that the credit could encourage more electricity 
consumption. On net, however, there would be less electricity 
produced from fossil fuels.
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    \90\ In the present case, the positive externality is thought to be 
pollution abatement. While pollution abatement per se does not occur 
from the production of electricity from wind, the presumption is that, 
indirectly, pollution is abated because less electricity is produced 
from the burning of fossil fuels.
---------------------------------------------------------------------------
    With respect to the expansion of the biomass materials 
eligible for the credit, the basic issues are the same as those 
outlined above for any tax benefit for energy conservation or 
pollution abatement. To justify the credit on economic grounds, 
the positive externalities from the burning of biomass for the 
production of electricity must outweigh the costs of the tax 
subsidy. With respect to the waste materials that are proposed 
to be made eligible for the credit, one positive externality is 
similar to that of wind power production, namely the reduction 
in electricity production from the more environmentally 
damaging coal. Another consideration with the waste products is 
whether their current disposal is harmful to the environment. 
If so, an additional positive externality may exist from 
discouraging such disposal. If the disposal is harmful to the 
environment and is a partial justification for the credit, then 
ideally the credit amount should vary for each biomass waste 
product if their present disposal varies in its harm to the 
environment. A single credit rate would be justified if the 
negative externalities are of a similar magnitude, or if 
administrative considerations would make multiple credit rates 
problematic.
    With respect to the special credit rate for biomass that is 
co-fired in coal plants, it is unclear why the rate should be 
lower. A possible rationale is that a higher rate is necessary 
for facilities that plan to exclusively burn biomass in order 
that more of such facilities get built. However, if the primary 
rationale for the credit is that biomass of a given Btu content 
substitutes for a given amount of coal that would otherwise be 
burned, then it would appear that coal plants should be given 
the same incentives to reduce coal burning as are facilities 
that exclusively burn biomass.

                    F. Retirement Savings Provisions

1. IRA contributions through payroll deduction

                              Present Law

    Under present law, an employer may establish a payroll 
deduction program to help employees save for retirement through 
individual retirement arrangements (``IRAs''). Under a payroll 
deduction program, an employee may contribute to an IRA by 
electing to have the employer withhold amounts from the 
employee's paycheck and forward them to the employee's IRA. 
Payroll deduction contributions are included in the employee's 
wages for the taxable year but the employee may deduct the 
contributions on the employee's tax return, subject to the 
normal IRA deduction limits.
    The legislative history of the Taxpayer Relief Act of 1997 
provides that employers that choose not to sponsor a retirement 
plan should be encouraged to set up a payroll deduction system 
to help employees save for retirement by making payroll 
deduction contributions to their IRAs. The Secretary of 
Treasury is encouraged to continue his efforts to publicize the 
availability of these payroll deduction IRAs.
    Under present law, an IRA payroll deduction program may be 
exempt from the provisions of Title I of the Employee 
Retirement Income Security Act of 1974, as amended (``ERISA''), 
which include reporting and disclosure and fiduciary 
requirements. In general, ERISA regulations provide an 
exception from the provisions of Title I of ERISA for an IRA 
payroll deduction program in which no contributions are made by 
the employer, participation is completely voluntary for 
employees, the employer does not endorse any part of the 
program (but may publicize the program, collect contributions, 
and remit them), and the employer receives no form of 
consideration other than reasonable compensation for services 
actually rendered in connection with payroll deductions. A 
payroll deduction program may be subject to Title I of ERISA 
if, for example, an employer makes contributions to the program 
or an employer receives more than reasonable compensation for 
services rendered in connection with payroll deductions.

                        Description of Proposal

    Under the proposal, contributions of up to $2,000 made to 
an IRA through payroll deduction generally would be excluded 
from an employee's income and, accordingly, would not be 
reported as income on the employee's Form W-2. However, the 
amounts would be subject to employment taxes (FICA and FUTA), 
and would be reported as a contributions to an IRA on the 
employee's W-2. If the full amount of the payroll deduction IRA 
contributions would not have been deductible had the employee 
contributed directly to an IRA, the employee would be required 
to include the amount that would not have been deductible in 
income.

                             Effective Date

    The proposal would be effective for taxable years beginning 
after December 31, 1999.

                              Prior Action

    A similar proposal was included in the President's fiscal 
year 1999 budget proposal.

                                Analysis

    The proposal is intended to encourage employers to offer 
payroll deduction programs to their employees and encourage 
employees to save for retirement. While present law permits 
such payroll deduction programs, the proposal is designed to 
make them more attractive (and more widely utilized) by 
providing employees with a convenient way to obtain the tax 
benefits for IRA contributions that will eliminate the need for 
some employees to report IRA contributions on their tax 
returns.
    It is not clear whether the proposal would have the desired 
effect. Increased IRA participation may not result because 
there is no change in the economic incentive to make IRA 
contributions (that is, the proposal would not change the 
present-law tax benefits of making IRA contributions). On the 
other hand, by increasing the convenience of making 
contributions, some taxpayers may participate who would not 
otherwise participate and more taxpayers may begin to save on a 
regular basis. Oppositely, some analysts have noted that under 
present law many IRA contributions are not made until 
immediately prior to the date the taxpayer files his or her tax 
return. Such taxpayers may not be motivated by the long-term 
economic benefits of an IRA, but rather by a short-term desire 
to affect the immediate consequence of tax filing. The proposal 
may or may not affect the psychology of such taxpayers.
    For the proposal to be effective, employers must create 
payroll deduction programs. In order to do so, employers may 
have to revise current payroll systems. Employers may not be 
willing to incur the costs of establishing and maintaining a 
payroll deduction program. The proposal does not create a 
direct economic incentive for employers to incur such costs. On 
the other hand, if employees find the payroll deduction program 
attractive and know such payroll options are available 
elsewhere, employers may find it to their benefit to extend 
this payroll deduction option to their employees. In addition, 
some employers may already have the systems capability to make 
payroll deduction contributions, for example, if the employer 
has a section 401(k) plan.
    The exclusion provided by the proposal may be confusing for 
some employees who may mistakenly believe they are entitled to 
the exclusion when they are not because of the IRA deduction 
income phase-out rules. In addition, some employees could 
mistakenly claim both the exclusion and the deduction on their 
return.

2. Small business tax credit for new retirement plan expenses

                              Present Law

    Under present law, the costs incurred by an employer 
related to the establishment and maintenance of a retirement 
plan (e.g., payroll system changes, investment vehicle set-up 
fees, consulting fees, etc.) generally are deductible by the 
employer as an ordinary and necessary expense in carrying on a 
trade or business.

                        Description of Proposal

    The proposal would provide a three-year tax credit, in lieu 
of a deduction, for 50 percent of the administrative and 
retirement-education expenses for any small business that 
adopts a new qualified defined benefit or defined contribution 
plan (including a section 401(k) plan), SIMPLE plan, simplified 
employee pension (``SEP''), or payroll deduction IRA 
arrangement. The credit would apply to 50 percent of the first 
$2,000 in administrative and retirement-education expenses for 
the plan or arrangement for the first year of the plan or 
arrangement and 50 percent of the first $1,000 of 
administrative and retirement-education expenses for each of 
the second and third years.
    The credit would be available to employers that did not 
employ, in the preceding year, more than 100 employees with 
compensation in excess of $5,000, but only if the employer did 
not have a retirement plan or payroll deduction IRA arrangement 
during any part of 1997. In order for an employer to be 
eligible for the credit, the plan would have to cover at least 
two individuals. In addition, if the credit is for the cost of 
a payroll deduction IRA arrangement, the arrangement would have 
to be made available to all employees of the employer who have 
worked with the employer for at least three months.
    The small business tax credit would be treated as a general 
business credit and the standard carry forward and backward 
rules would apply.

                             Effective Date

    The credit would be effective beginning in the year of 
enactment and would be available only for plans established 
after 1997 and on or before December 31, 2001. For example, if 
an eligible employer adopted a plan in the year 2000, the 
credit would be available for the years 2000, 2001, and 2002.

                              Prior Action

    A similar proposal was included in the President's budget 
proposal for fiscal year 1999.

                                Analysis

    Establishing and maintaining a qualified plan involves 
employer administrative costs both for initial start-up of the 
plan and for on-going operation of the plan. These expenses 
generally are deductible to the employer as a cost of doing 
business. The cost of these expenses to the employer is reduced 
by the tax deduction. Thus, for costs incurred of $C, the net, 
after-tax cost is $C(1-t) where t is the employer's marginal 
tax rate. The employer's tax rate may be either the applicable 
corporate tax rate or individual marginal tax rate, depending 
on the form in which the employer does business (e.g., as a C 
corporation or a sole proprietor). Under the proposal, a 50-
percent credit could be claimed for eligible costs in lieu of 
the deduction. Thus, for qualifying costs, C, the net cost to 
the employer would be C(1-0.5) or (.5)C. The proposal would 
reduce the cost of establishing a plan by the difference 
between the employer's marginal tax rate and 50 percent 
multiplied by up to $2,000 in the first year or by up to $1,000 
in the second or third years. At most the cost reduction would 
be $700 (the difference between the lowest marginal tax rate of 
15 percent and the proposed credit rate of 50 percent 
multiplied by $2,000) in the first year and $350 for the second 
and third years. The additional cost saving under the proposal 
compared to present law could be as little as $208 in the first 
year and $104 in the second and third years for a taxpayer in 
the 39.6-percent marginal income tax bracket.
    By reducing costs, providing a tax credit for the costs 
associated with establishing a retirement plan may promote the 
adoption of such plans by small businesses. On the other hand, 
it is unclear whether the magnitude of the cost saving provided 
by the proposed tax credit will provide sufficient additional 
incentive for small businesses to establish plans. In some 
cases the credit may be inefficient because it may be claimed 
by employers who would have established a plan in any event.

3. Simplified pension plan for small business (``SMART'')

                              Present Law

    Any employer, including a small employer, may adopt a 
qualified plan for its employees. In addition, present law 
contains some special plans designed specifically for small 
employers. Present law provides for a simplified retirement 
plan for small business employers called the savings incentive 
match plan for employees (``SIMPLE'') retirement plan. SIMPLE 
plans are not subject to the nondiscrimination rules applicable 
to qualified plans (including the top-heavy rules). A SIMPLE 
plan can be either an individual retirement arrangement 
(``IRA'') for each employee or part of a qualified cash or 
deferred arrangement (``401(k) plan''). SIMPLE plans can be 
adopted by employers who employ 100 or fewer employees who 
received at least $5,000 in compensation and who do not 
maintain another employer-sponsored retirement plan. Under a 
SIMPLE retirement plan, employees can elect to make pre-tax 
deferrals of up to $6,000 per year. In general, employers are 
required to make either a matching contribution of up to 3 
percent of the employee's compensation or a nonelective 
contribution equal to 2 percent of compensation. In the case of 
a SIMPLE IRA, the employer can elect a lower matching 
contribution percentage if certain requirements are satisfied. 
Employees are 100 percent vested in all contributions made to 
their accounts. A SIMPLE retirement plan cannot be a defined 
benefit plan.
    Alternatively, small business employers may offer their 
employees a simplified employee pension (``SEP''). SEPs are 
employer-sponsored plans under which employer contributions are 
IRAs established by the employees. Contributions under a SEP 
generally must bear a uniform relationship to the compensation 
of each employee covered under the SEP (e.g., each employee 
receives a contribution to the employee's IRA equal to 5 
percent of the employee's compensation for the year).

                        Description of Proposal

In general

    The proposal would create a new simplified tax-qualified 
pension plan for small business employers called the Secure 
Money Annuity or Retirement Trust (``SMART'') Plan. The SMART 
Plan would combine the features of both a defined benefit plan 
and a defined contribution plan. As is the case with other 
qualified retirement plans, contributions to the SMART Plan 
would be excludable from income, earnings would accumulate tax-
free, and distributions would be subject to income tax (unless 
rolled over). SMART plans would not be subject to many of the 
rules generally applicable to qualified plans, including the 
nondiscrimination and top-heavy rules.

Employer and employee eligibility and vesting

    The SMART Plan could be adopted by an employer who (1) 
employed 100 or fewer employees who received at least $5,000 in 
compensation in the prior year, and (2) has not maintained a 
defined benefit pension plan or money purchase pension plan 
within the preceding 5 years.
    All employees who have completed two years of service with 
at least $5,000 in compensation would participate in the SMART 
Plan. An employee's benefit would be 100 percent vested at all 
times.

Benefits and funding

    SMART Plans would provide a fully funded minimum defined 
benefit. Each year the employee participates, the employee 
would earn a minimum annual benefit at retirement equal to 1 
percent or 2 percent of compensation for that year, as elected 
by the employer. For example, if an employee participates for 
25 years in a SMART Plan, and the employer had elected a 2-
percent benefit, and the employee's average salary over the 
entire period was $50,000, the employee would accrue a minimum 
benefit of $25,000 per year at age 65. An employer could elect, 
for each of the first 5 years the SMART Plan is in existence, 
to provide all employees with a benefit equal to 3 percent of 
compensation. The maximum compensation that could be taken into 
account in determining an employee's benefit for a year would 
be $100,000 (indexed for inflation).
    Each year the employer would be required to contribute an 
amount to the SMART Plan on behalf of each participant 
sufficient to provide the annual benefit accrued for that year 
payable at age 65, using specified actuarial assumptions 
(including a 5-percent annual interest rate). Funding would be 
provided either through a SMART Plan individual retirement 
annuity (``SMART Annuity'') or through a trust (``SMART 
Trust''). In the case of a SMART Trust, each employee would 
have an account to which actual investment returns would be 
credited. If a participant's account balance were less than the 
total of past employer contributions credited with 5 percent 
interest per year, the employer would be required to make up 
the shortfall. In addition, the employer would be required to 
contribute an additional amount for the year to make up for any 
shortfall between the balance in the employee's account and the 
purchase price for an annuity paying the minimum guaranteed 
benefit when an employee retires and takes a life annuity. If 
the investment returns exceed the 5-percent assumption, the 
employee would be entitled to the larger account balance. SMART 
Trusts could invest only in readily tradable securities and 
insurance products regulated by state law.
    In the case of a SMART Annuity, each year the employer 
would be required to contribute the amount necessary to 
purchase an annuity that provides the benefit accrual for that 
year on a guaranteed basis.
    The required contributions would be deductible under the 
rules applicable to qualified defined benefit plans. An excise 
tax would apply if the employer failed to make the required 
contributions for a year.

Distributions

    No distributions would be allowed from a SMART Plan prior 
to the employee's attainment of age 65, except in the event of 
death or disability, or if the account balance of a terminated 
employee does not exceed $5,000. However, an employer could 
allow a terminated employee who has not yet attained age 65 to 
directly transfer the individual's account balance from a SMART 
Trust to either a SMART Annuity or a special individual 
retirement account (``SMART Account'') that is subject to the 
same distribution restrictions as the SMART Trust. If a 
terminated employee's account balance did not exceed $5,000, 
the SMART Plan would be allowed to make a cashout of the 
account balance. The employee would be allowed to transfer such 
distribution tax-free to a SMART Annuity, a SMART Account, or a 
regular IRA.
    SMART Plans would be subject to the qualified joint and 
survivor annuity rules that apply to qualified defined benefit 
plans. Lump sum payments also could be made available. In 
addition, an employer could allow the transfer of a terminated 
employee's account balance from SMART Trust to either a SMART 
Annuity or a SMART Account.
    Distributions from SMART Plans would be subject to tax 
under the present-law rules applicable to qualified plans. A 
20-percent additional tax would be imposed for violating the 
pre-age 65 distribution restrictions under a SMART Annuity or 
SMART Account.

PBGC guarantee and premiums

    The minimum guaranteed benefit under the SMART Trust would 
be guaranteed by the Pension Benefit Guarantee Corporation 
(``PBGC''). Reduced PBGC premiums would apply to the SMART 
Trust. Neither the PBGC guarantee, nor PBGC premiums, would 
apply to the SMART Annuity or SMART Account.

Nondiscrimination requirements and benefit limitations

    SMART Plans would not be subject to the nondiscrimination 
or top-heavy rules applicable to qualified retirement plans. 
SMART Plans also would not be subject to the limitations on 
contributions and benefits under qualified plans (sec. 415). 
However, if an employer maintained a SMART Plan, and then 
terminated it and established a qualified defined benefit plan, 
the SMART Plan accruals would be taken into account for 
purposes of the limitations applicable to the defined benefit 
plan.

Other rules

    Other plans maintained by the employer.--An employer that 
maintained a SMART Plan could not maintain additional tax-
qualified plans, other than a SIMPLE plan, a 401(k) plan, or a 
403(b) tax-sheltered annuity plan under which the only 
contributions that are permitted are elective contributions and 
matching contributions that are not greater than those provided 
for under the design-based safe harbor for 401(k) plans.
    Reporting and disclosure.--SMART Plans would be subject to 
simplified reporting requirements.
    Employee contributions.--No employee contributions would be 
permitted to a SMART Plan.
    IRS model.--The IRS would be directed to issue model SMART 
Plan provisions or a model SMART Plan document. Employers would 
not be required to use the IRS models.
    Coordination with IRA deduction rules.--SMART Plans would 
be treated as qualified plans for purposes of the IRA deduction 
phase-out rules. Thus, employees who participated in a SMART 
Plan and had modified adjusted gross income in excess of the 
applicable thresholds would be phased out of making deductible 
IRA contributions. This rule currently applies to SEPs and 
SIMPLE Plans.
    Calendar plan year.--The plan year for all SMART Plans 
would be the calendar year, which would be used in applying 
SMART Plan contribution limits, eligibility, and other 
requirements.

                             Effective Date

    The proposal would be effective for calendar years 
beginning after 1999.

                              Prior Action

    A similar proposal was included in the President's fiscal 
year 1999 budget proposal.\91\
---------------------------------------------------------------------------
    \91\ A similar proposal was included in H.R. 1656 (105th Cong.), 
introduced by Mrs. Johnson and others, and S. 2339 (105th Cong.), 
introduced by Senator Graham, Senator Grassley, and others.
---------------------------------------------------------------------------

                                Analysis

    Under present law, small businesses have many options 
available for providing retirement benefits for their 
employees, including SIMPLE plans and SEPs not available to 
larger employers. Nevertheless, retirement plan coverage is 
lower among smaller employers. There may be a number of reasons 
for such lower coverage. Some believe the retirement plan 
coverage for small business employers continues to be 
inadequate. They argue that the limits on qualified plan 
benefits are not sufficient to induce owners to establish a 
plan because the owners will not be able to receive as high a 
retirement benefit as they would like. Others point out that 
the limits are high enough to allow significant retirement 
benefits (the lesser of $130,000 per year or 100 percent of 
compensation), and that there are other causes for the low 
small employer plan coverage, such as the administrative 
burdens and costs, and the unpredictability of funding 
requirements associated with defined benefit plans that may 
inhibit small business employers from adopting and maintaining 
such plans.
    The SMART Plan provides another option for small businesses 
that does not involve many of the administrative burdens of the 
present-law qualified plan rules. Thus, some small businesses 
who would not otherwise adopt a plan may adopt a SMART Plan, 
leading to increased pension coverage. On the other hand, some 
are concerned that the SMART Plan will primarily benefit the 
owners of a small business, particularly if the plan is adopted 
when the owner is nearing retirement age. For example, suppose 
an owner of a business establishes a SMART Plan when he is age 
60. For each of the next 5 years, the contributions under the 
plan fund a benefit equal to 3 percent of compensation for the 
year, payable at age 65. Because there are only 5 years to fund 
the benefit for the owner, the contributions will be 
significantly larger than for other employees who may have many 
years until retirement. Thus, the SMART Plan in effect allows 
employers to weight contributions by age.
    The proposal may increase complexity by adding another 
option for small businesses. Such businesses may explore all 
available options in an effort to determine which option is 
most favorable for them.

4. Faster vesting of employer matching contributions

                              Present Law

    Under present law, a participant's employer-provided 
benefits under a qualified plan must either be fully vested 
after the participant has completed 5 years of service, or must 
become vested in increments of 20 percent for each year 
beginning after 3 years of service, with full vesting after the 
participant completes 7 years of service. If a plan is a ``top-
heavy plan'', employer contributions either must be fully 
vested after the participant has completed 3 years of service, 
or must become vested in increments of 20 percent for each year 
beginning after 2 years of service, with full vesting after the 
participant completes 6 years of service. Employer matching 
contributions are generally subject to these vesting rules. 
However, employer matching contributions that are used to 
satisfy the special nondiscrimination test under section 401(k) 
must be fully vested immediately.

                        Description of Proposal

    Under the proposal, employer matching contributions would 
be required either to be fully vested after an employee has 
completed 3 years of service, or to become vested in increments 
of 20 percent for each year beginning after the employee has 
completed 2 years of service, with full vesting after the 
employee has completed 6 years of service. Qualified matching 
contributions used to satisfy the 401(k) special 
nondiscrimination test would continue to be fully vested 
immediately, as under present law.

                             Effective Date

    The proposal would be effective for plan years beginning 
after December 31, 1999, with an (unspecified) extended 
effective date for plans maintained pursuant to a collective 
bargaining agreement.

                              Prior Action

    A similar provision was included in the President's fiscal 
year 1999 budget proposal.

                                Analysis

    The popularity and importance of 401(k) plans has grown 
substantially over the years. Employers often choose to 
contribute to 401(k) plans by matching the salary reduction 
contributions made by employees. The general justification for 
accelerating the vesting of employer matching contributions 
focuses on the mobile nature of today's workforce and the 
substantial risk that many participants will leave employment 
before fully vesting in employer matching contributions. 
Shortening the vesting period is consistent with encouraging 
retirement savings, proponents argue.
    Opponents may counter that in some cases accelerating the 
vesting schedule of employer matching contributions may reduce 
overall retirement savings by making plans more expensive for 
some employers. Because matching contributions that are 
forfeited are generally used by employers to reduce the 
contributions of the employer in subsequent years, employers 
may find that the shorter vesting period increases their plan 
costs. This could cause employers to eliminate or reduce the 
matching contribution. Reductions in matching contributions may 
in turn reduce employee participation in 401(k) plans, because 
employer matching contributions are a significant feature of 
plans that for many employees may provide the economic 
incentive to participate in the plan.
    Employers may use vesting schedules that are not immediate 
to promote longer job attachment from employees that may enable 
the employer and employee to reap benefits of job specific 
training the employee may have received when initially employed 
by the employer. Reducing the time to full vesting may cause 
the employer to make changes in other forms of compensation to 
balance any increased costs associated with accelerated 
vesting.

5. Count FMLA leave for retirement plan eligibility and vesting 
        purposes

                              Present Law

    Under the Family and Medical Leave Act (``FMLA''), eligible 
workers are entitled to up to 12 weeks of unpaid leave to care 
for a new child, to care for a family member who has a serious 
health condition, or because the worker has a serious health 
condition. The employer must provide continued medical coverage 
during the unpaid leave. Upon return from leave, the employee 
must be restored to the position or an equivalent position 
(i.e., same benefits, pay, and terms and conditions of 
employment).
    Although the employee must generally be restored to the 
same position, the employer is not required to count the period 
of unpaid leave for purposes of eligibility to participate in a 
qualified retirement plan or plan vesting.

                        Description of Proposal

    Leave taken under the FMLA would be taken into account in 
determining qualified retirement plan eligibility and vesting.

                             Effective Date

    The proposal would be effective for plan years beginning 
after December 31, 1999.

                              Prior Action

    No prior action.

                                Analysis

    Individuals who take FMLA may lose service credit for 
determining plan eligibility or vesting of benefits. The 
proposal may increase the opportunity for workers taking leave 
under the FMLA to become eligible for or vest in retirement 
benefits.
    Counting FMLA service under retirement plans may increase 
employer costs to the extent that workers vest or become 
eligible for plan benefits that might not otherwise do so. If 
the additional costs are significant, then employers may adjust 
plan benefits or other compensation to take into account the 
additional costs.

6. Require joint and 75-percent survivor annuity option for pension 
        plans

                              Present Law

    Defined benefit pension plans and money purchase pension 
plans are required to provide benefits in the form of a 
qualified joint and survivor annuity (``QJSA'') unless the 
participant and his or her spouse consent to another form of 
benefit. A QJSA is an annuity for the life of the participant, 
with a survivor annuity for the life of the spouse which is not 
less than 50 percent (and not more than 100 percent) of the 
amount of the annuity payable during the joint lives of the 
participant and his or her spouse. In the case of a married 
participant who dies before the commencement of retirement 
benefits, the surviving spouse must be provided with a 
qualified preretirement survivor annuity (``QPSA'') which 
provides the surviving spouse with a benefit that is not less 
than the benefit that would have been provided under the 
survivor portion of a QJSA.
    Defined contribution plans other than money purchase 
pension plans are not required to provide a QJSA or QPSA if the 
participant does not elect an annuity as the form of payment 
(or the plan does not offer an annuity) and the surviving 
spouse is the participant's beneficiary (unless the spouse 
consents to designation of another beneficiary).
    The participant and his or her spouse may waive the right 
to a QJSA and QPSA provided certain requirements are satisfied. 
In general, these conditions include providing the participant 
with a written explanation of the terms and conditions of the 
survivor annuity, the right to make, and the effect of, a 
waiver of the annuity, the rights of the spouse to waive the 
survivor annuity, and the right of the participant to revoke 
the waiver. In addition, the spouse must provide a written 
consent to the waiver, witnessed by a plan representative or a 
notary public, which acknowledges the effect of the waiver. 
Similar waiver and election rules apply to the waiver of the 
right of the spouse to be the beneficiary under a defined 
contribution plan that is not required to provide a QJSA.

                        Description of Proposal

    Under the proposal, plans subject to the survivor annuity 
rules would be required to offer a 75-percent joint and 
survivor annuity as an option. The definition of a QJSA and 
QPSA would not be modified. For example, the proposal and the 
QJSA and QPSA rules would be satisfied if a plan offers a 75-
percent joint and survivor annuity as its only annuity option 
for married participants. Under this example, benefits would be 
paid as a 75-percent QJSA unless the participant and his or her 
spouse elect another option. The QPSA would be based on the 75-
percent joint and survivor annuity. As another example, the 
proposal and the QJSA and QPSA rules would also be satisfied if 
a plan offers a 50-percent QJSA and QPSA and, in addition, 
allows married participants to elect a 75-percent joint and 
survivor annuity. Under this example, benefits would be paid in 
the form of a 50-percent QJSA unless the participant and his or 
her spouse elect otherwise. The QPSA would be based on the 50-
percent joint and survivor annuity.

                             Effective Date

    The proposal would be effective for plan years beginning 
after December 31, 1999, with an (unspecified) extended 
effective date for plans maintained pursuant to a collective 
bargaining agreement.

                                Analysis

    A joint and survivor annuity is generally the actuarial 
equivalent of an annuity payable over the life of the 
participant (a single life annuity). Under a joint and survivor 
annuity, the amount payable during the lifetime of the 
participant is generally less than the amount that would be 
paid if the benefit were paid as a single life annuity. Thus, 
while a joint and survivor annuity offers a survivor benefit, 
it typically pays a lower benefit during the participant's 
lifetime. Plans may, but are not required to, provide a fully 
subsidized joint and survivor annuity that pays the same amount 
during the participant's lifetime as would have been paid under 
a single life annuity. Under present law, a plan may provide 
for a more generous survivor benefit than the 50-percent joint 
and survivor annuity. In addition, a plan may provide for an 
optional joint and survivor benefit, e.g., a 50-percent QJSA 
and a 75-percent or 100-percent joint and survivor annuity 
option.
    The stated rationale for the proposal is that many couples 
may prefer an option that pays a somewhat smaller benefit to 
the couple while both are alive but a larger benefit than the 
present-law 50-percent survivor benefit. It is also argued that 
a surviving spouse typically has retirement needs that exceed 
half the retirement needs of a couple. For example, the poverty 
threshold for an aged individual is almost 80 percent of the 
threshold for an aged couple. Proponents of the proposal argue 
that the option would be especially helpful to women, because 
they tend to live longer than men, and many aged widows have 
income below the poverty level.
    Some plans may already provide options that satisfy the 
proposal. Other plans, however, would need to be modified to 
comply. Some employers may wish to restrict the options offered 
under the plan in order to minimize administrative costs. If an 
employer wishes to offer only one joint and survivor annuity 
option, it would have to provide a 75-percent joint and 
survivor annuity. Some participants prefer the 50-percent joint 
and survivor annuity, because they do not wish to receive lower 
benefits during the participant's lifetime. For such 
participants, the proposal may have the effect of causing the 
participant to elect a nonannuity form of benefit (if one is 
available) or a single life annuity.\92\
---------------------------------------------------------------------------
    \92\ Present law prohibits plan amendments that eliminate an 
optional form of benefit with respect to benefits attributable to 
service before the amendment (sec. 411(d)(6)). It is not clear whether 
the proposal would modify section 411(d)(6) so that a plan could 
eliminate existing forms of joint and survivor annuities when adopting 
the option required under the proposal.
---------------------------------------------------------------------------

7. Pension disclosure

                              Present Law

Spouse's right to know distribution information

    Defined benefit pension plans and money purchase pension 
plans are required to provide benefits in the form of a 
qualified joint and survivor annuity (``QJSA'') unless the 
participant and his or her spouse consent to another form of 
benefit. A QJSA is an annuity for the life of the participant, 
with a survivor annuity for the life of the spouse which is not 
less than 50 percent (and not more than 100 percent) of the 
amount of the annuity payable during the joint lives of the 
participant and his or her spouse. In the case of a married 
participant who dies before the commencement of retirement 
benefits, the surviving spouse must be provided with a 
qualified preretirement survivor annuity (``QPSA'') which 
provides the surviving spouse with a benefit that is not less 
than the benefit that would have been provided under the 
survivor portion of a QJSA.
    Defined contribution plans other than money purchase 
pension plans are not required to provide a QJSA or QPSA if the 
participant does not elect an annuity as the form of payment 
(or the plan does not offer an annuity) and the surviving 
spouse is the participant's beneficiary (unless the spouse 
consents to designation of another beneficiary).
    The participant and his or her spouse may waive the right 
to a QJSA and QPSA provided certain requirements are satisfied. 
In general, these conditions include providing the participant 
with a written explanation of the terms and conditions of the 
survivor annuity, the right to make, and the effect of, a 
waiver of the annuity, the rights of the spouse to waive the 
survivor annuity, and the right of the participant to revoke 
the waiver. In addition, the spouse must provide a written 
consent to the waiver, witnessed by a plan representative or a 
notary public, which acknowledges the effect of the waiver. 
Similar waiver and election rules apply to the waiver of the 
right of the spouse to be the beneficiary under a defined 
contribution plan that is not required to provide a QJSA.

Election periods and right to know employer contribution formula

    Under present law, there are certain nondiscrimination 
tests that apply to contributions made to 401(k) plans. In 
general, the actual deferral percentage (``ADP'') test applies 
to the elective contributions of all employees under the plan 
and the average contribution percentage (``ACP'') test applies 
to employer matching and after-tax employee contributions. The 
ADP test is satisfied if the average percentage of elective 
contributions for highly compensated employees does not exceed 
the average percentage of elective contributions for nonhighly 
compensated employees by a specified percentage. The ACP test 
is similar but it tests the average contribution percentages of 
the highly compensated employees and nonhighly compensated 
employees.
    As an alternative to annual testing under the ADP and ACP 
tests, the Small Business Job Protection Act of 1996 provides 
two alternative ``design-based'' 401(k) safe harbors, effective 
beginning in 1999. If the employees are provided a specified 
matching contribution (or a specified nonelective 
contribution), the employer does not have to apply the ADP or 
ACP tests of employee elective contributions and employer 
matching contributions. There are similar safe-harbor designs 
under a SIMPLE plan. Under SIMPLE plans, employees must be 
provided annual 60-day election periods and notification tied 
to those election periods. Unlike SIMPLE plans, 401(k) plans 
using the design-based safe harbor are not subject to specific 
requirements that prescribe the length and frequency of the 
election period or that tie the timing of the notice describing 
employee rights and obligations under the plan to the election 
period.

                        Description of Proposal

Spouse's right to know distribution information

    The proposal would provide that when an explanation of a 
plan's survivor benefits is provided to a participant, a copy 
of the explanation would be required to be provided to the 
participant's spouse. If the last known mailing address of the 
participant and spouse is the same, then the explanation and a 
copy of the explanation could be provided in a single mailing 
addressed to the participant and his or her spouse.

Election periods and right to know employer contribution formula

    The proposal would require employers who use one of the 
design-based safe harbors in lieu of ADP and ACP testing to 
provide notice and contribution opportunities comparable to 
those provided under SIMPLE plans. Thus, employees would have 
to be offered an opportunity to elect to make contributions (or 
modify a prior election) during a 60-day period before the 
beginning of each year and a 60-day period when they first 
become eligible. In addition, the present-law requirement that 
employers provide employees with notice of their rights to make 
contributions and notice of the safe harbor contribution 
formula the employer is currently using (in order to notify 
employees of their rights and obligations) would be modified to 
require the notice within a reasonable period of time before 
the 60-day periods begin rather than before the beginning of 
the year.

                             Effective Date

    The proposal would be effective for plan years beginning 
after December 31, 1999.

                              Prior Action

    A similar proposal was included in the President's fiscal 
year 1999 budget proposal.

                                Analysis

    The pension right to know proposals would add two new plan 
administration requirements. In one case, additional 
information must be provided to spouses of plan participants 
and in the other case employees must be provided specified 
notice and election periods when an employer chooses to use the 
401(k) safe harbors. In both cases, it can be argued that the 
requirements are necessary so that the individuals affected 
understand their rights and have the opportunity to make 
informed decisions regarding their benefit entitlements. On the 
other hand, the proposals may add to the costs of sponsoring a 
plan.

8. Benefits of nonhighly compensated employees under section 401(k) 
        safe harbor plans

                              Present Law

    Under present law, special nondiscrimination tests apply to 
contributions made to 401(k) plans. In general, the actual 
deferral percentage (``ADP'') test applies to the elective 
contributions of all employees under the plan and the average 
contribution percentage (``ACP'') test applies to employer 
matching and after-tax employee contributions. The ADP test is 
satisfied if the average percentage of elective contributions 
for highly compensated employees does not exceed the average 
percentage of elective contributions for nonhighly compensated 
employees by more than a specified percentage. The ACP test is 
similar but it tests the average contribution percentages 
(i.e., employer matching and after-tax employee contributions) 
of the highly compensated employees and nonhighly compensated 
employees.
    As an alternative to annual testing under the ADP and ACP 
tests, the Small Business Job Protection Act of 1996 provides 
two alternative ``design-based'' 401(k) safe harbors, effective 
beginning in 1999. Under the safe harbor, if the employees are 
provided a specified matching or nonelective contribution, ADP 
and ACP testing of employee elective contributions and employer 
matching contributions is not required. Under the matching 
contribution safe harbor, the employer must make nonelective 
contributions of at least 3 percent of compensation for each 
nonhighly compensated employee eligible to participate in the 
plan. Alternatively, under the other safe harbor, the employer 
must make a 100 percent matching contribution on an employee's 
elective contributions up to the first 3 percent of 
compensation and a matching contribution of at least 50 percent 
on the employee's elective contributions up to the next 2 
percent of compensation.

                        Description of Proposal

    The proposal would modify the section 401(k) matching 
formula safe harbor by requiring that, in addition to the 
matching contribution, employers would have to make a 
contribution of one percent of compensation for each eligible 
nonhighly compensated employee, regardless of whether the 
employee makes elective contributions.

                             Effective Date

    The proposal would be effective for plan years beginning 
after December 31, 1999.

                              Prior Action

    A similar proposal was included in the President's budget 
proposal for fiscal year 1999.

                                Analysis

    The special nondiscrimination rules for 401(k) plans are 
designed to ensure that nonhighly compensated employees, as 
well as highly compensated employees, actually receive benefits 
under the plan. The nondiscrimination rules give employers an 
incentive to make the plan attractive to lower- and middle-
income employees (e.g., by providing a match) and to undertake 
efforts to enroll such employees, because the greater the 
participation by such employees, the more highly compensated 
employees can contribute to the plan.
    The design-based safe harbors were designed to achieve the 
same objectives as the special nondiscrimination rules, but in 
a simplified manner. The nonelective safe harbor ensures a 
minimum benefit for employees covered by the plan, and it was 
believed that the required employer match would be sufficient 
incentive to induce participation by nonhighly compensated 
employees. It was also hoped that the design-based safe harbors 
would reduce the complexities associated with qualified plans, 
and induce more employers to adopt retirement plans for their 
employees.
    Some are concerned that the safe harbors will not have the 
intended effect, but instead will result in less participation 
by rank-and-file employees, in part because employers will no 
longer have a financial incentive to encourage employees to 
participate.
    Requiring employers who use the section 401(k) matching 
formula safe harbor to make an additional one percent 
nonelective contribution for each eligible nonhighly 
compensated employee, whether or not the employee makes 
elective contributions to the plan, will provide a minimum 
benefit for employees covered in the plan and also may 
encourage more employees to contribute to the plan and help 
ensure that lower- and middle-income employees receive some 
benefits. On the other hand, some argue that the purpose of the 
safe harbor formulas is to encourage more employers to sponsor 
401(k) plans by eliminating the costs associated with annual 
testing. Adding a required employer contribution increases 
costs to employers and may impede the establishment of 
retirement plans. Some also believe that it is inappropriate to 
require a contribution to a 401(k) plan if employees do not 
make any elective deferrals. Under this view, retirement 
savings is a shared obligation of the employer and employee.

9. Modify definition of highly compensated employee

                              Present Law

    Under present law, an employee is treated as highly 
compensated if the employee (1) was a 5-percent owner of the 
employer at any time during the year or the preceding year or 
(2) either (a) had compensation for the preceding year in 
excess of $80,000 (indexed for inflation) or (b) at the 
election of the employer had compensation for the preceding 
year in excess of $80,000 (indexed for inflation) and was in 
the top 20 percent of employees by compensation for such year.

                        Description of Proposal

    The proposal would eliminate the top-paid group election 
from the definition of highly compensated employee. Under the 
new definition, an employee would be treated as a highly 
compensated employee if the employee (1) was a 5-percent owner 
of the employer at any time during the year or the preceding 
year, or (2) for the preceding year, had compensation in excess 
of $80,000 (indexed for inflation).

                             Effective Date

    The proposal would be effective for plan years beginning 
after December 31, 1999.

                              Prior Action

    A similar proposal was included in the President's fiscal 
year 1999 budget proposal.

                                Analysis

    The proposal would further simplify the definition of 
highly compensated employee by eliminating the top-paid group 
election. Permitting elections that may vary from year to year 
increases complexity as employers that may benefit from the 
election may feel it necessary to run tests under both options. 
In addition, by use of the election, it is possible for 
employees earning very high compensation (in excess of $80,000) 
to be treated as nonhighly compensated for testing purposes if 
the employer has a sufficient percentage of high-paid employees 
in its workforce (i.e., if employees earning more than $80,000 
are in the top paid 20 percent of employees). This would allow 
some employers to effectively eliminate benefits for low- and 
moderate-wage workers without violating the nondiscrimination 
rules. The proposal may help ensure that the simplified 
definition of highly compensated employee better reflects the 
purpose of promoting meaningful benefits for low- and moderate-
wage workers, not only the high paid. On the other hand, some 
would argue that the greater flexibility provided to employers 
under present law is appropriate. Without the flexibility in 
testing, some employers may reduce plan benefits or choose to 
terminate plans, reducing aggregate pension coverage and 
potentially reducing aggregate retirement saving.

10. Modify benefit limits for multiemployer plans under section 415

                              Present Law

    In general, under present law, annual benefits under a 
defined benefit pension plan are limited to the lesser of 
$130,000 (for 1999) or 100 percent of average compensation for 
the 3 highest years. Reductions in these limits are generally 
required if the employee has fewer than 10 years of service or 
plan participation. If benefits under a defined benefit plan 
begin before social security retirement age, the dollar limit 
must be actuarially reduced to compensate for the early 
commencement.

                        Description of Proposal

    Under the proposal, the 100-percent-of-compensation limit 
on defined benefit plan benefits would not apply to 
multiemployer plans. In addition, certain survivor and 
disability benefits payable under multiemployer plans would be 
exempt from the adjustments for early commencement of benefits 
and for participation and service of less than 10 years.

                             Effective Date

    The proposal would be effective for years beginning after 
December 31, 1999.

                              Prior Action

    The proposal was included in the Administration's 1995 
Pension Simplification Proposal,\93\ in the Small Business Job 
Protection Act of 1996 as passed by the Senate, in the Taxpayer 
Relief Act of 1997 as passed by the Senate, and in the 
President's fiscal year 1999 budget proposal.
---------------------------------------------------------------------------
    \93\ See Department of the Treasury, Department of Labor, General 
Explanation of the Administration's Pension Simplification Proposal, 
September 1995.
---------------------------------------------------------------------------

                                Analysis

    The limits on benefits under qualified plans were designed 
to limit the tax benefits and revenue loss associated with such 
plans, while still ensuring that adequate retirement benefits 
could be provided. The 100-percent-of-compensation limitation 
reflects Congressional judgment that a replacement rate of 100-
percent-of-compensation is an adequate retirement benefit.
    The stated rationale for the proposal is that the qualified 
plan limitations present significant administrative problems 
for many multiemployer plans which base benefits on years of 
credited service rather than compensation. In addition, it is 
argued that the 100-percent of compensation rule produces an 
artificially low limit for employees in certain industries, 
such as building and construction, where wages vary 
significantly from year to year.
    Others argue that the limits on benefits under qualified 
plans create administrative problems for all plan sponsors, and 
that these problems are no greater for multiemployer plans than 
for any other plan. In addition, it is argued that there is no 
justification for higher benefit limitations for multiemployer 
plans, as persons affected by these limits are not all 
participants in multiemployer plans. Providing a special rule 
for such plans would merely create inequities among plan 
participants based upon the type of plan in which they are a 
participant. For example, many individuals work in industries 
where wages may vary significantly from year to year, but not 
all of those employees are participants in multiemployer plans. 
To the extent that the qualified plan limits are deemed to 
inappropriately reduce benefits in such (or similar cases), it 
is argued that it would be more equitable to provide an across 
the board rule that is not based upon the type of plan. If it 
is believed that a 100-percent of compensation limitation is 
not appropriate, it is not clear why only participants in 
multiemployer plans should receive the benefit of a higher 
limit.

11. Modify full funding limit for multiemployer plans

                              Present Law

    Under present law, employer deductions for contributions to 
a defined benefit pension plan cannot exceed the full funding 
limit. In general, the full funding limit is the lesser of a 
plan's accrued liability and 155-percent of current liability. 
The 155-percent of current liability limit is scheduled to 
increase gradually, until it is 170 percent in 2005 and 
thereafter.
    Defined benefit pension plans are required to have an 
actuarial valuation no less frequently than annually.

                        Description of Proposal

    Under the proposal, the current liability full funding 
limit would not apply to multiemployer plans. In addition, such 
plans would be required to have an actuarial valuation at least 
once every three years. Changes would be made to the 
corresponding provisions of title I of the Employee Retirement 
Income Security Act of 1974, as amended.

                             Effective Date

    The proposal would be effective for taxable years beginning 
after December 31, 1999.

                              Prior Action

    The proposal was included in the Administration's 1995 
Pension Simplification Proposal \94\ and in the President's 
fiscal year 1999 budget proposal.
---------------------------------------------------------------------------
    \94\ Ibid.
---------------------------------------------------------------------------

                                Analysis

    The current liability full funding limit was enacted as a 
balance between differing policy objectives. On one hand is the 
concern that defined benefit pension plans should be funded so 
as to provide adequate benefit security for plan participants. 
On the other hand is the concern that employers should not be 
entitled to make excessive contributions to a defined benefit 
pension plan to fund liabilities that it has not yet incurred. 
Such use of a defined benefit plan was believed to be 
equivalent to a tax-free savings account for future 
liabilities, and inconsistent generally with the treatment of 
unaccrued liabilities under the Internal Revenue Code. The 
current liability full funding limit as initially enacted was 
150 percent of current liability. It was increased to the 
present-law level by the Taxpayer Relief Act of 1997 because 
the Congress believed that the 150-percent limit unduly 
restricted funding of defined benefit pension plans.
    Proponents of the proposal argue that employers have no 
incentive to make excess contributions to a multiemployer plan, 
because the amount an employer contributes to the plan is set 
by a collective bargaining agreement and a particular 
employer's contributions are not set aside to pay benefits 
solely to the employees of that employer.
    Others would argue that it is inappropriate to provide 
special rules based on the type of plan. While many 
multiemployer plans restrict the ability of the employer to 
obtain reversions of excess plan assets on termination of the 
plan, not all do, so that an employer may still have an 
incentive to fund unincurred liabilities in order to obtain tax 
benefits. Also, many plans that are not multiemployer plans 
restrict the ability of employers to obtain excess assets, 
limiting any incentive to make excess contributions.

12. Eliminate partial termination rules for multiemployer plans

                              Present Law

    Under present law, tax-qualified plans are required to 
provide that plan benefits become 100 percent vested (to the 
extent funded) upon the termination or partial termination of a 
plan. Whether a partial termination has occurred in a 
particular situation is generally based on all the facts and 
circumstances. Situations that can result in a partial 
termination include, for example, the exclusion from the plan 
of a group of employees previously covered under the plan due 
to a plan amendment or termination of employment by the 
employer. In addition, if a defined benefit plan stops or 
reduces future benefit accruals under the plan, a partial 
termination of the plan is deemed to occur if, as a result of 
the cessation or reduction in accruals a potential reversion to 
the employer or employers maintaining the plan is created or 
increased. If no such reversion is created or increased, a 
partial termination is not deemed to occur; however, a partial 
termination may be found to have taken place under the 
generally applicable rule.

                        Description of Proposal

    The requirement that plan participants must be 100-percent 
vested upon partial termination of a plan would be repealed 
with respect to multiemployer plans.

                             Effective Date

    The proposal would be effective with respect to partial 
terminations that begin after December 31, 1999.

                              Prior Action

    The proposal was included in the Administration's 1995 
Pension Simplification Proposal,\95\ in the Taxpayer Relief Act 
of 1997 as passed by the Senate, and in the President's fiscal 
year 1999 budget proposal.
---------------------------------------------------------------------------
    \95\ Ibid.
---------------------------------------------------------------------------

                                Analysis

    The partial termination rules help to protect the benefits 
of plan participants in circumstances that do not give rise to 
a complete termination. In some cases, the partial termination 
rules prevent avoidance of the rule requiring vesting upon 
complete termination of a plan.
    Proponents of the proposal argue that the partial 
termination rules are not necessary to protect multiemployer 
plan participants in the case of terminations due to reductions 
in force, because the multiemployer plan structure itself 
provides protections. That is, participation in the plan is not 
tied to employment with a particular employer, so that an 
individual who terminates employment with one employer may 
continue participation in the plan if the individual is 
employed by other employer participating in the plan.
    Others question whether the plan structure will protect 
participants in the same manner as the partial termination 
rules. There is no assurance that an individual will continue 
participation in the plan after an event that would give rise 
to a partial termination. In addition, others argue that the 
multiemployer plan structure provides no special protection if 
the partial termination is due to a plan amendment regarding 
eligibility or due to cessation or reduction of accruals under 
a defined benefit pension plan.

13. Allow rollovers between qualified retirement plans and section 
        403(b) tax-sheltered annuities

                              Present Law

    Present law permits the rollover of funds from a tax-
favored retirement vehicle to another tax-favored retirement 
vehicle. The rules that apply depend on the type of plan 
involved.
    Under present law, an ``eligible rollover distribution'' 
from a tax-qualified employer-sponsored retirement plan (a 
``qualified plan'') may be rolled over tax free to a 
traditional individual retirement arrangement (``IRA'') \96\ or 
another qualified plan.\97\
---------------------------------------------------------------------------
    \96\ A ``traditional'' IRA refers to an IRA other than a Roth IRA.
    \97\ An eligible rollover distribution may either be rolled over by 
the distributee within 60 days of the date of the distribution or 
directly rolled over by the distributing plan.
---------------------------------------------------------------------------
    An ``eligible rollover distribution'' means any 
distribution to an employee of all or any portion of the 
balance to the credit of the employee, except the term does not 
include (1) any distribution which is one of a series of 
substantially equal periodic payments made (a) for the life (or 
life expectancy) of the employee or the joint lives) or joint 
life expectancies) of the employee and the employee's 
designated beneficiary, or (b) for a specified period of 10 
years or more, and (2) any distribution to the extent such 
distribution is required under the section 401(a)(9) minimum 
distribution rules. The portion of a distribution that is 
nontaxable cannot be rolled over.
    Distributions from a tax-sheltered annuity (``section 
403(b) annuity'') may be rolled over into a traditional IRA or 
another section 403(b) annuity. Distributions from a section 
403(b) annuity cannot be rolled over into a qualified plan.
    Distributions from a traditional IRA can be rolled over 
into another traditional IRA. In general, distributions from an 
IRA cannot be rolled over into a qualified plan or section 
403(b) annuity. An exception to this rule applies in the case 
of so-called ``conduit IRAs.'' Under the conduit IRA rule, 
amounts can be rolled from a qualified plan into a traditional 
IRA and then subsequently rolled back to another qualified plan 
if the amounts in the IRA are attributable solely to rollovers 
from a qualified plan. Similarly, an amount may be rolled over 
from a section 403(b) annuity to a traditional IRA and 
subsequently rolled back into a section 403(b) annuity if the 
amounts in the IRA are attributable solely to rollovers from a 
section 403(b) annuity.
    Under present law, amounts distributed from a qualified 
plan, section 403(b) annuity, or traditional IRA are generally 
includible in gross income. Capital gain treatment and income 
averaging may apply to certain distributions from qualified 
retirement plans. Capital gains treatment may be available for 
a lump-sum distribution that contains amounts attributable to 
participation in a plan before 1974. Five or 10-year averaging 
may be available for a lump-sum distribution in the case of 
individuals who were at least 50 years old by January 1, 1986, 
in 1986 (i.e., born before 1936). Five year averaging may be 
available in the case of a lump-sum distribution before 2000.

                        Description of Proposal

    The proposal would provide that eligible rollover 
distributions from qualified plans could be rolled over to 
another qualified plan, section 403(b) annuity, or traditional 
IRA. Similarly, an eligible rollover distribution from a 
section 403(b) annuity could be rolled over to another 403(b) 
annuity, qualified plan, or traditional IRA.
    A special rule would prevent individuals from receiving 
special capital gains and income averaging treatment available 
to qualified plan distributions if the individual's account 
includes any amounts previously held under a section 403(b) 
annuity.

                             Effective Date

    The proposal would be effective for distributions made 
after December 31, 1999.

                              Prior Action

    No prior action.\98\
---------------------------------------------------------------------------
    \98\ A similar proposal was included in H.R. 3788 (105th Cong.), 
introduced by Mr. Portman and Mr. Cardin, and S. 2339 (105th Cong.), 
introduced by Senator Graham, Senator Grassley, and others.
---------------------------------------------------------------------------

                                Analysis

    Some individuals may accumulate retirement savings in more 
than one different type of tax-favored retirement saving 
vehicle. Allowing rollovers between different types of plans 
will allow individuals to combine their retirement savings in 
one vehicle. The ability to combine savings may be 
administratively easier for individuals, and may also affect 
investment choices and returns.
    In general, the rationale for not permitting rollovers 
between qualified plans and section 403(b) annuities has been 
that benefits under such plans are taxed differently. The key 
difference is the availability of capital gains and income 
averaging treatment for certain qualified retirement plan 
distributions. These special rules have been repealed so that, 
after the expiration of certain transition rules, these 
differences in tax treatment between qualified plans and 
section 403(b) annuities will no longer remain.
    The proposal addresses the current differences in tax 
treatment by providing that the special rules will not apply to 
section 403(b) annuity amounts.\99\ In order to preserve the 
availability of averaging or capital gains treatment, it may be 
necessary for individuals to separately keep track of amounts 
attributable to section 403(b) annuities. Individuals may make 
mistakes, which can result in claiming averaging or capital 
gains treatment when the individual is not eligible to do so, 
or in losing the ability to claim such treatment when it is 
available.
---------------------------------------------------------------------------
    \99\ The details of this rule have not yet been specified.
---------------------------------------------------------------------------

14. Allow rollovers from deductible IRAs to qualified plans or section 
        403(b) tax-sheltered annuities

                              Present Law

    In general, amounts in an individual retirement arrangement 
(``IRA'') cannot be rolled over into a tax-qualified retirement 
plan or a section 403(b) tax-sheltered annuity.\100\
---------------------------------------------------------------------------
    \100\ An exception to this rule applies in the case of a ``conduit 
IRA.'' Under the conduit IRA rule, amounts can be rolled from a 
qualified retirement plan into a traditional IRA and then subsequently 
rolled back to another qualified plan if the amounts in the IRA are 
attributable solely to rollovers from qualified retirement plans. A 
similar rule applies to conduit IRAs with respect to section 403(b) 
annuities.
---------------------------------------------------------------------------

                        Description of Proposal

    Under the proposal, amounts in a deductible IRA could be 
transferred to a qualified defined contribution plan or section 
403(b) tax-sheltered annuity, provided that the retirement plan 
trustee meets the same standards as an IRA trustee.\101\
---------------------------------------------------------------------------
    \101\ Under present law, an IRA trustee must either be a bank or 
another person who demonstrates to the satisfaction of the Secretary 
that such other person will administer the trust in a manner consistent 
with the IRA rules. Persons wishing to be IRA trustees must make 
application to the Secretary. Among other things, the applicant must 
demonstrate in detail its ability to act within the accepted rules of 
fiduciary conduct, its experience and competence with respect to 
accounting for the interests of a large number of individuals, and its 
experience and competence with respect to other activities normally 
associated with the handling of retirement funds.
---------------------------------------------------------------------------

                             Effective Date

    The proposal would be effective for distributions after 
December 31, 1999.

                              Prior Action

    No prior action.\102\
---------------------------------------------------------------------------
    \102\ A similar proposal was included in H.R. 3788 (105th Cong.), 
introduced by Mr. Portman and Mr. Cardin, and S. 2339 (105th Cong.), 
introduced by Senator Graham, Senator Grassley, and others.
---------------------------------------------------------------------------

                                Analysis

    Like the proposal relating to rollovers between qualified 
plans and section 403(b) annuities, allowing rollovers from 
IRAs into qualified plans or section 403(b) annuities will 
allow individuals to combine their retirement savings in one 
vehicle. The ability to combine savings may be administratively 
easier for individuals, and may also affect investment choices 
and returns.
    As discussed above under the preceding rollover proposal, 
qualified plan distributions may be eligible for special tax 
treatment that is not available with respect to distributions 
from IRAs. Rules would need to be developed, similar to those 
contemplated under the preceding proposal so that this special 
treatment is not inadvertently applied to IRA balances rolled 
into a qualified plan.

15. Allow rollovers of after-tax contributions

                              Present Law

    Under present law, a qualified plan may permit individuals 
to make after-tax contributions to the plan. Present law 
provides that the maximum amount that can be rolled over to 
another qualified plan or an IRA is the amount of the 
distribution that is taxable. That is, employee after-tax 
contributions cannot be rolled over to another retirement plan 
or an IRA.

                        Description of Proposal

    The proposal would provide that employee after-tax 
contributions could be rolled over to another qualified 
retirement plan or a traditional IRA, provided that the plan or 
IRA provider agrees to track and report the after-tax portion 
of the rollover for the individual.\103\
---------------------------------------------------------------------------
    \103\ Under the proposal, it is not clear what tax consequences 
result when an individual rolls over some, but not all, of a 
distribution that consists of both taxable and nontaxable amounts. 
Ordering rules are necessary to determine which amounts are considered 
to be rolled over. A number of rules are possible. For example, the 
individual could be permitted to designate which amounts are treated as 
being rolled over. Under such a rule, the individual could roll over 
all taxable amounts, and retain the nontaxable amounts. This would 
allow an individual to in effect withdraw after-tax contributions from 
a plan, as occurs under present law. Under another possible rule, the 
individual could be deemed to roll over taxable amounts first. This 
would generally have the same effect as the first rule, assuming that 
taxpayers would generally wish to retain the nontaxable portion of the 
distribution in order to avoid paying tax currently. Under another 
possible rule, a pro rata rule could be applied. That is, the amount 
rolled over could consist in part of taxable amounts and in part of 
nontaxable amounts. This rule is more consistent with the present-law 
rules regarding taxation of distributions, which generally apply a pro 
rata rule. On the other hand, some individuals may not want to roll 
over their own contributions. Resolution of this issue is relevant not 
only in determining the tax consequences to the individual, but also 
could affect the plan's withholding obligations.
    Under present law, distributions that can be rolled over are 
subject to 20 percent withholding unless the distribution is directly 
rolled over into another qualified plan or IRA. This rule is intended 
to encourage direct rollovers. The proposal does not indicate whether 
this rule would apply to distributions of after-tax employee 
contributions.
---------------------------------------------------------------------------

                             Effective Date

    The proposal would be effective for distributions made 
after December 31, 1999.

                              Prior Action

    No prior action.\104\
---------------------------------------------------------------------------
    \104\ A similar proposal was included in H.R. 3788 (105th Cong.), 
introduced by Mr. Portman and Mr. Cardin, and S. 2339 (105th Cong.), 
introduced by Senator Graham, Senator Grassley, and others.
---------------------------------------------------------------------------

                                Analysis

    The primary rationale for not permitting after-tax 
contributions to be rolled over has generally been that the 
record keeping involved is too complex. An individual who rolls 
over such contributions will need to keep accurate records in 
order to determine the taxable amount of any subsequent 
distribution from the IRA or plan. Maintaining such records may 
be difficult, because they may have to be kept for a long time. 
In addition, keeping track of the after-tax contributions may 
be more difficult if new contributions are made to the plan or 
IRA or amounts are subsequently transferred to another IRA or 
plan. The proposal addresses this issue by placing the burden 
of keeping track of such amounts on the financial institution 
offering the IRA or the plan. However, financial institutions 
and plans may not want the responsibility of keeping track of 
such contributions. It is unclear how many plans will not 
accept such contributions because they do not want the record 
keeping burdens.
    The proposal may help individuals to save for retirement. 
By increasing the opportunities to retain after-tax 
contributions in a tax-favored vehicle, it may help increase 
retirement security.

16. Allow rollovers of contributions from nonqualified deferred 
        compensation plans of State and local governments to IRAs

                              Present Law

    Benefits under an eligible deferred compensation plan of 
tax-exempt and State and local governmental employers (a 
``section 457 plan'') cannot be rolled over into an individual 
retirement arrangement (``IRA'').

                        Description of Proposal

    Under the proposal, distributions from a governmental 
section 457 plan could be rolled over to a traditional 
IRA.\105\
---------------------------------------------------------------------------
    \105\ Although the proposal is not clear on this point, presumably 
the definition under present law of an eligible rollover distribution 
would apply to rollovers from a section 457 plan. For example, certain 
periodic distributions are not considered eligible rollover 
distributions under present law. It is also not clear whether the 
direct rollover rules would apply; i.e., whether the plan would be 
required to withhold if a distribution that could be rolled over is not 
directly rolled over.
---------------------------------------------------------------------------

                             Effective Date

    The proposal would be effective for distributions after 
December 31, 1999.

                              Prior Action

    No prior action.\106\
---------------------------------------------------------------------------
    \106\ A similar proposal was included in H.R. 3788 (105th Cong.), 
introduced by Mr. Portman and Mr. Cardin, and S. 2339 (105th Cong.), 
introduced by Senator Graham, Senator Grassley, and others.
---------------------------------------------------------------------------

                                Analysis

    Section 457 imposes rules on certain deferred compensation 
arrangements of tax-exempt and State and local governmental 
employers. Section 457 plans are not qualified retirement 
plans; rather such plans have traditionally been more like 
unfunded, nonqualified deferred compensation arrangements of 
private, taxable employers. Present law does not limit the 
amount of deferred compensation payable under nonqualified 
deferred compensation plans of taxable employers because there 
is tension between the employer and the employee-employers 
generally want a current deduction for compensation, whereas 
deferred compensation is not deductible until includible in 
employees' income. This tension is not present in the case of 
deferred compensation plans of tax-exempt and governmental 
employers. Thus, section 457 limits the amount that can be 
deferred under such plans and provides other rules regarding 
such plans. The tax rules applicable to section 457 plans are 
similar to those applicable to nonqualified deferred 
compensation arrangements of taxable employers.
    Section 457 plans have not received the same tax treatment 
as qualified retirement plans, because section 457 plans 
generally have not been subject to all of the same restrictions 
and rules as qualified plans. However, recent changes in the 
rules relating to section 457 plans of governmental employers 
have blurred the distinction between governmental section 457 
plans and governmental qualified plans. In particular, assets 
of governmental section 457 plans must now be held in trust, 
and governmental qualified plans are not subject to 
nondiscrimination rules. Given then narrowing of the 
differences between such plans, the reasons for prohibiting 
roll over governmental section 457 plans become less clear.
    Allowing distributions from governmental section 457 plans 
to be rolled over into an IRA will enable participants in such 
plans to continue to receive the benefits of tax deferral, and 
may help such individuals increase retirement savings. 
Individuals who roll over distributions from a section 457 plan 
into an IRA will need, however, to be aware that the tax 
consequences of a distribution from an IRA may be different 
than the tax consequences of a distribution from a section 457 
plan. For example, the withdrawal restrictions applicable to 
section 457 plans do not apply to IRAs; however, early 
distributions from an IRA are subject to a 10-percent early 
withdrawal tax.

17. Purchase of service credits in governmental defined benefit plans

                              Present Law

    Under present law, limits are imposed on the contributions 
and benefits under qualified pension plans (Code sec. 415). In 
the case of a defined contribution plan, the limit on annual 
additions is the lesser of $30,000 (for 1999) or 25 percent of 
compensation. Annual additions include employer contributions, 
as well as after-tax employee contributions. In the case of a 
defined benefit pension plan, the limit on the annual 
retirement benefit is the lesser of (1) 100 percent of 
compensation or (2) $130,000 (for 1999). The 100 percent of 
compensation limitation does not apply in the case of State and 
local governmental pension plans.
    Present law provides special rules with respect to 
contributions by a participant in a State or local governmental 
plan to purchase permissive service credits under a 
governmental defined benefit plan. Such contributions are 
subject to one of two limits. Either (1) the accrued benefit 
derived from all contributions to purchase permissive service 
credit must be taken into account in determining whether the 
defined benefit pension plan limit is satisfied, or (2) all 
such contributions must be taken into account in determining 
whether the $30,000 limit on annual additions is met for the 
year (taking into account any other annual additions of the 
participant). These limits may be applied on a participant-by-
participant basis. That is, contributions to purchase 
permissive service credits by all participants in the same plan 
do not have to satisfy the same limit.
    Permissive service credit means credit for a period of 
service recognized by the governmental plan only if the 
employee voluntarily contributes to the plan an amount (as 
determined by the plan) which does not exceed the amount 
necessary to fund the benefit attributable to the period of 
service and which is in addition to the regular employee 
contributions, if any, under the plan. Section 415 is violated 
if more than 5 years of permissive service credit is purchased 
for ``nonqualified service''. In addition, section 415 is 
violated if nonqualified service is taken into account for an 
employee who has less than 5 years of participation under the 
plan. Nonqualified service is service other than service (1) as 
a Federal, State, or local government employee, (2) as an 
employee of an association representing Federal, State or local 
government employees, (3) as an employee of an educational 
institution which provides elementary or secondary education, 
or (4) for military service. Service under (1), (2) or (3) is 
not qualified if it enables a participant to receive a 
retirement benefit for the same service under more than one 
plan.
    Under present law, benefits in a section 403(b) tax-
sheltered annuity or under a governmental section 457 plan 
cannot be rolled over or transferred in a tax-free transfer to 
a governmental defined benefit plan.
    Benefits under section 403(b) annuities and section 457 
plans are subject to certain distribution restrictions. 
Benefits under a section 403(b) annuity cannot be distributed 
prior to age 59\1/2\, separation from service, hardship, death 
or disability. Benefits under a section 457 plan cannot be 
distributed prior to the earliest of age 70\1/2\, hardship, or 
separation from service.

                        Description of Proposal

    Under the proposal, governmental employees would be able to 
transfer funds from a section 403(b) plan or a section 457 plan 
in a tax-free transfer in order to purchase permissive service 
credits under a governmental defined benefit plan. A transfer 
could be made even if the individual could not take a 
distribution from the transferree plan. Transferred funds would 
be subject to the present-law rules regarding permissive 
service credit.

                             Effective Date

    The proposal would be effective with respect to transfers 
made after December 31, 1999.

                              Prior Action

    No prior action.\107\
---------------------------------------------------------------------------
    \107\ A similar proposal was included in H.R. 3788 (105th Cong.), 
introduced by Mr. Portman and Mr. Cardin, and S. 2339 (105th Cong.), 
introduced by Senator Graham, Senator Grassley, and others.
---------------------------------------------------------------------------

                                Analysis

    Permitting tax-free transfers as under the proposal will 
make it easier for State and local government employees to 
purchase permissive service credit, thereby allowing such 
employees to increase their retirement benefits. Some question 
whether it is appropriate to provide such special rules only 
for employers of certain types of entities.

               G. Extend Certain Expiring Tax Provisions

1. Extend minimum tax relief for individuals

                              Present Law

    Present law provides for certain nonrefundable personal tax 
credits (i.e., the dependent care credit, the credit for the 
elderly and disabled, the adoption credit, the child tax 
credit, the credit for interest on certain home mortgages, the 
HOPE Scholarship and Lifetime Learning credits, and the D.C. 
homebuyer's credit \108\). Generally, these credits are reduced 
or eliminated for individuals with adjusted gross incomes above 
specified amounts. Except for taxable years beginning during 
1998, these credits are allowed only to the extent that the 
individual's regular income tax liability exceeds the 
individual's tentative minimum tax, determined without regard 
to the AMT foreign tax credit (``the sec. 26(a) limitation''). 
For taxable years beginning during 1998, these credits are 
allowed to the extent of the full amount of the individual's 
regular tax (without regard to the tentative minimum tax).
---------------------------------------------------------------------------
    \108\ The President's fiscal year 2000 budget proposal also 
includes personal tax credits for long-term care and for disabled 
workers.
---------------------------------------------------------------------------
    An individual's tentative minimum tax is an amount equal to 
(1) 26 percent of the first $175,000 ($87,500 in the case of a 
married individual filing a separate return) of alternative 
minimum taxable income (``AMTI'') in excess of a phased-out 
exemption amount and (2) 28 percent of the remaining AMTI. The 
maximum tax rates on net capital gain used in computing the 
tentative minimum tax are the same as under the regular tax. 
AMTI is the individual's taxable income adjusted to take 
account of specified preferences and adjustments. The exemption 
amounts are: (1) $45,000 in the case of married individuals 
filing a joint return and surviving spouses; (2) $33,750 in the 
case of other unmarried individuals; and (3) $22,500 in the 
case of married individuals filing a separate return, estates 
and trusts. The exemption amounts are phased out by an amount 
equal to 25 percent of the amount by which the individual's 
AMTI exceeds (1) $150,000 in the case of married individuals 
filing a joint return and surviving spouses, (2) $112,500 in 
the case of other unmarried individuals, and (3) $75,000 in the 
case of married individuals filing separate returns or an 
estate or a trust. These amounts are not indexed for inflation.
    For families with three or more qualifying children, a 
refundable child credit is provided, up to the amount by which 
the liability for social security taxes exceeds the amount of 
the earned income credit (sec. 24(d)). For taxable years 
beginning after 1998, the refundable child credit is reduced by 
the amount of the individual's minimum tax liability (i.e., the 
amount by which the tentative minimum tax exceeds the regular 
tax liability).

                        Description of Proposal

    The proposal would allow the nonrefundable personal credits 
to offset the individual's regular tax liability in full for 
taxable years beginning during 1999 and 2000 (as opposed to 
only the amount by which the regular tax liability exceeds the 
tentative minimum tax).
    The provision that reduces the refundable child credit by 
the amount of an individual's AMT would not apply for taxable 
years beginning during 1999 and 2000.

                             Effective Date

    The proposal would be effective for taxable years beginning 
during 1999 and 2000.

                              Prior Action

    The Taxpayer Relief Act of 1997, as passed by both the 
House and the Senate, provided for increases in the AMT 
exemption amounts. The conference agreement on that Act 
retained the present-law exemption amounts.
    The Tax and Trade Relief Extension Act of 1998 allowed the 
personal credits to offset the full regular tax, and provided 
that the refundable child credit would not be reduced by the 
amount of the individual's AMT for taxable years beginning 
during 1998.

                                Analysis

    The alternative minimum tax was enacted by Congress to 
ensure that no taxpayer with substantial economic income can 
avoid significant tax liability by using exclusions, 
deductions, and credits.\109\ In 1998, the Congress determined 
that allowing middle-income families to use the nonrefundable 
personal tax credits to offset the regular tax in full would 
not undermine the policy of the minimum tax, and would promote 
the important social policies underlying each of the credits. 
The Congress thus allowed taxpayers to use the credits to 
offset the regular tax in full for taxable years beginning 
during 1998.
---------------------------------------------------------------------------
    \109\ See H. Rept. 99-426, pp. 305-306, and S. Rept. 99-313, p. 
518.
---------------------------------------------------------------------------
    It is estimated that under present law the number of 
individuals who will receive zero or less than the full 
nonrefundable personal credits due to the AMT limitations will 
be 1 million in 1999 and 1.2 million in 2000.
    Allowing the personal credits to offset the regular tax in 
full results in significant simplification. Substantially fewer 
taxpayers need to complete the minimum tax form (Form 6251) and 
the worksheets accompanying the credits can be greatly 
simplified. For example, the child credit worksheet proposed by 
the IRS under the legislation in effect before the changes made 
by the 1998 Act would have required any individual claiming the 
child credit who filed a schedule C (business income), schedule 
D (capital gains), schedule E (rents and royalties) or schedule 
F (farm income) to file a minimum tax form (Form 6251). Form 
6251 contains 28 lines for those individuals without any net 
capital gain and an additional 22 lines for individuals with a 
net capital gain. In addition, many individuals with only wage, 
dividend and interest income would have been required to 
compute their tentative minimum tax using a shorter schedule. 
Also, the additional child credit form (Form 8812) would have 
contained two additional lines to adjust for the minium tax.
    The following examples compare present law with the 
Administration proposal extending the minimum tax relief of the 
1998 Act:
    Example 1.--Assume in 1999 a married couple has an adjusted 
gross income of $65,800, they do not itemize deductions, and 
they have four dependent children. Also assume they are 
entitled to an $1,000 child credit for two of the children, a 
$3,000 HOPE scholarship credit with respect to the other two 
children, and a $960 dependent care tax credit--for a total 
amount of tax credits of $4,960. The couple's net tax liability 
under present law and under the proposal are computed as 
follows:

------------------------------------------------------------------------
                                                     Present
                                                       law      Proposal
------------------------------------------------------------------------
Adjusted gross income.............................    $65,800    $65,800
Less standard deduction...........................      7,200      7,200
Less personal exemptions (6 @ $2,750).............     16,500     16,500
                                                   ---------------------
Taxable income....................................     42,100     42,100
Regular tax (15% of $42,100)......................      6,315      6,315
Tentative minimum tax (26% of $20,800)............      5,408      5,408
Pre-limitation credits ($1,000+$3,000+$960).......      4,960      4,960
Section 26(a) limit on nonrefundable credits:
    Regular tax...................................      6,315      6,315
    Less tentative minimum tax for sec. 26(a)(2)..      5,408          0
    Maximum nonrefundable credits allowable.......        907      6,315
Total credits allowed.............................        907      4,960
Net tax...........................................      5,408      1,355
                                                   ---------------------
Net tax reduction.................................  .........      4,053
------------------------------------------------------------------------

    Example 2.--Assume the same facts as Example 1, except the 
couple has five dependent children, three of whom qualify for 
the child tax credit, and their adjusted gross income is 
$68,550. Thus, the couple is eligible for tax credits totaling 
$5,460. Also assume the couple paid $5,000 in social security 
taxes for purposes of determining the refundable child tax 
credit for three or more qualifying children. The couple's net 
tax liability under present law and under the proposal are 
computed as follows:

------------------------------------------------------------------------
                                                     Present
                                                       law      Proposal
------------------------------------------------------------------------
Adjusted gross income.............................    $68,550    $68,550
Less standard deduction...........................      7,200      7,200
Less personal exemptions (7 @ $2,750).............     19,250     19,250
                                                   ---------------------
Taxable income....................................     42,100     42,100
Regular tax (15% of $42,100)......................      6,315      6,315
Tentative minimum tax (26% of $23,550)............      6,123      6,123
Pre-limitation credits ($1,500+$3,000+$960).......      5,460      5,460
Section 26(a) limit on nonrefundable credits:
    Regular tax...................................      6,315      6,315
    Less tentative minimum tax for sec. 26(a)(2)..      6,123          0
    Maximum nonrefundable credits allowable.......        192      6,315
Total nonrefundable credits allowed...............        192      5,460
Section 24(d) refundable child credit \110\.......      1,500          0
\110\ Section 24(d) provides for a refundable
 child credit for families with three or more
 eligible children. The section 24(d) credit is
 the lesser of (1) the amount by which allowable
 credits would increase if the social security
 taxes were added to the section 26(a) limit or
 (2) the amount of the child tax credit,
 determined without regard to the section 26(a)
 limitation. Under present law, the section 24(d)
 child credit would be $1,500 (the lesser of
 $1,500 or the amount that the total credits would
 be increased if the section 26(a) limit is
 increased by the $5,000 social security taxes
 paid). Because the credits would be allowed in
 full under the proposal, the couple's section
 24(d) child credit would be zero under the
 proposal.
Total credits allowed.............................      1,692      5,460
Net tax...........................................      4,623        855
                                                   ---------------------
Net tax reduction.................................  .........      3,768
------------------------------------------------------------------------

    Under the proposal, in addition to the tax savings, the 
couple would no longer be required to compute the tentative 
minimum tax or the section 24(d) refundable child credit to 
determine their net tax liability.
    Example 3.--Assume the same facts as Example 2, except the 
couple has six dependent children, four of whom are eligible 
for the child credit, and their adjusted gross income is 
$71,300. Thus, the couple is eligible for tax credits totaling 
$5,960. The couple's net tax liability under present law and 
under the proposal are computed as follows:

------------------------------------------------------------------------
                                                     Present
                                                       law      Proposal
------------------------------------------------------------------------
Adjusted gross income.............................    $71,300    $71,300
Less standard deduction...........................      7,200      7,200
Less personal exemptions (8 @ $2,750).............     22,000     22,000
                                                   ---------------------
Taxable income....................................     42,100     42,100
    Regular tax (15% of $42,100)..................      6,315      6,315
    Tentative minimum tax (26% of $26,300)........      6,838      6,838
    Minimum tax ($6,838 less $6,315)..............        523        523
Pre-limitation credits ($2,000+$3,000+$960).......      5,960      5,960
Section 26(a) limit on nonrefundable credits:
    Regular tax...................................      6,315      6,315
    Less tentative minimum tax for sec. 26(a)(2)..      6,838          0
    Maximum nonrefundable credits allowable.......          0      6,315
Total nonrefundable credits allowed...............          0      5,960
Section 24(d) refundable child credit \111\.......      1,477          0
\111\ Under present law, the $1,477 section 24(d)
 refundable child credit is $2,000 less the $523
 minimum tax liability. Because the credits would
 be allowed in full under the proposal, the
 couple's section 24(d) child credit would be zero
 under the proposal.
Total credits allowed.............................      1,477      5,960
Net tax...........................................      5,361        878
                                                   ---------------------
Net tax reduction.................................  .........      4,483
------------------------------------------------------------------------

    Under the proposal, in addition to the tax savings, the 
couple would no longer be required to compute the tentative 
minimum tax or the section 24(d) refundable child credit to 
determine their net tax liability.
    Example 4.--Assume in 1999 a married couple has an adjusted 
gross income of $63,050, they do not itemize deductions, and 
they have three dependent children who qualify for the child 
tax credit. Also assume the couple is entitled to a dependent 
care credit of $960. Thus, the couple is eligible for $2,460 of 
credits. Also, assume the couple paid $4,000 in social security 
taxes for purposes of determining the refundable child credit 
for three or more qualifying children. The couple's net tax 
liability under present law and under the proposal are computed 
as follows:

------------------------------------------------------------------------
                                                     Present
                                                       law      Proposal
------------------------------------------------------------------------
Adjusted gross income.............................    $63,050    $63,050
Less standard deduction...........................      7,200      7,200
Less personal exemptions (5 @ $2,750).............     13,750     13,750
                                                   ---------------------
Taxable income....................................     42,100     42,100
Regular tax (15% of $42,100)......................      6,315      6,315
Tentative minimum tax (26% of $18,050)............      4,693      4,693
Pre-limitation credits ($1,500+$960)..............      2,460      2,460
Section 26(a) limit on nonrefundable credits:
    Regular tax...................................      6,315      6,315
    Less tentative minimum tax for sec. 26(a)(2)..      4,693          0
    Maximum nonrefundable credits allowable.......      1,622      6,315
Total nonrefundable credits allowed...............      1,622      2,460
Section 24(d) refundable child credit \112\.......        838          0
\112\ Under present law, this is the amount (not
 in excess of the $1,500 child tax credit) by
 which the nonrefundable credits would have been
 increased if the social security taxes were added
 to the section 26(a) limitation ($2,460 total
 credits less $1,622 credits otherwise allowable).
Total credits allowed.............................      2,460      2,460
Net tax...........................................      3,855      3,855
                                                   ---------------------
Net tax reduction.................................  .........          0
------------------------------------------------------------------------

    Although there would be no net tax reduction under the 
proposal, the couple would no longer be required to compute the 
tentative minimum tax or the section 24(d) refundable child 
credit to determine their net tax liability.

               2. Extend the work opportunity tax credit

                              Present Law

    The work opportunity tax credit (``WOTC'') is available on 
an elective basis for employers hiring individuals from one or 
more of eight targeted groups. The credit generally is equal to 
a percentage of qualified wages. The credit percentage is 25 
percent for employment of at least 120 hours but less than 400 
hours and 40 percent for employment of 400 hours or more. 
Qualified wages consist of wages attributable to service 
rendered by a member of a targeted group during the one-year 
period beginning with the day the individual begins work for 
the employer.
    Generally, no more than $6,000 of wages during the first 
year of employment is permitted to be taken into account with 
respect to any individual. Thus, the maximum credit per 
individual is $2,400. With respect to qualified summer youth 
employees, the maximum credit is 40 percent of up to $3,000 of 
qualified first-year wages, for a maximum credit of $1,200. The 
credit expires for wages paid to, or incurred with respect to, 
qualified individuals who begin work for the employer after 
June 30, 1999.
    The employer's deduction for wages is reduced by the amount 
of the credit.

                        Description of Proposal

    The proposal would extend the WOTC for one year (through 
June 30, 2000). The proposal would also clarify the 
coordination of the WOTC and the welfare-to-work tax credit 
with respect to an individual whose first year of employment 
does not coincide with the employer's taxable year.

                             Effective Date

    Generally, the proposal would be effective for wages paid 
to, or incurred with respect to, qualified individuals who 
begin work for the employer after June 30, 1999, and before 
July 1, 2000. The clarification of the coordination of WOTC and 
the welfare-to-work tax credit would be effective for taxable 
years beginning on or after the date of first committee action.

                              Prior Action

    A 22-month extension of the WOTC was included in the 
President's fiscal year 1999 budget proposal.

                                Analysis

Overview

    The WOTC is intended to increase the employment and 
earnings of targeted group members. The credit is made 
available to employers as an incentive to hire members of the 
targeted groups. To the extent the value of the credit is 
passed on from employers to employees, the wages of target 
group employees will be higher than they would be in the 
absence of the credit.\113\
---------------------------------------------------------------------------
    \113\ For individuals with productivity to employers lower than the 
minimum wage, the credit may result in these individuals being hired 
and paid the minimum wage. For these cases, it would be clear that the 
credit resulted in the worker receiving a higher wage than would have 
been received in the absence of the credit (e.g., zero).
---------------------------------------------------------------------------
    The rationale for the WOTC is that employers will not hire 
certain individuals without a subsidy, because either the 
individuals are stigmatized (e.g., convicted felons) or the 
current productivity of the individuals is below the prevailing 
wage rate. Where particular groups of individuals suffer 
reduced evaluations of work potential due to membership in one 
of the targeted groups, the credit may provide employers with a 
monetary offset for the lower perceived work potential. In 
these cases, employers may be encouraged to hire individuals 
from the targeted groups, and then make an evaluation of the 
individual's work potential in the context of the work 
environment, rather than from the job application. Where the 
current productivity of individuals is currently below the 
prevailing wage rate, on-the-job-training may provide 
individuals with skills that will enhance their productivity. 
In these situations, the WOTC provides employers with a 
monetary incentive to bear the costs of training members of 
targeted groups and providing them with job-related skills 
which may increase the chances of these individuals being hired 
in unsubsidized jobs. Both situations encourage employment of 
members of the targeted groups, and may act to increase wages 
for those hired as a result of the credit.
    As discussed below, the evidence is mixed on whether the 
rationales for the credit are supported by economic data. The 
information presented is intended to provide a structured way 
to determine if employers and employees respond to the 
existence of the credit in the desired manner.

Efficiency of the credit

    The credit provides employers with a subsidy for hiring 
members of targeted groups. For example, assume that a worker 
eligible for the credit is paid an hourly wage of w and works 
2,000 hours during the year. The worker is eligible for the 
full credit (40 percent of the first $6,000 of wages), and the 
firm will receive a $2,400 credit against its income taxes and 
reduce its deduction for wages by $2,400. Assuming the firm 
faces the full 35-percent corporate income tax rate, the cost 
of hiring the credit-eligible worker is lower than the cost of 
hiring a credit-ineligible worker for 2,000 hours at the same 
hourly wage w by 2,400 (1-.35) = $1,560.\114\ This $1,560 
amount would be constant for all workers unless the wage (w) 
changed in response to whether or not the individual was a 
member of a targeted group. If the wage rate does not change in 
response to credit eligibility, the WOTC subsidy is larger in 
percentage terms for lower wage workers. If w rises in response 
to the credit, it is uncertain how much of the subsidy remains 
with the employer, and therefore the size of the WOTC subsidy 
to employers is uncertain.
---------------------------------------------------------------------------
    \114\ The after-tax cost of hiring this credit eligible worker 
would be ((2,000)(w)-2,400)(1-.35) dollars. This example does not 
include the costs to the employer for payroll taxes (e.g., Social 
security, Medicare and unemployment taxes) and any applicable fringe 
benefits.
---------------------------------------------------------------------------
    To the extent the WOTC subsidy flows through to the workers 
eligible for the credit in the form of higher wages, the 
incentive for eligible individuals to enter the paid labor 
market may increase. Since many members of the targeted groups 
receive governmental assistance (e.g., Temporary Assistance for 
Needy Families or food stamps), and these benefits are phased 
out as income increases, these individuals potentially face a 
very high marginal tax rate on additional earnings. Increased 
wages resulting from the WOTC may be viewed as a partial offset 
to these high marginal tax rates. In addition, it may be the 
case that even if the credit has little effect on observed 
wages, credit-eligible individuals may have increased earnings 
due to increased employment.
    The structure of the WOTC (the 40-percent credit rate for 
the first $6,000 of qualified wages) appears to lend itself to 
the potential of employers churning employees who are eligible 
for the credit. This could be accomplished by firing employees 
after they earn $6,000 in wages and replacing them with other 
WOTC-eligible employees. If training costs are high relative to 
the size of the credit, it may not be in the interest of an 
employer to churn such employees in order to maximize the 
amount of credit claimed. Empirical research in this area has 
not found an explicit connection between employee turnover and 
utilization of WOTC's predecessor, the Targeted Jobs Tax Credit 
(``TJTC'').\115\
---------------------------------------------------------------------------
    \115\ See, for example, Macro Systems, Inc., Final Report of the 
Effect of the Targeted Jobs Tax Credit Program on Employers, U.S. 
Department of Labor, 1986.
---------------------------------------------------------------------------

Job creation

    The number of jobs created by the WOTC is certainly less 
than the number of certifications. To the extent employers 
substitute WOTC-eligible individuals for other potential 
workers, there is no net increase in jobs created. This could 
be viewed as merely a shift in employment opportunities from 
one group to another. However, this substitution of credit-
eligible workers for others may not be socially undesirable. 
For example, it might be considered an acceptable trade-off for 
a targeted group member to displace a secondary earner from a 
well-to-do family (e.g., a spouse or student working part-
time).
    In addition, windfall gains to employers or employees may 
accrue when the WOTC is received for workers that the firm 
would have hired even in the absence of the credit. When 
windfall gains are received, no additional employment has been 
generated by the credit. Empirical research on the employment 
gains from the TJTC has indicated that only a small portion of 
the TJTC-eligible population found employment because of the 
program. One study indicates that net new job creation was 
between 5 and 30 percent of the total certifications. This 
finding is consistent with some additional employment as a 
result of the TJTC program, but with considerable uncertainty 
as to the exact magnitude.\116\
---------------------------------------------------------------------------
    \116\ Macro Systems, Inc., Impact Study of the Implementation and 
Use of the Targeted Jobs Tax Credit: Overview and Summary, U.S. 
Department of Labor, 1986.
---------------------------------------------------------------------------
    A necessary condition for the credit to be an effective 
employment incentive is that firms incorporate WOTC eligibility 
into their hiring decisions. This could be done by determining 
credit eligibility for each potential employee or by making a 
concerted effort to hire individuals from segments of the 
population likely to include members of targeted groups. 
Studies examining this issue through the TJTC found that some 
employers made such efforts, while other employers did little 
to determine eligibility for the TJTC prior to the decision to 
hire an individual.\117\ In these latter cases, the TJTC 
provided a cash benefit to the firm, without affecting the 
decision to hire a particular worker.
---------------------------------------------------------------------------
    \117\ For example, see U.S. General Accounting Office, Targeted 
Jobs Tax Credit: Employer Actions to Recruit, Hire, and Retain Eligible 
Workers Vary (GAO-HRD 91-33), February 1991.
---------------------------------------------------------------------------

3. Extend the welfare-to-work tax credit

                              Present Law

    The Code provides to employers a tax credit on the first 
$20,000 of eligible wages paid to qualified long-term family 
assistance (AFDC or its successor program) recipients during 
the first two years of employment. The credit is 35 percent of 
the first $10,000 of eligible wages in the first year of 
employment and 50 percent of the first $10,000 of eligible 
wages in the second year of employment. The maximum credit is 
$8,500 per qualified employee.
    Qualified long-term family assistance recipients are: (1) 
members of a family that has received family assistance for at 
least 18 consecutive months ending on the hiring date; (2) 
members of a family that has received family assistance for a 
total of at least 18 months (whether or not consecutive) after 
the date of enactment of this credit if they are hired within 2 
years after the date that the 18-month total is reached; and 
(3) members of a family who are no longer eligible for family 
assistance because of either Federal or State time limits, if 
they are hired within two years after the Federal or State time 
limits made the family ineligible for family assistance.
    Eligible wages include cash wages paid to an employee plus 
amounts paid by the employer for the following: (1) educational 
assistance excludable under a section 127 program (or that 
would be excludable but for the expiration of sec. 127); (2) 
health plan coverage for the employee, but not more than the 
applicable premium defined under the health care continuation 
rules (section 4980B(f)(4)); and (3) dependent care assistance 
excludable under section 129.
    The welfare-to-work tax credit is effective for wages paid 
or incurred to a qualified individual who begins work for an 
employer on or after January 1, 1998 and before June 30, 1999.

                        Description of Proposal

    The welfare-to-work tax credit would be extended for one 
year, so that the credit would be available for eligible 
individuals who begin work before July 1, 2000.

                             Effective Date

    The proposal would be effective for wages paid to, or 
incurred with respect to, qualified individuals who begin work 
for an employer after June 30, 1999 and before July 1, 2000.

                              Prior Action

    A one-year extension of the welfare-to-work tax credit was 
included in the President's fiscal year 1999 budget proposal.

                                Analysis

    Proponents argue that an extension of the welfare-to-work 
tax credit will encourage employers to hire, train, and provide 
certain benefits and more permanent employment, to longer-term 
welfare recipients. Opponents argue that tax credits to 
employers for hiring certain classes of individuals do not 
increase overall employment and may disadvantage other 
deserving job applicants. There are also concerns about the 
efficiency of tax credits as an incentive to potential 
employees to enter the job market as well as an incentive for 
employers to retain such employees after they no longer qualify 
for the tax credit (e.g., replacing an employee whose wages no 
longer qualify for the tax credit with another employee whose 
wages do qualify). (For a more detailed discussion of these 
issues, refer to the analysis section of the extension of the 
work opportunity tax credit in Part I.G.2., above, of this 
pamphlet.)

4. Extend the research tax credit

                              Present Law

General rule

    Section 41 provides for a research tax credit equal to 20 
percent of the amount by which a taxpayer's qualified research 
expenditures for a taxable year exceeded its base amount for 
that year. The research tax credit is scheduled to expire and 
generally will not apply to amounts paid or incurred after June 
30,\118\ 1999.
---------------------------------------------------------------------------
    \118\ A special termination rule applies under section 41(h)(1) for 
taxpayers that elected to be subject to the alternative incremental 
research credit regime for their first taxable year beginning after 
June 30, 1996, and before July 1, 1997.
---------------------------------------------------------------------------
    A 20-percent research tax credit also applied to the excess 
of (1) 100 percent of corporate cash expenditures (including 
grants or contributions) paid for basic research conducted by 
universities (and certain nonprofit scientific research 
organizations) over (2) the sum of (a) the greater of two 
minimum basic research floors plus (b) an amount reflecting any 
decrease in nonresearch giving to universities by the 
corporation as compared to such giving during a fixed-base 
period, as adjusted for inflation. This separate credit 
computation is commonly referred to as the ``university basic 
research credit'' (see sec. 41(e)).

Computation of allowable credit

    Except for certain university basic research payments made 
by corporations, the research tax credit applies only to the 
extent that the taxpayer's qualified research expenditures for 
the current taxable year exceed its base amount. The base 
amount for the current year generally is computed by 
multiplying the taxpayer's ``fixed-base percentage'' by the 
average amount of the taxpayer's gross receipts for the four 
preceding years. If a taxpayer both incurred qualified research 
expenditures and had gross receipts during each of at least 
three years from 1984 through 1988, then its ``fixed-base 
percentage'' is the ratio that its total qualified research 
expenditures for the 1984-1988 period bears to its total gross 
receipts for that period (subject to a maximum ratio of .16). 
All other taxpayers (so-called ``start-up firms'') are assigned 
a fixed-base percentage of 3 percent.\119\
---------------------------------------------------------------------------
    \119\ The Small Business Job Protection Act of 1996 expanded the 
definition of ``start-up firms'' under section 41(c)(3)(B)(I) to 
include any firm if the first taxable year in which such firm had both 
gross receipts and qualified research expenses began after 1983.
    A special rule (enacted in 1993) is designed to gradually recompute 
a start-up firm's fixed-base percentage based on its actual research 
experience. Under this special rule, a start-up firm will be assigned a 
fixed-base percentage of 3 percent for each of its first five taxable 
years after 1993 in which it incurs qualified research expenditures. In 
the event that the research credit is extended beyond the scheduled 
expiration date, a start-up firm's fixed-base percentage for its sixth 
through tenth taxable years after 1993 in which it incurs qualified 
research expenditures will be a phased-in ratio based on its actual 
research experience. For all subsequent taxable years, the taxpayer's 
fixed-base percentage will be its actual ratio of qualified research 
expenditures to gross receipts for any five years selected by the 
taxpayer from its fifth through tenth taxable years after 1993 (sec. 
41(c)(3)(B)).
---------------------------------------------------------------------------
    In computing the credit, a taxpayer's base amount may not 
be less than 50 percent of its current-year qualified research 
expenditures.
    To prevent artificial increases in research expenditures by 
shifting expenditures among commonly controlled or otherwise 
related entities, a special aggregation rule provides that all 
members of the same controlled group of corporations are 
treated as a single taxpayer (sec. 41(f)(1)). Special rules 
apply for computing the credit when a major portion of a 
business changes hands, under which qualified research 
expenditures and gross receipts for periods prior to the change 
of ownership of a trade or business are treated as transferred 
with the trade or business that gave rise to those expenditures 
and receipts for purposes of recomputing a taxpayer's fixed-
base percentage (sec. 41(f)(3)).

Alternative incremental research credit regime

    Taxpayers are allowed to elect an alternative incremental 
research credit regime. If a taxpayer elects to be subject to 
this alternative regime, the taxpayer is assigned a three-
tiered fixed-base percentage (that is lower than the fixed-base 
percentage otherwise applicable under present law) and the 
credit rate likewise is reduced. Under the alternative credit 
regime, a credit rate of 1.65 percent applies to the extent 
that a taxpayer's current-year research expenses exceed a base 
amount computed by using a fixed-base percentage of 1 percent 
(i.e., the base amount equals 1 percent of the taxpayer's 
average gross receipts for the four preceding years) but do not 
exceed a base amount computed by using a fixed-base percentage 
of 1.5 percent. A credit rate of 2.2 percent applies to the 
extent that a taxpayer's current-year research expenses exceed 
a base amount computed by using a fixed-base percentage of 1.5 
percent but do not exceed a base amount computed by using a 
fixed-base percentage of 2 percent. A credit rate of 2.75 
percent applies to the extent that a taxpayer's current-year 
research expenses exceed a base amount computed by using a 
fixed-base percentage of 2 percent. An election to be subject 
to this alternative incremental credit regime may be made for 
any taxable year beginning after June 30, 1996, and such an 
election applies to that taxable year and all subsequent years 
unless revoked with the consent of the Secretary of the 
Treasury.

Eligible expenditures

    Qualified research expenditures eligible for the research 
tax credit consist of: (1) ``in-house'' expenses of the 
taxpayer for wages and supplies attributable to qualified 
research; (2) certain time-sharing costs for computer use in 
qualified research; and (3) 65 percent of amounts paid by the 
taxpayer for qualified research conducted on the taxpayer's 
behalf (so-called ``contract research expenses'').\120\
---------------------------------------------------------------------------
    \120\ Under a special rule enacted as part of the Small Business 
Job Protection Act of 1996, 75 percent of amounts paid to a research 
consortium for qualified research is treated as qualified research 
expenses eligible for the research credit (rather than 65 percent under 
the general rule under section 41(b)(3) governing contract research 
expenses) if (1) such research consortium is a tax-exempt organization 
that is described in section 501(c)(3) (other than a private 
foundation) or section 501(c)(6) and is organized and operated 
primarily to conduct scientific research, and (2) such qualified 
research is conducted by the consortium on behalf of the taxpayer and 
one or more persons not related to the taxpayer.
---------------------------------------------------------------------------
    To be eligible for the credit, the research must not only 
satisfy the requirements of present-law section 174 (described 
below) but must be undertaken for the purpose of discovering 
information that is technological in nature, the application of 
which is intended to be useful in the development of a new or 
improved business component of the taxpayer, and must pertain 
to functional aspects, performance, reliability, or quality of 
a business component. Research does not qualify for the credit 
if substantially all of the activities relate to style, taste, 
cosmetic, or seasonal design factors (sec. 41(d)(3)). In 
addition, research does not qualify for the credit if conducted 
after the beginning of commercial production of the business 
component, if related to the adaptation of an existing business 
component to a particular customer's requirements, if related 
to the duplication of an existing business component from a 
physical examination of the component itself or certain other 
information, or if related to certain efficiency surveys, 
market research or development, or routine quality control 
(sec. 41(d)(4)).
    Expenditures attributable to research that is conducted 
outside the United States do not enter into the credit 
computation. In particular, expenditures undertaken in the 
Commonwealth of Puerto Rico are not eligible for the research 
credit. In addition, the credit is not available for research 
in the social sciences, arts, or humanities, nor is it 
available for research to the extent funded by any grant, 
contract, or otherwise by another person (or governmental 
entity).

Relation to deduction

    Under section 174, taxpayers may elect to deduct currently 
the amount of certain research or experimental expenditures 
incurred in connection with a trade or business, 
notwithstanding the general rule that business expenses to 
develop or create an asset that has a useful life extending 
beyond the current year must be capitalized. However, 
deductions allowed to a taxpayer under section 174 (or any 
other section) are reduced by an amount equal to 100 percent of 
the taxpayer's research tax credit determined for the taxable 
year. Taxpayers may alternatively elect to claim a reduced 
research tax credit amount under section 41 in lieu of reducing 
deductions otherwise allowed (sec. 280C(c)(3)).

                        Description of Proposal

    The research tax credit would be extended for twelve 
months--i.e., for the period July 1, 1999, through June 30, 
2000.
    The proposal also would make expenditures on qualified 
research activities undertaken in the Commonwealth of Puerto 
Rico eligible for the research tax credit.

                             Effective Date

    The proposal would be effective for qualified research 
expenditures paid or incurred during the period July 1, 1999, 
through June 30, 2000. With respect to qualifying activities 
undertaken in Puerto Rico the provision would be effective for 
taxable years beginning on or after the date of enactment.

                              Prior Action

    The research tax credit initially was enacted in the 
Economic Recovery Tax Act of 1981 as a credit equal to 25 
percent of the excess of qualified research expenses incurred 
in the current taxable year over the average of qualified 
research expenses incurred in the prior three taxable years. 
The research tax credit was modified in the Tax Reform Act of 
1986, which (1) extended the credit through December 31, 1988, 
(2) reduced the credit rate to 20 percent, (3) tightened the 
definition of qualified research expenses eligible for the 
credit, and (4) enacted the separate, university basic research 
credit.
    The Technical and Miscellaneous Revenue Act of 1988 (``1988 
Act'') extended the research tax credit for one additional 
year, through December 31, 1989. The 1988 Act also reduced the 
deduction allowed under section 174 (or any other section) for 
qualified research expenses by an amount equal to 50 percent of 
the research tax credit determined for the year.
    The Omnibus Budget Reconciliation Act of 1989 (``1989 
Act'') effectively extended the research credit for nine months 
(by prorating qualified expenses incurred before January 1, 
1991). The 1989 Act also modified the method for calculating a 
taxpayer's base amount (i.e., by substituting the present-law 
method which uses a fixed-base percentage for the prior-law 
moving base which was calculated by reference to the taxpayer's 
average research expenses incurred in the preceding three 
taxable years). The 1989 Act further reduced the deduction 
allowed under section 174 (or any other section) for qualified 
research expenses by an amount equal to 100 percent of the 
research tax credit determined for the year.
    The Omnibus Budget Reconciliation Act of 1990 extended the 
research tax credit through December 31, 1991 (and repealed the 
special rule to prorate qualified expenses incurred before 
January 1, 1991).
    The Tax Extension Act of 1991 extended the research tax 
credit for six months (i.e., for qualified expenses incurred 
through June 30, 1992).
    The Omnibus Budget Reconciliation Act of 1993 (``1993 
Act'') extended the research tax credit for three years--i.e., 
retroactively from July 1, 1992 through June 30, 1995. The 1993 
Act also provided a special rule for start-up firms, so that 
the fixed-base ratio of such firms eventually will be computed 
by reference to their actual research experience (see footnote 
60 supra).
    Although the research tax credit expired during the period 
July 1, 1995, through June 30, 1996, the Small Business Job 
Protection Act of 1996 (``1996 Act'') extended the credit for 
the period July 1, 1996, through May 31, 1997 (with a special 
11-month extension for taxpayers that elect to be subject to 
the alternative incremental research credit regime). In 
addition, the 1996 Act expanded the definition of ``start-up 
firms'' under section 41(c)(3)(B)(I), enacted a special rule 
for certain research consortia payments under section 
41(b)(3)(C), and provided that taxpayers may elect an 
alternative research credit regime (under which the taxpayer is 
assigned a three-tiered fixed-base percentage that is lower 
than the fixed-base percentage otherwise applicable and the 
credit rate likewise is reduced) for the taxpayer's first 
taxable year beginning after June 30, 1996, and before July 1, 
1997.
    The Taxpayer Relief Act of 1997 (``1997 Act'') extended the 
research credit for 13 months--i.e., generally for the period 
June 1, 1997, through June 30, 1998. The 1997 Act also provided 
that taxpayers are permitted to elect the alternative 
incremental research credit regime for any taxable year 
beginning after June 30, 1996 (and such election will apply to 
that taxable year and all subsequent taxable years unless 
revoked with the consent of the Secretary of the Treasury). The 
Tax and Trade Relief Extension Act of 1998 extended the 
research credit for 12 months, i.e., through June 30, 1999.

                                Analysis

Overview

    Technological development is an important component of 
economic growth. However, while an individual business may find 
it profitable to undertake some research, it may not find it 
profitable to invest in research as much as it otherwise might 
because it is difficult to capture the full benefits from the 
research and prevent such benefits from being used by 
competitors. In general, businesses acting in their own self-
interest will not necessarily invest in research to the extent 
that would be consistent with the best interests of the overall 
economy. This is because costly scientific and technological 
advances made by one firm are cheaply copied by its 
competitors. Research is one of the areas where there is a 
consensus among economists that government intervention in the 
marketplace can improve overall economic efficiency.\121\ 
However, this does not mean that increased tax benefits or more 
government spending for research always will improve economic 
efficiency. It is possible to decrease economic efficiency by 
spending too much on research. It is difficult to determine 
whether, at the present levels of government subsidies for 
research, further government spending on research or additional 
tax benefits for research would increase or decrease overall 
economic efficiency. There is evidence that the current level 
of research undertaken in the United States, and worldwide, is 
too little to maximize society's well-being.\122\
---------------------------------------------------------------------------
    \121\ This conclusion does not depend upon whether the basic tax 
regime is an income tax or a consumption tax.
    \122\ See Zvi Griliches, ``The Search for R&D Spillovers,'' 
Scandinavian Journal of Economics, XCIV, (1992) and M. Ishaq Nadiri, 
``Innovations and Technological Spillovers,'' National Bureau of 
Economic Research, Working Paper No. 4423, 1993. These papers suggest 
that the rate of return to privately funded research expenditures is 
high compared to that in physical capital and the social rate of return 
exceeds the private rate of return. Griliches concludes, ``In spite of 
[many] difficulties, there has been a significant number of reasonably 
well-done studies all pointing in the same direction: R&D spillovers 
are present, their magnitude may be quite large, and social rates of 
return remain significantly above private rates.'' (p. S43)
---------------------------------------------------------------------------
    If it is believed that too little research is being 
undertaken, a tax subsidy is one method of offsetting the 
private-market bias against research, so that research projects 
undertaken approach the optimal level. Among the other policies 
employed by the Federal Government to increase the aggregate 
level of research activities are direct spending and grants, 
favorable anti-trust rules, and patent protection. The effect 
of tax policy on research activity is largely uncertain because 
there is relatively little evidence about the responsiveness of 
research to changes in taxes and other factors affecting its 
price. To the extent that research activities are responsive to 
the price of research activities, the research and 
experimentation tax credit should increase research activities 
beyond what they otherwise would be. However, the present-law 
treatment of research expenditures does create certain 
complexities and compliance costs.

The scope of present-law tax expenditures on research activities

    The tax expenditure related to the research and 
experimentation tax credit is estimated to be $1.6 billion for 
1999. The related tax expenditure for expensing of research and 
development expenditures is estimated to be $1.9 billion for 
1999 growing to $3.0 billion for 2003.\123\ As noted above, the 
Federal Government also directly subsidizes research 
activities. For example, in fiscal 1998 the National Science 
Foundation made $2.4 billion in grants, subsidies, and 
contributions to research activities, the Department of Defense 
financed $2.1 billion in advanced technology development, and 
the Department of Energy financed $250 million in fuels 
research and clean/efficient power systems research.\124\
---------------------------------------------------------------------------
    \123\ Joint Committee on Taxation, Estimates of Federal Tax 
Expenditures for Fiscal Years 1999-2003 (JCS-7-98), December 14, 1998, 
p.15.
    \124\ Office of Management and Budget, Budget of the United States 
Government, Fiscal Year 2000: Appendix, pp. 1062, 291, and 400.
---------------------------------------------------------------------------
    Tables 2 and 3 present data for 1993 on those industries 
that utilized the research tax credit and the distribution of 
the credit claimants by firm size. Three quarters of the 
research tax credits claimed are claimed by taxpayers whose 
primary activity is manufacturing. Nearly two-thirds of the 
credits claimed are claimed by large firms (assets of $500 
million or more). Nevertheless, as Table 3 documents, a large 
number of small firms are engaged in research and are able to 
claim the research tax credit.

 Table 2.--Percentage Distribution of Firms Claiming Research Tax Credit
            and of Amount of Credit Claimed  by Sector, 1993
------------------------------------------------------------------------
                                                 Number  of     Credit
                      Sector                       firms       claimed
                                                 (percent)    (percent)
------------------------------------------------------------------------
Agriculture, Forestry and Fishing.............        (\1\)        (\1\)
Mining........................................        (\1\)        (\1\)
Construction..................................          0.7          0.4
Manufacturing.................................         58.0         75.2
Transportation, Communication, and Public               1.4          8.1
 Utilities....................................
Wholesale and Retail Trade....................          9.1          2.6
Finance, Insurance, and Real Estate...........          1.5          1.3
Services......................................         28.3        12.0
------------------------------------------------------------------------
\1\ Data undisclosed to protect taxpayer confidentiality.
 
Source: Joint Committee on Taxation staff calculations from Internal
  Revenue Service, Statistics of Income data.


 Table 3.--Percentage Distribution of Firms Claiming Research Tax Credit
           and of Amount of Credit Claimed  by Firm Size, 1993
------------------------------------------------------------------------
                                                 Number  of     Credit
               Asset size (dollars)                firms       claimed
                                                 (percent)    (percent)
------------------------------------------------------------------------
0.............................................          0.6          0.2
1-100,000.....................................         13.4          0.4
100,000-250,000...............................          6.0          0.5
250,000-500,000...............................         10.2          0.9
500,000-1 million.............................         14.6          1.4
1 million-10 million..........................         32.7          7.9
10 million-50 million.........................         12.2          8.5
50 million-100 million........................          2.8          4.2
100 million-250 million.......................          2.4          5.0
250 million-500 million.......................          1.4          6.0
500 million and over..........................          3.7        64.9
------------------------------------------------------------------------
Source: Joint Committee on Taxation staff calculations from Internal
  Revenue Service, Statistics of Income data.

Incremental tax credits

    For a tax credit to be effective in increasing a taxpayer's 
research expenditures it is not necessary to provide that 
credit for all the taxpayer's research expenditures. By 
limiting the credit to expenditures above a base amount, 
incremental tax credits attempt to target the tax incentives 
where they will have the most effect on taxpayer behavior.
    Suppose, for example, a taxpayer is considering two 
potential research projects: Project A will generate cash flow 
with a present value of $105 and Project B will generate cash 
flow with present value of $95. Suppose that the cost of 
investing in each of these projects is $100. Without any tax 
incentives, the taxpayer will find it profitable to invest in 
Project A and will not invest in Project B.
    Consider now the situation where a 10-percent ``flat 
credit'' applies to all research expenditures incurred. In the 
case of Project A, the credit effectively reduces the cost to 
$90. This increases profitability, but does not change behavior 
with respect to that project, since it would have been 
undertaken in any event. However, because the cost of Project B 
also is reduced to $90, this previously neglected project (with 
a present value of $95) would now be profitable. Thus, the tax 
credit would affect behavior only with respect to this marginal 
project.
    Incremental credits attempt not to reward projects which 
would have been undertaken in any event and to target 
incentives to marginal projects. To the extent this is 
possible, incremental credits have the potential to be far more 
effective per dollar of revenue cost than flat credits in 
inducing taxpayers to increase qualified expenditures.\125\ 
Unfortunately, it is nearly impossible as a practical matter to 
determine which particular projects would be undertaken without 
a credit and to provide credits only to other projects. In 
practice, almost all incremental credit proposals rely on some 
measure of the taxpayer's previous experience as a proxy for a 
taxpayer's total qualified expenditures in the absence of a 
credit. This is referred to as the credit's ``base amount.'' 
Tax credits are provided only for amounts above this base 
amount.
---------------------------------------------------------------------------
    \125\ In the example above, if an incremental credit were properly 
targeted, the Government could spend the same $20 in credit dollars and 
induce the taxpayer to undertake a marginal project so long as its 
expected cash flow exceeded $80.
---------------------------------------------------------------------------
    Since a taxpayer's calculated base amount is only an 
approximation of what would have been spent in the absence of a 
credit, in practice, the credit may be less effective per 
dollar of revenue cost than it otherwise might be in increasing 
expenditures. If the calculated base amount is too low, the 
credit is awarded to projects that would have been undertaken 
even in the absence of a credit. If, on the other hand, the 
calculated base amount is too high, then there is no incentive 
for projects that actually are on the margin.
    Nevertheless, the incentive effects of incremental credits 
per dollar of revenue loss can be many times larger than those 
of a flat credit. However, in comparing a flat credit to an 
incremental credit, there are other factors that also deserve 
consideration. A flat credit generally has lower administrative 
and compliance costs than does an incremental credit. Probably 
more important, however, is the potential misallocation of 
resources and unfair competition that could result as firms 
with qualified expenditures determined to be above their base 
amount receive credit dollars, while other firms with qualified 
expenditures considered below their base amount receive no 
credit.

     The responsiveness of research expenditures to tax incentives

    Like any other commodity, the amount of research 
expenditures that a firm wishes to incur generally is expected 
to respond positively to a reduction in the price paid by the 
firm. Economists often refer to this responsiveness in terms of 
``price elasticity,'' which is measured as the ratio of the 
percentage change in quantity to a percentage change in price. 
For example, if demand for a product increases by five percent 
as a result of a 10-percent decline in price paid by the 
purchaser, that commodity is said to have a price elasticity of 
demand of 0.5.\126\ One way of reducing the price paid by a 
buyer for a commodity is to grant a tax credit upon purchase. A 
tax credit of 10 percent (if it is refundable or immediately 
usable by the taxpayer against current tax liability) is 
equivalent to a 10-percent price reduction. If the commodity 
granted a 10-percent tax credit has an elasticity of 0.5, the 
amount consumed will increase by five percent. Thus, if a flat 
research tax credit were provided at a 10-percent rate, and 
research expenditures had a price elasticity of 0.5, the credit 
would increase aggregate research spending by five 
percent.\127\
---------------------------------------------------------------------------
    \126\ For simplicity, this analysis assumes that the product in 
question can be supplied at the same cost despite any increase in 
demand (i.e., the supply is perfectly elastic). This assumption may not 
be valid, particularly over short periods of time, and particularly 
when the commodity--such as research scientists and engineers--is in 
short supply.
    \127\ It is important to note that not all research expenditures 
need be subject to a price reduction to have this effect. Only the 
expenditures which would not have been undertaken otherwise--so called 
marginal research expenditures--need be subject to the credit to have a 
positive incentive effect.
---------------------------------------------------------------------------
    Despite the central role of the measurement of the price 
elasticity of research activities, there is little empirical 
evidence on this subject. What evidence exists generally 
indicates that the price elasticity for research is 
substantially less than one. For example, one survey of the 
literature reached the following conclusion:

          In summary, most of the models have estimated long-
        run price elasticities of demand for R&D on the order 
        of -0.2 and -0.5. . . . However, all of the 
        measurements are prone to aggregation problems and 
        measurement errors in explanatory variables.\128\
---------------------------------------------------------------------------
    \128\ Charles River Associates, An Assessment of Options for 
Restructuring the R&D Tax Credit to Reduce Dilution of its Marginal 
Incentive (final report prepared for the National Science Foundation), 
February, 1985, p. G-14.

    Although most analysts agree that there is substantial 
uncertainty in these estimates, the general consensus when 
assumptions are made with respect to research expenditures is 
that the price elasticity of research is less than 1.0 and may 
be less than 0.5.\129\ Apparently there have been no specific 
studies of the effectiveness of the university basic research 
tax credit.
---------------------------------------------------------------------------
    \129\ In a 1983 study, the Treasury Department used an elasticity 
of .92 as its upper range estimate of the price elasticity of R&D, but 
noted that the author of the unpublished study from which this estimate 
was taken conceded that the estimate might be biased upward. See, 
Department of the Treasury, The Impact of Section 861-8 Regulation on 
Research and Development, p. 23. As stated in the text, although there 
is uncertainty, most analysts believe the elasticity is considerable 
smaller. For example, the General Accounting Office summarizes: ``These 
studies, the best available evidence, indicate that spending on R&E is 
not very responsive to price reductions. Most of the elasticity 
estimates fall in the range of 0.2 and 0.5. . . . Since it is commonly 
recognized that all of the estimates are subject to error, we used a 
range of elasticity estimates to compute a range of estimates of the 
credit's impact.'' See, The Research Tax Credit Has Stimulated Some 
Additional Research Spending (GAO/GGD-89-114), September 1989, p. 23. 
Similarly, Edwin Mansfield concludes: ``While our knowledge of the 
price elasticity of demand for R&D is far from adequate, the best 
available estimates suggest that it is rather low, perhaps about 0.3.'' 
See, ``The R&D Tax Credit and Other Technology Policy Issues,'' 
American Economic Review, Vol. 76, no. 2, May 1986, p. 191.
    More recent empirical analyses have estimated higher elasticity 
estimates. One recent empirical analysis of the research credit has 
estimated a short-run price elasticity of 0.8 and a long-run price 
elasticity of 2.0. The author of this study notes that the long-run 
estimate should be viewed with caution for several technical reasons. 
In addition, the data utilized for the study cover the period 1980 
through 1991, containing only two years under the revised credit 
structure. This makes it empirically difficult to distinguish short-run 
and long-run effects, particularly as it may take firms some time to 
fully appreciate the incentive structure of the revised credit. See, 
Bronwyn H. Hall, ``R&D Tax Policy During the 1980s: Success or 
Failure?'' in James M. Poterba (ed.), Tax Policy and the Economy, 7, 
pp. 1-35 (Cambridge: The MIT Press, 1993). Another recent study 
examined the post-1986 growth of research expenditures by 40 U.S.-based 
multinationals and found price elasticities between 1.2 and 1.8. 
However, including an additional 76 firms, that had initially been 
excluded because they had been involved in merger activity, the 
estimated elasticities fell by half. See, James R. Hines, Jr., ``On the 
Sensitivity of R&D to Delicate Tax Changes: The Behavior of U.S. 
Multinationals in the 1980s'' in Alberto Giovannini, R. Glenn Hubbard, 
and Joel Slemrod (eds.), Studies in International Taxation, (Chicago: 
University of Chicago Press 1993). Also see M. Ishaq Nadiri and 
Theofanis P. Mamuneas, ``R&D Tax Incentives and Manufacturing-Sector 
R&D Expenditures,'' in James M. Poterba, editor, Borderline Case: 
International Tax Policy, Corporate Research and Development, and 
Investment, (Washington, D.C.: National Academy Press), 1997. While 
their study concludes that one dollar of research tax credit produces 
95 cents of research, they note that time series empirical work is 
clouded by poor measures of the price deflators used to convert nominal 
research expenditures to real expenditures.
    Other research suggests that many of the elasticity studies may 
overstate the efficiency of subsidies to research. Most R&D spending is 
for wages and the supply of qualified scientists is small, particularly 
in the short run. Subsidies may raise the wages of scientists, and 
hence research spending, without increasing actual research. See Austan 
Goolsbee, ``Does Government R&D Policy Mainly Benefit Scientists and 
Engineers?'' National Bureau of Economic Research Working Paper #6532, 
April 1998.
---------------------------------------------------------------------------

Other issues related to the research and experimentation credit

    Perhaps the greatest criticism of the research and 
experimentation tax credit among taxpayers regards its 
temporary nature. Research projects frequently span years. If a 
taxpayer considers an incremental research project, the lack of 
certainty regarding the availability of future credits 
increases the financial risk of the expenditure. A credit of 
longer duration may more successfully induce additional 
research than would a temporary credit, even if the temporary 
credit is periodically renewed.
    An incremental credit does not provide an incentive for all 
firms undertaking qualified research expenditures. Many firms 
have current-year qualified expenditures below the base amount. 
These firms receive no tax credit and have an effective rate of 
credit of zero. Although there is no revenue cost associated 
with firms with qualified expenditures below base, there may be 
a distortion in the allocation of resources as a result of 
these uneven incentives.
    If a firm has no current tax liability, or if the firm is 
subject to the alternative minimum tax (AMT) or the general 
business credit limitation, the research credit must be carried 
forward for use against future-year tax liabilities. The 
inability to use a tax credit immediately reduces its value 
according to the length of time between when it actually is 
earned and the time it actually is used to reduce tax 
liability.\130\
---------------------------------------------------------------------------
    \130\ As with any tax credit that is carried forward, its full 
incentive effect could be restored, absent other limitations, by 
allowing the credit to accumulate interest that is paid by the Treasury 
to the taxpayer when the credit ultimately is utilized.
---------------------------------------------------------------------------
    Under present law, firms with research expenditures 
substantially in excess of their base amount may be subject to 
the 50-percent limitation. In general, although these firms 
receive the largest amount of credit when measured as a 
percentage of their total qualified research expenditures, 
their marginal effective rate of credit is exactly one half of 
the statutory credit rate of 20 percent (i.e., firms on the 
base limitation effectively are governed by a 10-percent credit 
rate).
    Although the statutory rate of the research credit is 
currently 20 percent, it is likely that the average marginal 
effective rate may be substantially below 20 percent. 
Reasonable assumptions about the frequency that firms are 
subject to various limitations discussed above yields estimates 
of an average effective rate of credit between 25 and 40 
percent below the statutory rate i.e., between 12 and 15 
percent.\131\
---------------------------------------------------------------------------
    \131\ For a more complete discussion of this point see Joint 
Committee on Taxation, Description and Analysis of Tax Provisions 
Expiring in 1992 (JCS-2-92), January 27, 1992, pp. 65-66.
---------------------------------------------------------------------------
    Since sales growth over a long time frame will rarely track 
research growth, it can be expected that over time each firm's 
base will ``drift'' from the firm's actual current qualified 
research expenditures. Therefore, increasingly over time there 
will be a larger number of firms either substantially above or 
below their calculated base. This could gradually create an 
undesirable situation where many firms receive no credit and 
have no reasonable prospect of ever receiving a credit, while 
other firms receive large credits (despite the 50-percent base 
limitation). Thus, over time, it can be expected that, for 
those firms eligible for the credit, the average marginal 
effective rate of credit will decline while the revenue cost to 
the Federal Government increases.
    Administrative and compliance burdens also result from the 
present-law research tax credit. The General Accounting Office 
(``GAO'') has testified that the research tax credit is 
difficult for the IRS to administer. The GAO reports that the 
IRS view is that it is ``required to make difficult technical 
judgments in audits concerning whether research was directed to 
produce truly innovative products or processes.'' While the IRS 
employs engineers in such audits, the companies engaged in the 
research typically employ personnel with greater technical 
expertise and, as would be expected, personnel with greater 
expertise regarding the intended application of the specific 
research conducted by the company under audit. Such audits 
create a burden for both the IRS and taxpayers. The credit 
generally requires taxpayers to maintain records more detailed 
than those necessary to support the deduction of research 
expenses under section 174.\132\
---------------------------------------------------------------------------
    \132\ Natwar M. Gandhi, Associate Director Tax Policy and 
Administration Issues, General Government Division, U.S. General 
Accounting Office, ``Testimony before the Subcommittee on Taxation and 
Internal Revenue Service Oversight,'' Committee on Finance, United 
States Senate, April 3, 1995.
---------------------------------------------------------------------------
    Under present law, research activities conducted in U.S. 
territories are not eligible for the research credit. Some have 
advocated that, to help foster economic development in the 
territories, it might be appropriate to extend credit 
eligibility to research undertaken in U.S. territories. 
Proponents note that incomes in the territories, and 
particularly in Puerto Rico, lag behind those of the 
States.\133\
---------------------------------------------------------------------------
    \133\ The 1990 Census reported that in 1989 the median family 
income in the United States was $35,225, while in Puerto Rico it was 
$9,988, in the Virgin Islands it was $24,036, in Guam it was $31,178, 
in American Samoa it was $15,979, and in the Northern Mariana Islands 
it was $21,275. Bureau of the Census, U.S. Department of Commerce, 
Statistical Abstract of the United States, 1997, p. 813.
---------------------------------------------------------------------------
    Permitting the research credit to be claimed for activities 
in the territories may encourage businesses to expand in the 
territories and encourage the growth of technology industries 
in the territories. Technology industries generally pay higher 
wages. It is unclear whether, and in what manner, the research 
credit would apply to active businesses located in the 
territories that are subsidiaries of a U.S. business. If an 
active business in a U.S. territory is a branch of a domestic 
corporation, the taxation of its activity in the territory, 
including any qualified research activities, would be 
equivalent to the taxation of the same activities carried out 
in the States. However, in this circumstance, the corporation 
may be able to claim the economic activity credit permitted 
under section 30A. Coordination of the research credit with the 
economic activity credit may be appropriate under such 
circumstances.\134\
---------------------------------------------------------------------------
    \134\ The Administration proposes extending and modifying the 
section 30A credit. See Part I.I.1 of this pamphlet for a description 
and discussion of that proposal.
---------------------------------------------------------------------------

5. Make permanent the expensing of brownfields remediation costs

                              Present Law

    Code section 162 allows a deduction for ordinary and 
necessary expenses paid or incurred in carrying on any trade or 
business. Treasury regulations provide that the cost of 
incidental repairs which neither materially add to the value of 
property nor appreciably prolong its life, but keep it in an 
ordinarily efficient operating condition, may be deducted 
currently as a business expense. Section 263(a)(1) limits the 
scope of section 162 by prohibiting a current deduction for 
certain capital expenditures. Treasury regulations define 
``capital expenditures'' as amounts paid or incurred to 
materially add to the value, or substantially prolong the 
useful life, of property owned by the taxpayer, or to adapt 
property to a new or different use. Amounts paid for repairs 
and maintenance do not constitute capital expenditures. The 
determination of whether an expense is deductible or 
capitalizable is based on the facts and circumstances of each 
case.
    Under Code section 198, taxpayers can elect to treat 
certain environmental remediation expenditures that would 
otherwise be chargeable to capital account as deductible in the 
year paid or incurred. The deduction applies for both regular 
and alternative minimum tax purposes. The expenditure must be 
incurred in connection with the abatement or control of 
hazardous substances at a qualified contaminated site. In 
general, any expenditure for the acquisition of depreciable 
property used in connection with the abatement or control of 
hazardous substances at a qualified contaminated site does not 
constitute a qualified environmental remediation expenditure. 
However, depreciation deductions allowable for such property, 
which would otherwise be allocated to the site under the 
principles set forth in Commissioner v. Idaho Power Co.\135\ 
and section 263A, are treated as qualified environmental 
remediation expenditures.
---------------------------------------------------------------------------
    \135\ Commissioner v. Idaho Power Co., 418 U.S. 1 (1974) (holding 
that equipment depreciation allocable to the taxpayer's construction of 
capital facilities must be capitalized under section 263(a)(1)).
---------------------------------------------------------------------------
    A ``qualified contaminated site'' generally is any property 
that: (1) is held for use in a trade or business, for the 
production of income, or as inventory; (2) is certified by the 
appropriate State environmental agency to be located within a 
targeted area; and (3) contains (or potentially contains) a 
hazardous substance (so-called ``brownfields''). Targeted areas 
are defined as: (1) empowerment zones and enterprise 
communities as designated under present law and under the Act 
\136\ (including any supplemental empowerment zone designated 
on December 21, 1994); (2) sites announced before February 
1997, as being subject to an Environmental Protection Agency 
(``EPA'') Brownfields Pilot; (3) any population census tract 
with a poverty rate of 20 percent or more; and (4) certain 
industrial and commercial areas that are adjacent to tracts 
described in (3) above.
---------------------------------------------------------------------------
    \136\ Thus, the 22 additional empowerment zones authorized to be 
designated under the Taxpayer Relief Act of 1997, as well as the D.C. 
Enterprise Zone, are ``targeted areas'' for purposes of this provision.
---------------------------------------------------------------------------
    Both urban and rural sites qualify. However, sites that are 
identified on the national priorities list under the 
Comprehensive Environmental Response, Compensation, and 
Liability Act of 1980 (``CERCLA'') cannot qualify as targeted 
areas. The chief executive officer of a State, in consultation 
with the Administrator of the EPA, was authorized to designate 
an appropriate State environmental agency. If no State 
environmental agency was so designated within 60 days of the 
date of enactment, the Administrator of the EPA was authorized 
to designate the appropriate environmental agency for such 
State. Hazardous substances generally are defined by reference 
to sections 101(14) and 102 of CERCLA, subject to additional 
limitations applicable to asbestos and similar substances 
within buildings, certain naturally occurring substances such 
as radon, and certain other substances released into drinking 
water supplies due to deterioration through ordinary use.
    In the case of property to which a qualified environmental 
remediation expenditure otherwise would have been capitalized, 
any deduction allowed under the Act is treated as a 
depreciation deduction and the property is treated as section 
1245 property. Thus, deductions for qualified environmental 
remediation expenditures are subject to recapture as ordinary 
income upon sale or other disposition of the property. In 
addition, sections 280B (demolition of structures) and 468 
(special rules for mining and solid waste reclamation and 
closing costs) do not apply to amounts which are treated as 
expenses under this provision.
    The provision applies only to eligible expenditures paid or 
incurred in taxable years ending after August 5, 1997, and 
before January 1, 2001.

                        Description of Proposal

    The proposal would eliminate the requirement that 
expenditures must be paid or incurred in taxable years ending 
before January 1, 2001, to be deductible as eligible 
environmental remediation expenditures. Thus, the provision 
would become permanent.

                             Effective Date

    The proposal would be effective on the date of enactment.

                              Prior Action

    An identical proposal was included in the President's 
fiscal year 1999 budget proposal. The special expensing for 
environmental remediation expenditures was enacted as part of 
the Taxpayer Relief Act of 1997.

                                Analysis

    The proposal to make permanent the expensing of brownfields 
remediation costs would promote the goal of environmental 
remediation and remove doubt as to the future deductibility of 
remediation expenses. Removing the doubt about deductibility 
may be desirable if the present-law expiration date is 
currently affecting investment planning. For example, the 
temporary nature of relief under present law may discourage 
projects that require a significant ongoing investment, such as 
groundwater clean-up projects. On the other hand, extension of 
the provision for a limited period of time would allow 
additional time to assess the efficacy of the law, adopted only 
recently as part of the Taxpayer Relief act of 1997, prior to 
any decision as to its permanency.
    The proposal is intended to encourage environmental 
remediation, and general business investment, in sites located 
in enterprise communities and empowerment zones, the original 
EPA Brownfields Pilots, or in census tracts with poverty rates 
of 20 percent or more, or certain adjacent tracts. With respect 
to environmental remediation, it is not clear that the 
restriction to certain areas will lead to the most socially 
desirable distribution of environmental remediation. It is 
possible that the same dollar amount of expenditures for 
remediation in other areas could produce a greater net social 
good, and thus the restriction to specific areas diminishes 
overall efficiency. On the other hand, property located in a 
nonqualifying area may have sufficient intrinsic value so that 
environmental remediation will be undertaken absent a special 
tax break. With respect to environmental remediation tax 
benefits as an incentive for general business investment, it is 
possible that the incentive may have the effect of distorting 
the location of new investment, rather than increasing 
investment overall.\137\ If the new investments are offset by 
less investment in neighboring, but not qualifying, areas, the 
neighboring communities could suffer. On the other hand, the 
increased investment in the qualifying areas could have 
spillover effects that are beneficial to the neighboring 
communities.
---------------------------------------------------------------------------
    \137\ For a discussion of the economic effects of enterprise zones, 
see Leslie E. Papke, ``What Do We Know About Enterprise Zones,'' in Jim 
Poterba, ed., Tax Policy and the Economy (Cambridge, MA: The MIT 
Press), 1993.
---------------------------------------------------------------------------
    Further, permanently extending the brownfields provision 
raises administrative issues. For example, it is unclear 
whether currently qualified zone sites will continue to qualify 
after such designation expires, by law, after 10 years. 
Similarly, it is unclear whether the application to census 
tracts (currently defined by the 1990 census) with poverty 
rates of 20 percent or more (or certain adjacent tracts) 
applies to tracts that meet such qualifications on (1) August 
5, 1997 (the effective date of the original brownfields 
legislation), (2) the effective date of this proposal, or (3) 
the date of the expenditure.

6. Extend tax credit for first-time D.C. homebuyers

                              Present Law

    First-time homebuyers of a principal residence in the 
District of Columbia are eligible for a nonrefundable tax 
credit of up to $5,000 of the amount of the purchase price. The 
$5,000 maximum credit applies both to individuals and married 
couples. Married individuals filing separately can claim a 
maximum credit of $2,500 each. The credit phases out for 
individual taxpayers with adjusted gross income between $70,000 
and $90,000 ($110,000-$130,000 for joint filers). For purposes 
of eligibility, ``first-time homebuyer'' means any individual 
if such individual did not have a present ownership interest in 
a principal residence in the District of Columbia in the one 
year period ending on the date of the purchase of the residence 
to which the credit applies.
    The credit is scheduled to expire for residences purchased 
after December 31, 2000.

                        Description of Proposal

    The D.C. first-time homebuyer tax credit would be extended 
for 12 months, from January 1, 2001, through December 31, 2001.

                             Effective Date

    The proposal would be effective on the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    The District of Columbia has experienced a long-term 
decline in the number of residents, though there are some signs 
that this trend may be slowing down or reversing.\138\ Between 
1990 and 1998, the District of Columbia population fell by 
83,776, from 606,900 to 523,124.\139\ The D.C. first-time 
homebuyer credit aims to encourage eligible homebuyers to buy 
in the District of Columbia rather than in the outlying suburbs 
in Virginia and Maryland. The aim is to encourage home 
ownership in the District of Columbia to stabilize or increase 
its population and thus to improve its tax base.
---------------------------------------------------------------------------
    \138\ See ``Population Loss Eases Again in District,'' The 
Washington Post, December 31, 1998, p. A1.
    \139\ See ``State Population Estimates and Demographic Components 
of Population Change: April 1, 1990 to July 1, 1998,'' Department of 
Commerce, Bureau of the Census.
---------------------------------------------------------------------------
    Recently, home sales in the District of Columbia have 
reached record levels, and sales prices have increased. From 
1996 to 1998, home sales have increased 90 percent, and average 
prices have risen 6.5 percent. However, the market has been 
strong across the entire metropolitan region, with home sales 
up 45 percent and prices up 6 percent from 1996 to 1998.\140\ 
It is thus difficult to know the extent to which the D.C. 
homebuyer credit may have been a factor in the surge in home 
sales.
---------------------------------------------------------------------------
    \140\ See ``SOLD! It's a Hot Market as Sales and Prices Rise Across 
the Region,'' The Washington Post, January 30, 1999, p. G 1.
---------------------------------------------------------------------------
    A number of policy issues are raised with respect to 
whether the D.C. homebuyer credit should be extended. One 
concern is whether it is the proper role of the Federal 
government to distort local housing markets by favoring the 
choice of home ownership in one jurisdiction over another. 
Favoring home ownership in one area can only come at the 
expense of home ownership in adjacent areas. Thus, if the 
credit stimulates demand in the District of Columbia, this can 
only come at the expense of demand in other portions of the 
relevant housing market, namely the nearby suburbs of Virginia 
and Maryland.
    To the extent that local jurisdictions vary in their tax 
rates and services, individuals purchasing a home will choose 
to buy in the jurisdiction that offers them the combination of 
tax rates and services and other amenities that they desire. If 
a jurisdiction has a low tax rate, some might choose it on that 
basis. If a jurisdiction has a high tax rate but offers a high 
level of services, some will decide that the high tax rate is 
worth the services and will choose to buy in that jurisdiction. 
If tax rates are high but services are not correspondingly 
high, individuals may avoid such jurisdictions. It is in part 
this individual freedom to choose where to live that can 
promote competition in the provision of local public services, 
helping to assure that such services are provided at reasonable 
tax rates. If a jurisdiction fails at providing reasonable 
services at reasonable tax rates, individuals might choose to 
move to other jurisdictions. This may cause property values in 
the jurisdiction to fall, and, together with taxpayer 
departures, may put pressure on the local government to change 
its behavior and improve its services. If the Federal 
government were to intervene in this market by encouraging the 
purchase of a home in one local market over another, 
competition among local jurisdictions in the provision of 
public services may be undermined.
    In the above scenario, however, a dwindling tax base may 
make it financially difficult to improve government services. 
Many would argue that the District of Columbia has found itself 
in this position and that it needs Federal assistance to 
reverse the downward spiral of poor services leading to a 
smaller tax base, which then leads to even poorer services. The 
tax credit may help reverse this process by improving the 
District's revenue base. An alternative view is that the tax 
credit could take some of the pressure off the local government 
to make necessary improvements. By improving the local 
government's tax base without a commensurate improvement in 
government services, the Federal expenditure could encourage a 
slower transition to good governance.
    Some argue that the credit is appropriate because a number 
of factors distinguish the District of Columbia from other 
cities or jurisdictions and that competition among the District 
and neighboring jurisdictions is constrained by outside 
factors. For example, some argue that the credit is a means of 
compensating the District for an artificially restricted tax 
base. While many residents of the suburbs work in the District 
and benefit from certain of its services, the Federal 
government precludes the imposition of a ``commuter tax,'' 
which is used by some other jurisdictions to tax income earned 
within the jurisdiction by workers who reside elsewhere. In 
addition, some argue that the District has artificially reduced 
property, sales, and income tax revenues because the Federal 
government is headquartered in the District. The Federal 
government makes a payment to the District to compensate for 
the forgone revenues, but some argue that the payment is 
insufficient. Some also argue that to the extent migration from 
the District is a result of a high tax rate and poor services, 
it is not entirely within the control of the District to fix 
such problems, because the District government is not 
autonomous, but is subject to the control of Congress.
    Another issue regarding the D.C. homebuyer credit is how 
effectively it achieves its objective. Several factors might 
diminish its effectiveness. First, the $5,000 will not reduce 
the net cost of homes by $5,000. Some of the $5,000 is likely 
to be captured by sellers, as eligible buyers entering the 
market with effectively an additional $5,000 to spend will push 
prices to levels higher than would otherwise attain. If the 
supply of homes for sale is relatively fixed, and potential 
buyers relatively plentiful, then the credit will largely 
evaporate into sellers' hands through higher prices for homes.
    A second reason the credit might not be very effective at 
boosting the residential base of the District is that it 
applies to existing homes as well as any new homes that are 
built. Thus, the family that sells its D.C. home to a credit-
eligible buyer must move elsewhere. To the extent that they 
sell in order to move outside of the District of Columbia, 
there is no gain in D.C. residences. And to the extent that the 
credit caused home prices to rise, the credit can be seen as an 
encouragement to sell a home in the District as much as an 
encouragement to buy.
    Finally, the income restrictions on the credit might lead 
to a lower level of average incomes in the District of Columbia 
than would have otherwise been the case in the absence of the 
credit. Such lower average incomes would reduce the D.C. income 
tax base, thus potentially undermining an objective of the 
credit, if the lower average income is not outweighed by an 
increase in the number of residents. To see how this could be 
so, consider two families, each seeking housing in the D.C. 
area, one with an income of $100,000 who is eligible for the 
full credit and one with an income of $130,000 and thus not 
eligible. Now consider two homes, one in Virginia and one in 
the District of Columbia, that each can objectively be said to 
be worth $300,000 in the absence of the credit. The credit-
eligible family with the lower income has a much greater 
incentive to buy the D.C. home, as the net cost to them would 
be only $295,000, assuming the price did not increase as a 
result of the credit. The credit-ineligible family would be 
indifferent. Because of the credit, credit-eligible families 
would be willing to pay up to $305,000 for the home in the 
District, at which point they would be indifferent between the 
D.C. home and the $300,000 Virginia home. Because of demand 
induced by the cedit, the price of the D.C. home might thus 
increase to, perhaps, $302,000, yielding a net cost to the 
credit-eligible buyer of $297,000. To the credit-eligible 
buyers, the $302,000 price for the D.C. home has a lower net 
cost than the $300,000 Virginia home, and thus they would 
prefer the D.C. home at the higher gross price. The credit-
ineligible buyers would not partake in bidding up the price of 
the D.C. home because they would bear the full cost of the 
higher sales price, and would thus prefer the similar Virginia 
home at the $300,000 price to any price above $300,000 for the 
D.C. home. The outcome might be that some upper middle class 
families get ``pushed-out'' to the suburbs as a result of the 
credit, which would actually undermine the District's income 
tax base because average incomes would fall as a result.

                      H. Simplification Provisions

1. Optional Self-Employment Contribution Act (``SECA'') computations

                              Present Law

    The Self-Employment Contributions Act (``SECA'') imposes 
taxes on net earnings from self-employment to provide social 
security and Medicare coverage to self-employed individuals. 
The maximum amount of earnings subject to the SECA tax is 
coordinated with, and is set at the same level as, the maximum 
level of wages and salaries subject to FICA taxes ($72,600 for 
OASDI taxes in 1999 and indexed annually, and without limit for 
the Hospital Insurance tax). Special rules allow certain self-
employed individuals to continue to maintain social security 
coverage during a period of low income. The method applicable 
to farmers is slightly more favorable than the method 
applicable to other self-employed individuals.
    A farmer may increase his or her self-employment income, 
for purposes of obtaining social security coverage, by 
reporting two-thirds of the first $2,400 of gross income as net 
earnings from self-employment, i.e., the optional amount of net 
earnings from self-employment would not exceed $1,600. There is 
no limit on the number of times a farmer may use this method. 
The optional method for nonfarm income is similar, also 
permitting two-thirds of the first $2,400 of gross income to be 
treated as self-employment income. However, the optional 
nonfarm method may not be used more than five times by any 
individual, and may only be used if the taxpayer had net 
earnings from self-employment of $400 or more in at least two 
of the three years immediately preceding the year in which the 
optional method is elected.
    In general, to receive benefits, including Disability 
Insurance Benefits, under the Social Security Act, a worker 
must have a minimum number of quarters of coverage. A minimum 
amount of wages or self-employment income must be reported to 
obtain a quarter of coverage. A maximum of four quarters of 
coverage may be obtained each year. In 1978, the amount of 
earnings required to obtain a quarter of coverage began 
increasing each year. Starting in 1994, a farmer could obtain 
only two quarters of coverage under the optional method 
applicable to farmers.

                        Description of Proposal

    The proposal would combine the farm and nonfarm optional 
methods into a single combined optional method applicable to 
all self-employed workers under which self-employment income 
for SECA tax purposes would be two-thirds of the first $2,400 
of gross income. A self-employed individual could elect to use 
the optional method an unlimited number of times. If it is 
used, it would have to be applied to all self-employment 
earnings for the year, both farm and nonfarm. As under present 
law, the $2,400 amount would not be increased for inflation.

                             Effective Date

    The proposal would be effective for taxable years beginning 
after December 31, 1999.

                              Prior Action

    The proposal was included in the Administration's 1997 tax 
simplification proposals \141\ and the President's budget 
proposal for fiscal year 1999. A similar proposal was also 
included in the Taxpayer Relief Act of 1997, as passed by the 
House. However, that provision also would have initially 
increased the $2,400 limit to the amount that would provide for 
four quarters of coverage in 1998, and increased the limit 
thereafter as the earnings requirement for quarters of coverage 
increases under the Social Security Act. That provision also 
would have provided that the optional method could not be 
elected retroactively on an amended return.
---------------------------------------------------------------------------
    \141\ See Department of the Treasury, Taxpayer Bill of Rights 3 and 
Tax Simplification Proposals, April 1997.
---------------------------------------------------------------------------

                                Analysis

    Approximately 48,000 taxpayers use one of the optional 
methods. The proposal would simplify SECA calculations for 
those who use the optional method.
    The present-law optional farm method is more advantageous 
than the nonfarm method. The proposal would eliminate 
inequities between the two methods.
    Some argue that the proposal should be expanded to increase 
the $2,400 limit so that the optional method will continue to 
fulfill its original purpose of allowing self-employed 
individuals to earn full quarters of coverage.
    Also, some argue that taxpayers should not be able to make 
an election on a retroactive basis, just as insurance cannot be 
purchased after the occurrence of an insurable event. On the 
other hand, some argue that not permitting the election on an 
amended return may unduly penalize taxpayers who mistakenly do 
not claim the election when they first file their return.

2. Statutory hedging and other rules to ensure business property is 
        treated as ordinary property

                              Present Law

    Capital gain treatment applies to gain on the sale or 
exchange of a capital asset. Capital assets include property 
other than (1) stock in trade or other types of assets 
includible in inventory, (2) property used in a trade or 
business that is real property or property subject to 
depreciation, (3) accounts or notes receivable acquired in the 
ordinary course of a trade or business, or (4) certain 
copyrights (or similar property) and U.S. government 
publications. Gain or loss on such assets generally is treated 
as ordinary, rather than capital, gain or loss. Certain other 
Code sections also treat gains or losses as ordinary, such as 
the gains or losses of a securities or commodities trader or 
dealer that is subject to ``mark-to-market'' accounting (sec. 
475). Other Code sections treat certain assets as giving rise 
to capital gain or loss.
    Under case law in a number of Federal courts prior to 1988, 
business hedges generally were treated as giving rise to 
ordinary, rather than capital, gain or loss. In 1988, the U.S. 
Supreme Court rejected this interpretation in Arkansas Best v. 
Commissioner, 485 U.S. 212 (1988), which, relying on the 
statutory definition of a capital asset described above, held 
that a loss realized on a sale of stock was capital even though 
the stock was purchased for a business, rather than an 
investment, purpose.
    In 1993, the Department of the Treasury issued temporary 
regulations, which were finalized in 1994, that require 
ordinary character treatment for most business hedges and 
provide timing rules requiring that gains or losses on hedging 
transactions be taken into account in a manner that matches the 
income or loss from the hedged item or items. The regulations 
apply to hedges that meet a standard of ``risk reduction'' with 
respect to ordinary property held (or to be held) or certain 
liabilities incurred (or to be incurred) by the taxpayer and 
that meet certain identification and other requirements (Treas. 
reg. sec. 1.1221-2).

                        Description of Proposal

    The proposal would add three categories to the list of 
assets gain or loss on which is treated as ordinary (sec. 
1221). The new categories would be: (1) derivative contracts 
entered into by derivative dealers; (2) supplies of a type 
regularly used by the taxpayer in the provision of services or 
the production of ordinary property; and (3) hedging 
transactions.
    In defining a hedging transaction, the proposal generally 
would codify the approach taken by the Treasury regulations, 
but would modify the rules to some extent. The ``risk 
reduction'' standard of the regulations would be broadened to 
one of ``risk management'' with respect to ordinary property 
held (or to be held) or certain liabilities incurred (or to be 
incurred). As under the Treasury regulations, the transaction 
would have to be identified as a hedge of specified property. 
If a transaction was improperly identified as a hedging 
transaction, losses would retain their usual character (i.e., 
usually capital), but gains would be ordinary. If a hedging 
transaction was not identified (and there was no reasonable 
basis for that failure), gains would be ordinary but losses 
would retain their non-hedging character. The proposal would 
provide an exclusive list of assets the gains and losses which 
would receive ordinary character treatment; other rationales 
for ordinary treatment generally would not be allowed. The 
Treasury Department would be given authority to apply these 
rules to related parties.
    As under current Treasury regulations, the proposal would 
require that the timing of income, gain, deduction or loss from 
hedging transactions must reasonably match the income, gain, 
deduction or loss from the items being hedged.

                             Effective Date

    The proposal generally would be effective after the date of 
enactment. The Treasury would be given the authority to issue 
regulations applying treatment similar to that provided in the 
proposal to transactions entered into prior to the effective 
date.

                              Prior Action

    This proposal is substantially identical to a proposal made 
in the President's budget proposals for fiscal years 1998 and 
1999.

                                Analysis

Overview

    The basic thrust of the Administration proposal is (1) to 
codify certain positions taken in regulations that deal with 
hedging transactions in light of the U.S. Supreme Court's 
decision in the Arkansas Best case and (2) to broaden those 
rules so that they apply to transactions that are intended to 
``manage'' risk, not just those transactions that ``reduce'' 
risk.
    The Administration proposal would codify the following 
positions taken by IRS regulations: (1) add supplies to the 
list of ordinary assets (e.g., jet fuel); (2) validate the IRS 
rule of the regulations that identification is necessary to get 
ordinary treatment of hedge gains and losses and that 
inaccurate identifications result in ordinary income and 
capital loss; (3) validate the IRS rule of the regulations that 
hedge gain and losses on short positions and options can be 
ordinary; and (4) validate the IRS rule of the regulations that 
the clear reflection of income standard of section 446 requires 
matching of hedging gains and losses to income from hedged 
positions.

Additional ordinary income assets

    The proposal's additions to the list of assets that give 
rise to ordinary gain and loss would to some extent be a 
clarification of present law. Hedging transactions have long 
been treated as ordinary under the case law and, more recently, 
under Treasury regulations. Gains on derivative contracts 
referencing interest rates, equity or foreign currencies 
recognized by a dealer in such contracts are treated as 
ordinary under the ``mark-to-market'' rules (sec. 475(c)(2) and 
(d)(3)). One addition the proposal would make to the ordinary 
list would be gains on commodities derivative contracts 
recognized by a dealer in such contracts. Some would argue that 
this addition is justifiable in order to eliminate the 
disparity between commodities derivatives dealers and dealers 
in other derivative contracts, whose gains are treated as 
ordinary as described above.\142\ The other addition that the 
proposal would make to the list of ordinary assets is supplies 
used in the provision of services or the production of ordinary 
property. An example would be a sale of excess jet fuel by an 
airline, which is treated as giving rise to capital gain under 
present law. Advocates of this addition would argue that such 
supplies are so closely related to the taxpayer's business that 
ordinary character should apply. Indeed, if the fuel were used 
rather than sold by the airline, it would give rise to an 
ordinary deduction. In addition, hedges of such items generally 
are treated as ordinary in character under present law, giving 
rise to a potential character mismatch, e.g., ordinary gain on 
the hedging transaction with a capital loss on the fuel sale 
that cannot be used to offset it (Treas. reg. sec. 1.1221-
2(c)(5)(ii)). However, opponents would argue that not all 
business-related income is ordinary in character and, thus, 
that the proposal would only create other disparities. For 
example, under present law, a special regime applies to gains 
and losses from property used in a trade or business that is 
either real property or depreciable property held for more than 
one year (sec. 1231). The effect of these rules generally is to 
treat a taxpayer's net amount of gain in any year from these 
items as long-term capital gain, but any net losses as ordinary 
losses.
---------------------------------------------------------------------------
    \142\ The disparity between commodities dealers and dealers in 
other derivative contracts was reduced somewhat by the Taxpayer Relief 
Act of 1997, which added Code section 475(e) allowing commodities 
dealers to elect section 475 treatment.
---------------------------------------------------------------------------

Broaden definition of hedging

    The proposal with respect to the definition of hedging 
transactions is largely a codification of the current Treasury 
regulations, with the expansion of the regulations' definition 
of hedging transactions to cover transactions that involve 
``risk management.'' As noted above, the Treasury regulations 
were issued in response to the U.S. Supreme Court's decision in 
Arkansas Best, which narrowed the definition of hedging allowed 
by some Federal courts and resulted in confusion in the 
business community as to what types of business hedges would 
receive tax hedging treatment. The regulations adopted a more 
expansive standard than Arkansas Best, with the result that 
more types of business hedging practices can now be treated as 
hedges for character and timing purposes, and the regulations 
have generally been well received by the business community. 
Thus, codifying the regulations would serve to validate the 
Treasury regulations, as well as to assure businesses that the 
current regime for hedges will be available for some time. They 
would also prevent taxpayers from taking aggressive positions 
that transactions that are not described in the proposal 
qualify as hedges.
    The principal change that the proposal would make in the 
hedging definition is the replacement of the regulations' 
requirement that a hedging transaction result in ``risk 
reduction'' with respect to the hedged item with a broader 
``risk management'' standard. This is a change that is arguably 
not within the Treasury's authority to adopt by regulations. 
The parameters of the ``risk management'' standard are not 
clear in the proposal, yielding the possibility that the 
proposal could result in essentially speculative transactions 
obtaining the favorable character and timing benefits of 
hedging transactions. However, advocates of the proposal would 
point to some common types of business hedging transactions 
that arguably do not meet a ``risk reduction'' standard. One 
example frequently cited is a fixed-rate debt instrument hedged 
with a floating rate hedging instrument. A fixed-rate debt 
instrument bears little interest-rate risk and, thus, the 
transaction would arguably not meet the ``risk reduction'' 
standard (cf. Treas. reg. sec. 1.1221-2(c)(1)(ii)(B)). However, 
businesses frequently enter into transactions hedging such 
instruments in order to obtain the benefits of floating 
interest rates, and such transactions should meet a ``risk 
management'' standard. There have been also reports of tax 
controversies over the present law ``risk reduction'' standard 
that should be reduced by the proposal. Finally, advocates of 
the proposal would point out that the expansiveness of the 
``risk management'' standard would be limited by identification 
requirement of the present Treasury regulations that would be 
codified by the proposal. Under that requirement, in order to 
obtain hedging character and timing treatment, the taxpayer 
must identify the hedging position in its own records on the 
day that the position is acquired and must identify the 
specific property or liabilities being hedged within 35 days 
thereafter (Treas. reg. sec. 1.1221-2(e)). Despite the 
potential overbreadth of the ``risk management'' standard, 
these identification requirements limit the ability of 
taxpayers to utilize the hedging rules for essentially 
speculative transactions.

Timing rules

    The proposal generally would codify the Treasury 
regulations' timing rules for hedges, with the advantages of 
codification described above. The hedge timing rules account 
for income in an economic manner--the timing of gains and 
losses on the hedging transaction must reasonably match those 
from the items being hedged. Advocates of the proposal also 
would point to the identification requirement, which would 
require taxpayers to elect hedge accounting for a transaction 
at the time it is entered into and to follow that treatment 
whether or not it proves advantageous.

3. Clarify rules relating to certain disclaimers

                              Present Law

    There must be acceptance of a gift in order for the gift to 
be completed under State law, and there is no taxable gift for 
Federal gift tax purposes unless there is a completed gift. 
Most States have rules which provide that, when there is a 
disclaimer of a gift, the property passes to the person who 
would be entitled to the property had the disclaiming party 
died before the purported transfer.
    In the Tax Reform Act of 1976, Congress provided a uniform 
disclaimer rule (sec. 2518) that specified how and when a 
disclaimer must be made in order to be effective for Federal 
transfer tax purposes. Under section 2518, a disclaimer is 
effective for Federal transfer tax purposes if it is an 
irrevocable and unqualified refusal to accept an interest in 
property and certain other requirements are satisfied. One of 
the requirements is that the disclaimer generally must be made 
in writing not later than nine months after the transfer 
creating the interest occurs. In order to be a qualified 
disclaimer, the disclaiming person must not have accepted the 
disclaimed interest or any of its benefits. Section 2518 
currently is effective only for Federal transfer tax purposes 
(e.g., it is not effective for Federal income tax purposes).
    In 1981, Congress added a rule to section 2518 that allowed 
certain transfers of property to be treated as a qualified 
disclaimer, even if not a qualified disclaimer under State law. 
In order to qualify, these transfer-type disclaimers must be a 
written transfer of the disclaimant's ``entire interest in the 
property'' to persons who would have received the property had 
there been a valid disclaimer under State law (sec. 
2518(c)(3)). Like other disclaimers, the transfer-type 
disclaimer generally must be made within nine months of the 
transfer creating the interest.
    Under present-law assignment of income principles, an 
individual can avoid tax on the income from property only after 
the individual has made a gift of the income-producing 
property, rather than simply assigning the income from the 
property.

                        Description of Proposal

    The proposal would allow a transfer-type disclaimer of an 
``undivided portion'' of the disclaimant transferor's interest 
in property to qualify under section 2518. Also, the proposal 
would allow a spouse to make a qualified transfer-type 
disclaimer where the disclaimed property is transferred to a 
trust in which the disclaimant spouse has an interest (e.g., a 
credit shelter trust). Further, the proposal would provide that 
a qualified disclaimer for transfer tax purposes under section 
2518 also would be effective for Federal income tax purposes 
(e.g., disclaimers of interests in annuities and income in 
respect of a decedent).

                             Effective Date

    The proposal would apply to disclaimers made after the date 
of enactment.

                              Prior Action

    The proposal is identical to a provision contained in the 
House version of the Taxpayer Relief Act of 1997 and in the 
President's budget proposal for fiscal year 1999.

                                Analysis

    Under present law, a State-law disclaimer can be a 
qualified disclaimer even (1) when it is only a partial 
disclaimer of the property interest, or (2) when the 
disclaimant spouse retains an interest in the property. It is 
currently unclear, however, whether a transfer-type disclaimer 
described in section 2518(c)(3) can qualify under similar 
circumstances. Thus, in order to equalize the treatment of 
State-law disclaimers and transfer-type disclaimers, it may be 
appropriate to allow a transfer-type disclaimer of an undivided 
portion of property or a transfer-type disclaimer where the 
disclaimant spouse has retained an interest in the property to 
be treated as a qualified disclaimer for transfer tax purposes.
    The present-law rules pertaining to qualified disclaimers, 
as set forth in section 2518, are effective for Federal 
transfer tax purposes but not Federal income tax purposes. If a 
disclaimer satisfies the requirements for a qualified 
disclaimer under present law, it may be appropriate to allow 
the disclaimer to be effective for Federal income tax purposes 
as well as Federal transfer tax purposes. It should be noted, 
however, that allowing disclaimers to be effective for Federal 
income tax purposes would override the general assignment of 
income concepts in that area.

4. Simplify the foreign tax credit limitation for dividends from 10/50 
        companies

                              Present Law

    U.S. persons may credit foreign taxes against U.S. tax on 
foreign-source income. The amount of foreign tax credits that 
may be claimed in a year is subject to a limitation that 
prevents taxpayers from using foreign tax credits to offset 
U.S. tax on U.S.-source income. Separate limitations are 
applied to specific categories of income.
    Special foreign tax credit limitations apply in the case of 
dividends received from a foreign corporation in which the 
taxpayer owns at least 10 percent of the stock by vote and 
which is not a controlled foreign corporation (a so-called 
``10/50 company'').\143\ Dividends paid by a 10/50 company in 
taxable years beginning before January 1, 2003 are subject to a 
separate foreign tax credit limitation for each 10/50 company. 
Dividends paid by a 10/50 company that is not a passive foreign 
investment company in taxable years beginning after December 
31, 2002, out of earnings and profits accumulated in taxable 
years beginning before January 1, 2003, are subject to a single 
foreign tax credit limitation for all 10/50 companies (other 
than passive foreign investment companies). Dividends paid by a 
10/50 company that is a passive foreign investment company out 
of earnings and profits accumulated in taxable years beginning 
before January 1, 2003, continue to be subject to a separate 
foreign tax credit limitation for each such 10/50 company. 
Dividends paid by a 10/50 company in taxable years beginning 
after December 31, 2002, out of earnings and profits 
accumulated in taxable years after December 31, 2002, are 
treated as income in a foreign tax credit limitation category 
in proportion to the ratio of the earnings and profits 
attributable to income in such foreign tax credit limitation 
category to the total earnings and profits (a so-called ``look-
through'' approach). For these purposes, distributions are 
treated as made from the most recently accumulated earnings and 
profits. Regulatory authority is granted to provide rules 
regarding the treatment of distributions out of earnings and 
profits for periods prior to the taxpayer's acquisition of such 
stock.
---------------------------------------------------------------------------
    \143\ A controlled foreign corporation in which the taxpayer owns 
at least 10 percent of the stock by vote is treated as a 10/50 company 
with respect to any distribution out of earnings and profits for 
periods when it was not a controlled foreign corporation.
---------------------------------------------------------------------------

                        Description of Proposal

    The proposal would simplify the application of the foreign 
tax credit limitation by applying the look-through approach 
immediately to all dividends paid by a 10/50 company, 
regardless of the year in which the earnings and profits out of 
which the dividend is paid were accumulated. The proposal would 
broaden the regulatory authority to provide rules regarding the 
treatment of distributions out of earnings and profits for 
periods prior to the taxpayer's acquisition of the stock, 
specifically including rules to disregard both pre-acquisition 
earnings and profits and foreign taxes, in appropriate 
circumstances.

                             Effective Date

    The proposal would be effective for taxable years beginning 
after December 31, 1998.

                              Prior Action

    The proposal was included in the President's fiscal year 
1999 budget proposal. The proposal would modify the effective 
date of a provision included in the Taxpayer Relief Act of 1997 
(the ``1997 Act'').

                                Analysis

    The proposal would eliminate the single-basket limitation 
approach for dividends from 10/50 companies and would 
accelerate the application of the look-through approach for 
dividends from such companies for foreign tax credit limitation 
purposes. It is argued that the current rules for dividends 
from 10/50 companies will result in complexity and compliance 
burdens for taxpayers. For instance, dividends paid by a 10/50 
company in taxable years beginning after December 31, 2002, 
will be subject to the concurrent application of both the 
single-basket approach (for pre-2003 earnings and profits) and 
the look-through approach (for post-2002 earnings and profits). 
In light of the delayed effective date for the look-through 
provision included in the 1997 Act, the 1997 Act's application 
of the look-through approach only to post-effective date 
earnings and profits was necessary to avoid affecting the 
timing of distributions before the effective date. The 
provision included in the 1997 Act was aimed at reducing the 
bias against U.S. participation in foreign joint ventures and 
foreign investment by U.S. companies through affiliates that 
are not majority-owned. In this regard, the proposal to 
accelerate the application of the look-through approach would 
be consistent with this objective.
    Under present law, regulatory authority is granted to 
provide rules regarding the treatment of distributions out of 
earnings and profits for periods prior to the taxpayer's 
acquisition of the stock of a 10/50 company. The proposal would 
broaden such regulatory authority to include rules to disregard 
(upon distributions from a 10/50 company) both pre-acquisition 
earnings and profits and foreign taxes, in appropriate 
circumstances. Under such an approach, in appropriate cases, a 
shareholder of a 10/50 company would not be entitled to a 
foreign tax credit with respect to distributions from that 
company out of pre-acquisition earnings and profits, but also 
would not be required to include such distributions in its 
income. Such an approach may provide administrative 
simplification in cases where it would be difficult for a 
minority shareholder to reconstruct the historical records of 
an acquired company. Such an approach also may be appropriate 
in certain cases where a taxpayer enters into transactions 
effectively to ``purchase'' foreign tax credits that can be 
used to reduce the taxpayer's U.S. residual taxes on other 
foreign-source income. However, this concept of disregarding 
earnings and profits and taxes is inconsistent with the general 
treatment of distributions from acquired corporations for 
foreign tax credit purposes.

5. Interest treatment for dividends paid by certain regulated 
        investment companies to foreign persons

                              Present Law

    A regulated investment company (``RIC'') is a domestic 
corporation that, at all times during the taxable year, is 
registered under the Investment Company Act of 1940 as a 
management company or as a unit investment trust, or has 
elected to be treated as a business development company under 
that Act (sec. 851(a)).
    In addition, to qualify as a RIC, a corporation must elect 
such status and must satisfy certain tests (sec. 851(b)). These 
tests include a requirement that the corporation derive at 
least 90 percent of its gross income from dividends, interest, 
payments with respect to certain securities loans, and gains on 
the sale or other disposition of stock or securities or foreign 
currencies or other income derived with respect to its business 
of investment in such stock, securities, or currencies.
    Generally, a RIC pays no income tax because it is permitted 
a deduction for dividends paid to its shareholders in computing 
its taxable income. Dividends paid by a RIC generally are 
includable in income by its shareholders as dividends, but the 
character of certain income items of the RIC may be passed 
through to shareholders receiving the dividend. A RIC generally 
may pass through to its shareholders the character of its long-
term capital gains by designating a dividend it pays as a 
capital gain dividend to the extent that the RIC has net 
capital gain. A RIC generally also can pass through to its 
shareholders the character of its tax-exempt interest from 
State and municipal bonds, but only if, at the close of each 
quarter of its taxable year, at least 50 percent of the value 
of the total assets of the RIC consists of these obligations.
    Under the Code, a 30-percent tax, collected by withholding, 
generally is imposed on the gross amount of certain U.S.-source 
income, such as interest and dividends, of nonresident alien 
individuals and foreign corporations (collectively, ``foreign 
persons''). Dividends paid by a RIC generally are treated as 
dividends for withholding tax purposes, subject to the 
exceptions noted above. This 30-percent withholding tax may be 
reduced or eliminated pursuant to an applicable income tax 
treaty. In the case of dividends on portfolio investments, U.S. 
income tax treaties commonly provide for a withholding tax at a 
rate of at least 15 percent.
    An exception from the U.S. 30-percent withholding tax is 
provided for so-called ``portfolio interest.'' Portfolio 
interest is interest (including original issue discount) which 
would be subject to the U.S. withholding tax but for the fact 
that specified requirements are met with respect to the 
obligation on which the interest is paid and with respect to 
the interest recipient. Pursuant to these requirements, in the 
case of an obligation that is in registered form, the U.S. 
person who otherwise would be required to withhold tax must 
receive a statement that the beneficial owner of the obligation 
is not a United States person. Alternatively, if the obligation 
is not in registered form, it must be ``foreign targeted.'' If 
the obligation is issued by a corporation or a partnership, the 
recipient of the interest must not have 10 percent or more of 
the voting power of the corporation or 10 percent or more of 
the capital or profits interest in the partnership. A corporate 
recipient of the interest must be neither a controlled foreign 
corporation receiving interest from a related person, nor 
(unless the obligor is the United States) a bank receiving the 
interest on an extension of credit made pursuant to a loan 
agreement entered into in the ordinary course of its trade or 
business. Finally, certain contingent interest does not qualify 
as portfolio interest.

                        Description of Proposal

    In the case of a RIC that invests substantially all of its 
assets in certain debt instruments or cash, the proposal would 
treat all dividends paid by the RIC to shareholders who are 
foreign persons as interest that qualifies for the ``portfolio 
interest'' exception from the U.S. withholding tax. Under the 
proposal, the debt instruments taken into account to satisfy 
this ``substantially all'' test generally would be limited to 
debt instruments of U.S. issuers that would themselves qualify 
for the ``portfolio interest'' exception if held by a foreign 
person. However, under the proposal, some amount of foreign 
debt instruments that are free from foreign tax (pursuant to 
the laws of the relevant foreign country) also would be treated 
as debt instruments that count toward the ``substantially all'' 
test.

                             Effective Date

    The proposal would be effective for mutual fund taxable 
years beginning after the date of enactment.

                              Prior Action

    The proposal was included in the President's fiscal year 
1999 budget proposal.

                                Analysis

    The major advantage claimed by advocates of the proposal is 
that it would eliminate the disparity in tax treatment between 
debt instruments qualifying for the ``portfolio interest'' 
exception that are held by a foreign person directly and 
similar instruments owned indirectly through a RIC. The 
proposal may encourage investment by foreign persons in U.S. 
debt instruments by making the benefits of the ``portfolio 
interest'' exception available to investors who are willing to 
invest in such instruments only through a diversified fund. 
Expanding demand for U.S. debt instruments could lower 
borrowing costs of issuers. It is argued that U.S. RICs are at 
a competitive disadvantage as compared with foreign mutual 
funds whose home countries do not impose withholding tax on 
dividends attributable to income from debt investments. The 
proposal would ameliorate this disparate treatment between U.S. 
and foreign mutual funds.
    Opponents of the proposal would argue that holding an 
interest in a RIC that holds debt instruments that qualify for 
the ``portfolio interest'' exception is sufficiently different 
from holding such instruments directly that the ``portfolio 
interest'' exception should not apply in the RIC case. A RIC is 
a widely diversified pool of investments, and managers of RICs 
have discretion to acquire and dispose of debt instruments in 
the pool. Moreover, under the proposal, a portion of the RIC's 
assets may be foreign debt instruments, making an investment in 
the RIC less analogous to a direct interest in U.S. debt 
instruments.

6. Expand declaratory judgment remedy for non-charitable organizations 
        seeking determinations of tax-exempt status

                              Present Law

    In order for an organization to be granted tax exemption as 
a charitable entity described in section 501(c)(3), it 
generally must file an application for recognition of exemption 
with the IRS and receive a favorable determination of its 
status. Similarly, for most organizations, a charitable 
organization's eligibility to receive tax-deductible 
contributions is dependent upon its receipt of a favorable 
determination from the IRS. In general, a section 501(c)(3) 
organization can rely on a determination letter or ruling from 
the IRS regarding its tax-exempt status, unless there is a 
material change in its character, purposes, or methods of 
operation. In cases where an organization violates one or more 
of the requirements for tax exemption under section 501(c)(3), 
the IRS is authorized to revoke an organization's tax 
exemption, notwithstanding an earlier favorable determination.
    In situations where the IRS denies an organization's 
application for recognition of exemption under section 
501(c)(3) or fails to act on such application, or where the IRS 
informs a section 501(c)(3) organization that it is considering 
revoking or adversely modifying its tax-exempt status, present 
law authorizes the organization to seek a declaratory judgment 
regarding its tax status. Specifically, section 7428 provides a 
remedy in the case of a dispute involving a determination by 
the IRS with respect to: (1) the initial qualification or 
continuing qualification of an organization as a charitable 
organization for tax exemption purposes or for charitable 
contribution deduction purposes, (2) the initial classification 
or continuing classification of an organization as a private 
foundation, (3) the initial classification or continuing 
classification of an organization as a private operating 
foundation, or (4) the failure of the IRS to make a 
determination with respect to (1), (2), or (3). A determination 
in this context generally is a final decision by the IRS 
affecting the tax qualification of a charitable organization, 
although it also can include a proposed revocation of an 
organization's tax-exempt status or public charity 
classification. Section 7428 vests jurisdiction over 
controversies involving such a determination in the U.S. 
District Court for the District of Columbia, the U.S. Court of 
Federal Claims, and the U.S. Tax Court.
    Prior to utilizing the declaratory judgment procedure, an 
organization must have exhausted all administrative remedies 
available to it within the IRS. For the first 270 days after a 
request for a determination is made, an organization is deemed 
to not have exhausted its administrative remedies. Provided 
that no determination is made during the 270-day period, the 
organization may initiate an action for declaratory judgment 
after the period has elapsed. If, however, the IRS makes an 
adverse determination during the 270-day period, an 
organization may initiate a declaratory judgment immediately. 
The 270-day period does not begin with respect to applications 
for recognition of tax-exempt status until the date a 
substantially completed application is submitted.
    In contrast to the rules governing charities, it is a 
disputed issue as to whether non-charities (i.e., organizations 
not described in section 501(c)(3), including trade 
associations, social welfare organizations, social clubs, labor 
and agricultural organizations, and fraternal organizations) 
are required to file an application with the IRS to obtain a 
determination of their tax-exempt status. If an organization 
voluntarily files an application for recognition of exemption 
and receives a favorable determination from the IRS, the 
determination of tax-exempt status is usually effective as of 
the date of formation of the organization if its purposes and 
activities during the period prior to the date of the 
determination letter were consistent with the requirements for 
exemption. However, if the organization later receives an 
adverse determination from the IRS, the IRS may assert that the 
organization is subject to tax on some or all of its income for 
open taxable years. Furthermore, as with charitable 
organizations, the IRS may revoke or modify an earlier 
favorable determination regarding an organization's tax-exempt 
status.
    Under present law, a non-charity (i.e., an organization not 
described in section 501(c)(3)) may not seek a declaratory 
judgment with respect to an IRS determination regarding its 
tax-exempt status. The only remedies available to such an 
organization are to petition the U.S. Tax Court for relief 
following the issuance of a notice of deficiency or to pay any 
tax owed and sue for refund in federal district court or the 
U.S. Court of Federal Claims.

                        Description of Proposal

    The proposal would extend declaratory judgment procedures 
similar to those currently available only to charities under 
section 7428 to other section 501(c) determinations. Thus, if 
the application of any organization seeking tax-exempt status 
under section 501(c) is pending with the IRS for more than 270 
days, and the organization has exhausted all administrative 
remedies available within the IRS, then the organization may 
seek a declaratory judgment as to its tax status from the 
United States Tax Court.

                             Effective Date

    The proposal would be effective for applications for 
recognition of exemption filed after December 31, 1999.

                              Prior Action

    No prior action.

                                Analysis

    The declaratory judgment procedures are designed to provide 
a relatively simple and prompt means (as compared to deficiency 
or refund proceedings) of judicial review of certain issues 
relating to the tax-exempt status of organizations. The primary 
benefit of permitting tax-exempt organizations other than those 
described in section 501(c)(3) to use the declaratory judgment 
procedures would be to provide a remedy in cases where the IRS 
delays action on an application for recognition of tax-exempt 
status filed by such an organization and, consequently, the 
organization is left uncertain about its status and any 
potential tax liability for an extended period of time. While 
section 501(c)(3) organizations that are eligible to receive 
tax-deductible contributions arguably require faster judicial 
resolution of issues related to their tax-exempt status in 
order to protect their ability to receive deductible 
contributions, it is unlikely that allowing non-charities 
access to the declaratory judgment procedures would impede this 
objective.
    The proposal does not specify whether non-charities would 
be permitted to use the declaratory judgment procedures in 
situations other than an initial denial of tax-exempt status 
(e.g., a proposed revocation of exemption after the IRS 
previously had issued a favorable determination or a 
determination by the IRS that an organization should be 
reclassified from section 501(c)(4) to 501(c)(19)).
    The proposal would limit jurisdiction over declaratory 
judgments for non-charities to the United States Tax 
Court.\144\ The United States Tax Court is the only one of the 
three possible jurisdictions for present-law section 7428 
declaratory judgment actions to have adopted formal procedural 
rules for such actions.\145\ The most significant feature of 
these rules is that, in the case of a denial by the IRS for an 
initial determination of exemption, they generally confine the 
Court to a review based solely on the facts contained in the 
administrative record. Thus, the parties are not permitted to 
submit new evidence while the case is pending before the Court.
---------------------------------------------------------------------------
    \144\ This limitation currently applies to declaratory judgments 
relating to tax qualification for certain employee retirement plans 
(sec. 7476).
    \145\ Rules of Practice and Procedure, U.S. Tax Court, Title XXI. 
Many of the U.S. Tax Court procedures have been adopted on a case-by-
case basis by the U.S. District Court for the District of Columbia and 
the U.S. Court of Federal Claims.
---------------------------------------------------------------------------

7. Simplify the active trade or business requirement for tax-free spin-
        offs

                              Present Law

    A corporation generally is required to recognize gain on 
the distribution of property (including stock of a subsidiary) 
to its shareholders as if such property had been sold for its 
fair market value. An exception to this rule is where the 
distribution of the stock of a controlled corporation satisfies 
the requirements of section 355 of the Code. Among the 
requirements that must be satisfied in order to qualify for 
tax-free treatment under section 355 is that, immediately after 
the distribution, both the distributing corporation and the 
controlled corporation must be engaged in the active conduct of 
a trade or business (sec. 355(b)(1)).\146\ For this purpose, a 
corporation is engaged in the active conduct of a trade or 
business only if (1) the corporation is directly engaged in the 
active conduct of a trade or business, or (2) if the 
corporation is not directly engaged in an active trade or 
business, then substantially all of its assets consist of stock 
and securities of a corporation it controls that is engaged in 
the active conduct of a trade or business (sec. 355(b)(2)(A)).
---------------------------------------------------------------------------
    \146\ If immediately before the distribution, the distributing 
corporation had no assets other than stock or securities in the 
controlled corporations, then each of the controlled corporations must 
be engaged immediately after the distribution in the active conduct of 
a trade or business.
---------------------------------------------------------------------------
    In determining whether a corporation satisfies the active 
trade or business requirement, the Internal Revenue Service's 
position for advance ruling purposes is that the value of the 
gross assets of the trade or business being relied on must 
constitute at least five percent of the total fair market value 
of the gross assets of the corporation directly conducting the 
trade or business.\147\ However, if the corporation is not 
directly engaged in an active trade or business, then the 
``substantially all'' test requires that at least 90 percent of 
the value of the corporation's gross assets consist of stock 
and securities of a controlled corporation that is engaged in 
the active conduct of a trade or business.\148\
---------------------------------------------------------------------------
    \147\ Rev. Proc. 99-3, sec. 4.01(33), 1999-1 I.R.B. 111.
    \148\ Rev. Proc. 86-41, sec. 4.03(4), 1986-2 C.B. 716; Rev. Proc. 
77-37, sec. 3.04, 1977-2 C.B. 568.
---------------------------------------------------------------------------

                        Description of Proposal

    The Administration proposes to simplify the active trade or 
business requirement by eliminating the ``substantially all'' 
test, and instead, applying the active business requirement on 
an affiliated group basis. In applying the active business 
requirement to an affiliated group, each relevant affiliated 
group (immediately after the distribution) must satisfy the 
requirement. For the distributing corporation, the relevant 
affiliated group would consist of the distributing corporation 
as the common parent and all corporations connected with the 
distributing corporation through stock ownership described in 
section 1504(a)(1)(B) (regardless of whether the corporations 
are includible corporations under sec. 1504(b)). The relevant 
affiliated group for a controlled corporation would be 
determined in a similar manner (with the controlled corporation 
as the common parent).

                             Effective Date

    The proposal would be effective for distributions after the 
date of enactment.

                              Prior Action

    No prior action. However, a similar proposal (S. 2538) was 
introduced in the 105th Congress by Senator John Breaux.

                                Analysis

    The proposal would make it easier for affiliated groups 
that operate active businesses using a holding company 
structure to engage in transactions that qualify for tax-free 
treatment under section 355. It is not uncommon for a holding 
company, in contemplation of a tax-free spin-off, to undergo a 
series of internal restructurings which serve little purpose 
other than to satisfy the active trade or business test. 
Applying the active trade or business requirement on a limited 
affiliated group basis is also consistent with the treatment 
accorded to affiliated groups for other purposes of section 
355(b)(2).\149\
---------------------------------------------------------------------------
    \149\ All distributee corporations which are members of the same 
affiliated group are treated as one distributee corporation for 
purposes of determining acquisition of control of a corporation under 
section 355(b)(2)(D).
---------------------------------------------------------------------------
    It is unclear whether section 355(b)(2)(A), which was 
enacted in 1954, was intended to impose different active trade 
or business tests depending on the corporate structure. Indeed, 
Treasury Regulations issued a year earlier had provided that a 
corporation would be treated as engaged in an active trade or 
business if it was engaged in the trade or business directly or 
indirectly through another corporation (the policies of which 
were directed by the corporate parent).\150\ It is conceivable 
that the ``substantially all'' test was only intended to 
override that aspect of the regulations.
---------------------------------------------------------------------------
    \150\ Treas. Reg. sec. 29.112(b)(11)-2, 1953-1 C.B. 143.
---------------------------------------------------------------------------

                      I. Miscellaneous Provisions

1. Extend and modify Puerto Rico tax credit

                              Present Law

    The Small Business Job Protection Act of 1996 generally 
repealed the Puerto Rico and possession tax credit. However, 
certain domestic corporations that had active business 
operations in Puerto Rico or another U.S. possession on October 
13, 1995, may continue to claim credits under section 936 or 
section 30A for a 10-year transition period. Such credits apply 
to possession business income, which is derived from the active 
conduct of a trade or business within a U.S. possession or from 
the sale or exchange of substantially all of the assets that 
were used in such a trade or business. In contrast to the 
foreign tax credit, the Puerto Rico and possession tax credit 
is granted whether or not the corporation pays income tax to 
the possession.
    One of two alternative limitations is applicable to the 
amount of the credit attributable to possession business 
income. Under the economic activity limit, the amount of the 
credit with respect to such income cannot exceed the sum of a 
portion of the taxpayer's wage and fringe benefit expenses and 
depreciation allowances (plus, in certain cases, possession 
income taxes); beginning in 2002, the income eligible for the 
credit computed under this limit generally is subject to a cap 
based on the corporation's pre-1996 possession business income. 
Under the alternative limit, the amount of the credit is 
limited to the applicable percentage (40 percent for 1998 and 
thereafter) of the credit that would otherwise be allowable 
with respect to possession business income; beginning in 1998, 
the income eligible for the credit computed under this limit 
generally is subject to a cap based on the corporation's pre-
1996 possession business income. Special rules apply in 
computing the credit with respect to operations in Guam, 
American Samoa, and the Commonwealth of the Northern Mariana 
Islands. The credit is eliminated for taxable years beginning 
after December 31, 2005.

                        Description of Proposal

    The proposal would modify the credit computed under the 
economic activity limit with respect to operations in Puerto 
Rico only. First, the proposal would extend the December 31, 
2005 termination date with respect to such credit to December 
31, 2008. Second, the proposal would eliminate the limitation 
that applies the credit only to certain corporations with pre-
existing operations in Puerto Rico. Accordingly, under the 
proposal, the credit computed under the economic activity limit 
would be available with respect to corporations with new 
operations in Puerto Rico.\151\ The proposal would not modify 
the credit computed under the economic activity limit with 
respect to operations in possessions other than Puerto Rico. 
The proposal also would not modify the credit computed under 
the alternative limit with respect to operations in Puerto Rico 
or other possessions.
---------------------------------------------------------------------------
    \151\ An operation would be defined as ``new'' if established after 
October 13, 1995, the end of the base period established by the Small 
Business Job Protection Act of 1996.
---------------------------------------------------------------------------

                             Effective Date

    The proposal would apply to taxable years beginning after 
December 31, 1998.

                              Prior Action

    Similar proposals were included in the President's fiscal 
year 1998 and 1999 budget proposals.

                                Analysis

    When the Puerto Rico and possession tax credit was repealed 
in 1996, the Congress expressed its concern that the tax 
benefits provided by the credit were enjoyed by only the 
relatively small number of large U.S. corporations that operate 
in the possessions and that the tax cost of the benefits 
provided to these possessions corporations was borne by all 
U.S. taxpayers. In light of the then current budget 
constraints, the Congress believed that the continuation of the 
tax exemption provided to corporations pursuant to the Puerto 
Rico and possession tax credit was no longer appropriate.
    The proposal to extend and modify the credit computed under 
the economic activity limit is intended to provide an incentive 
for job creation and economic activity in Puerto Rico. In this 
regard, it should be noted that the Puerto Rican government 
itself has enacted a package of incentives effective January 1, 
1998, designed to attract business investment in Puerto Rico. 
This proposal should be analyzed in light of these local 
initiatives which have just gone into force; issues to be 
considered include whether additional Federal tax incentives 
are necessary or appropriate and whether the proposed credit 
would interact efficiently with the particular local incentives 
already in place.
    In 1996, the unemployment rate averaged 14 percent in 
Puerto Rico. By comparison, the United States's unemployment 
rate averaged 5.4 percent in 1996 and the State with the 
highest average unemployment rate, New Mexico, averaged 8.1 
percent unemployment.\152\ The incomes of individuals and 
families are lower in Puerto Rico than in the United States. In 
the last year for which comparable data are available, 1989, 
the median family income in the United States was $35,225, and 
the median family income in Puerto Rico was $9,988. For 1989, 
the lowest median household income among the States was $26,159 
in Alabama.\153\ In 1996, per capita GDP in Puerto Rico was 
$8,104, while per capita GDP for the United States was 
$28,784.\154\ Puerto Rico has long lagged the mainland by such 
measures of economic performance. (See Tables 4 and 5 below.) 
It has been these, or comparable, facts that have motivated 
efforts to encourage economic development in Puerto Rico.
---------------------------------------------------------------------------
    \152\ The unemployment rate in the District of Columbia averaged 
8.5 percent in 1996. Source: Bureau of the Census, U.S. Department of 
Commerce, Statistical Abstract of the United States, 1997.
    \153\ Ibid. The data are drawn from the 1990 Census. Comparison of 
the income figures reported for Puerto Rico or the United States to the 
figure for Alabama should be made with some caution as the Alabama 
figure reports household income rather than family income. For 1989, 
median household income in the United States was $35,526 and in Puerto 
Rico median household income was $8,895. U.S. Department of Commerce, 
Bureau of the Census, 1990 Census of Population, Social and Economic 
Characteristics, Puerto Rico, p. 42.
    \154\ Ibid.

           Table 4.--Unemployment Rate in the United States and Puerto Rico, Selected Years, 1970-1997
----------------------------------------------------------------------------------------------------------------
                                                                                                            Dec.
                                                                  1970   1980   1985   1990   1995   1996   1997
----------------------------------------------------------------------------------------------------------------
United States..................................................    4.9    7.1    7.2    5.6    5.6    5.4    4.7
Puerto Rico....................................................   10.0   17.0   21.0   14.0   14.0   14.0   14.5
----------------------------------------------------------------------------------------------------------------
Source: U.S. Department of Commerce, Bureau of the Census, Statistical Abstract of the United States, 1997.
  December 1997 figures are preliminary data from the Bureau of Labor Statistics.


  Table 5.--Per Capita Gross Domestic Product for the United States and
                 Puerto Rico, Selected Years, 1980-1995
                         [Current year dollars]
------------------------------------------------------------------------
                                 1980       1985       1990       1995
------------------------------------------------------------------------
United States...............     12,226     17,529     22,979     27,571
Puerto Rico.................      3,475      4,441      6,130      7,640
------------------------------------------------------------------------
Source: U.S. Department of Commerce, Bureau of the Census, Statistical
  Abstract of the United States, 1997.

    The credit computed under the economic activity limit as 
provided in section 30A reduces the Federal income tax burden 
on economic activity located in Puerto Rico. By reducing the 
Federal income tax burden, the credit may make it attractive 
for a business to locate in Puerto Rico, even if the costs of 
operation or transportation to or from the United States would 
otherwise make such an undertaking unprofitable. As such, the 
credit is a deliberate attempt to distort taxpayer behavior. 
Generally, distortions of taxpayer behavior, such as those that 
distort decisions regarding investment, labor choice, or choice 
of business location reduce overall well-being by not putting 
labor and capital resources to their highest and best use. 
However, proponents of the credit argue that such a distortion 
of choice may increase aggregate economic welfare because 
Puerto Rico has so many underutilized resources, as evidenced 
by its chronic high unemployment rate.
    Some also have suggested that the credit may offset 
partially certain other distortions that exist in the Puerto 
Rican economy. For example, some have suggested that the 
application of the Federal minimum wage, which generally has 
been chosen based on the circumstances of the States, to Puerto 
Rico may contribute to Puerto Rico's relatively high 
unemployment rate. Others have suggested that the cost of 
investment funds to Puerto Rican businesses may be higher than 
is dictated by the actual risk of those investments. If this is 
the case, there may be an imperfect capital market. The credit, 
as it applies to wages and capital, may partially offset a 
distortion created by the minimum wage or a capital market 
imperfection.
    The proposal would extend the credit computed under the 
economic activity limit with respect to operations in Puerto 
Rico to new business operations in Puerto Rico. The credit 
computed under the economic activity limit is based loosely on 
the value added by a business that occurs within a qualifying 
Puerto Rican facility. That is, the credit is based upon 
compensation paid to employees in Puerto Rico and upon tangible 
personal property located in Puerto Rico. Proponents of the 
credit note that this design does not bias a business's choice 
of production between more labor intensive or more capital 
intensive methods, and thus should not promote an inefficient 
use of resources in production.\155\ Proponents further observe 
that the economic activity credit under section 30A is based 
upon the labor employed in Puerto Rico and the equipment 
located within Puerto Rico which add value to the good or 
service produced, not the cost of raw materials, land, 
intangibles, interest, or other expenses. Thus, they argue that 
the credit directly targets underemployed resources within 
Puerto Rico.
---------------------------------------------------------------------------
    \155\ The income-based credit of prior law was criticized for 
encouraging intangible capital intensive business development rather 
than business development of any type. See the discussion in Department 
of the Treasury, The Operation and Effect of the Possessions 
Corporation System of Taxation, Sixth Report, March 1989.
---------------------------------------------------------------------------
    The economic activity credit only has been available to 
taxpayers since 1994. There have been no studies of its 
efficacy to date. However, the tax credit can never be fully 
efficient. The credit would be available to any business 
locating in Puerto Rico, regardless of whether the business 
would have chosen to locate in Puerto Rico in the absence of 
the credit for other business reasons. Thus, as with most tax 
benefits designed to change economic decisions, in some cases, 
the Federal Government will lose revenue even when there has 
been no change in taxpayer behavior.
    Use of a tightly defined tax benefit as a business 
development tool may limit Federal Government funds available 
for other development initiatives that might foster business 
development in Puerto Rico. For example, a lack of 
infrastructure (such as roads or waste water treatment 
facilities) may forestall certain business investments. It is 
difficult for tax credits to address those sorts of business 
development initiatives. More generally, one might question the 
efficacy of using tax benefits in lieu of direct spending to 
foster economic development. Direct subsidies could be made to 
certain businesses to encourage location in Puerto Rico, and 
the subsidies could be tailored to the specific circumstance of 
the business. A tax credit operates as an open-ended 
entitlement to any business that is eligible to claim the 
credit. On the other hand, unlike direct subsidies, under such 
a credit the marginal investment decisions are left to the 
private sector rather than being made by government officials.

2. Exempt first $2,000 of severance pay from income tax

                              Present Law

    Under present law, severance payments are includible in 
gross income.

                        Description of Proposal

    Under the proposal, up to $2,000 of certain severance 
payments would be excludable from the income of the recipient. 
The 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. The exclusion would not be 
available if the individual becomes employed within 6 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. The exclusion would not 
apply if the total severance payments received by the 
individual exceed $75,000.

                             Effective Date

    The proposal would be effective for severance pay received 
in taxable years beginning after December 31, 1999, and before 
January 1, 2003.

                              Prior Action

    A similar proposal was included in the President's fiscal 
year 1999 budget proposal.

                                Analysis

    The proposal lacks specificity in certain respects. For 
example, the proposal does not define a ``reduction in the 
employer's work force.'' Without an adequate definition, almost 
any termination of employment could be construed as in 
connection with a reduction in the employer's work force, 
meaning that up to $2,000 of any payments made upon termination 
of employment would be excludable from income. While the 
proposal was not intended to be interpreted so broadly, 
additional details would be necessary to determine the breadth 
and impact of the proposal. The proposal also does not define 
``severance payments,'' so it is unclear whether the proposal 
is intended to be limited to certain types of payments received 
upon a separation from service, or only some payments. The 
definition is important not only in determining what payments 
qualify for the exclusion, but also in determining whether any 
payments qualify because the $75,000 cap is exceeded.
    It is also not clear from the proposal whether the 
exclusion is a one-time exclusion, an annual exclusion, or 
whether it applies separately to each qualifying separation 
from service of the individual.
    The stated rationale for the proposal is that the tax on 
severance payments places an additional burden on displaced 
workers, especially if the worker is separated from service 
because of a reduction in work force, in which case it may be 
difficult for the worker to find new, comparable employment. 
Some would agree that it is appropriate to provide tax relief 
for individuals in such circumstances. However, others would 
argue that the proposal does not provide relief for all persons 
in similar circumstances. For example, some would argue that 
relief would be even more necessary in cases in which severance 
payments are not provided by the employer, and that a more fair 
approach to providing relief for displaced workers would be to 
provide that some portion of unemployment benefits are 
excludable from income. Others would argue that there is no 
clear rationale for distinguishing separations from service in 
connection with a reduction in the work force from other 
separations--the hardship on the individual may be just as 
great in other circumstances. Some would also argue that the 
proposal is not well-targeted because it provides tax relief 
for individuals who are not in financial distress as a result 
of the separation from service. The limit on the exclusion to 
cases in which the payments do not exceed $75,000, is one way 
of addressing this concern, as is the restriction that the 
exclusion does not apply if comparable employment is attained 
within 6 months. Other methods would also be possible, but 
would also add complexity to the proposal. The 6-month rule may 
itself add some complexity, because the new employment may 
occur in a tax year other than the one in which the payments 
were received and after the individual's tax return for the 
year of payment had been filed. An individual may need to file 
an amended return in such cases.

3. Extend carryback period for NOLs of steel companies

                              Present Law

    The net operating loss (``NOL'') of a taxpayer (generally, 
the amount by which the business deductions of a taxpayer 
exceeds its gross income) may be carried back two years and 
carried forward 20 years to offset taxable income in such 
years. A taxpayer may elect to forgo the carryback of an NOL. 
In the case of NOLs arising from (1) casualty or theft losses 
of individual taxpayers, or (2) losses incurred in a 
Presidentially declared disaster area by small business 
taxpayers, such NOLs can be carried back three years. NOLs 
attributable to a farming business may be carried back 5 years, 
whether or not incurred in a Presidentially declared disaster 
area. Other special rules apply to real estate investment 
trusts (REITs) (no carrybacks), specified liability losses (10-
year carryback), and excess interest losses (no carrybacks).

                        Description of Proposal

    The proposal would extend the carryback period for the NOL 
of a steel company to 5 years. The proposal would not change 
the 20-year carryforward period. An eligible taxpayer could 
elect to forgo the 5-year carryback and apply the present-law 
carryback rules. Only losses related to activities incurred in 
the manufacture or production of steel and steel products would 
be eligible for the 5-year carryback.

                             Effective Date

    The proposal would be effective for taxable years ending 
after the date of enactment, regardless of when the NOL arose. 
The proposal would not apply to taxable years ending 5 years or 
more after the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    The NOL carryback and carryforward rules allow taxpayers to 
smooth out swings in business income (and Federal income taxes 
thereon) that result from business cycle fluctuations and 
unexpected financial losses. Some argue that the steel industry 
is particularly vulnerable to such fluctuations and losses 
because foreign governments subsidize or otherwise encourage 
the export of steel in order to preserve their domestic steel 
industry.
    On the other hand, Congress has determined that a two-year 
carryback of NOLs is sufficient in all but extraordinary 
situations. Many industries face the challenge of subsidized 
foreign competition. It is argued that it is not appropriate to 
provide a special set of rules for the steel industry and not 
for other industries.

                      J. Electricity Restructuring

1. Tax-exempt bonds for electric facilities of public power entities

                              Present Law

In general

    Interest on debt incurred by States or local governments is 
excluded from income if the proceeds of the borrowing are used 
to carry out governmental functions of those entities or the 
debt is repaid with governmental funds (Code sec. 103). 
Interest on bonds that nominally are issued by States or local 
governments, but the proceeds of which are used (directly or 
indirectly) by a private person and payment of which is derived 
from funds of such a private person (``private activity 
bonds'') is taxable unless the purpose of the borrowing is 
approved specifically in the Code or in another provision of a 
revenue Act. The provision of electric service (generation, 
transmission, distribution, and retailing) is an activity 
eligible for financing with governmental tax-exempt bonds when 
the financed facilities are used by or paid for by a State or 
local government (``public power''). Except as described below, 
public power is subject to the same limits on private business 
use that apply to other governmental functions. Exempt-facility 
private activity tax-exempt bonds for the provision of electric 
service (e.g., bonds for investor-owned utilities) may be 
issued only for facilities used in the local furnishing of 
electricity.\156\
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    \156\ Local furnishing is limited to private facilities serving no 
more than two counties (or a city and a contiguous county). Further, 
these tax-exempt bonds may only be issued for the benefit of persons 
engaged in that activity on January 1, 1997, and in general only for 
areas served on that date.
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    The general structure of the rules for determining whether 
a tax-exempt bond is a governmental or a private activity bond 
was enacted in 1968, at which time State or local government 
bonds were classified as ``industrial development bonds'' if 
private business use and security for debt repayment exceeded 
25 percent of the proceeds and debt service.\157\ The Tax 
Reform Act of 1986 (the ``1986 Act'') further restricted the 
amount of private business use that may be financed before a 
State or local government bond is classified as a private 
activity bond (and therefore in the case of bonds for the 
provision of electric service, generally lose their tax-exempt 
status). The principal present-law test for determining whether 
a State or local government bond is in substance a private 
activity bond consists of two parts:
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    \157\ Industrial development bonds were subsumed into the category 
of ``private activity bonds'' by the 1986 Act.
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    (1) More than 10 percent of the bond proceeds is to be used 
(directly or indirectly) by a private business; and
    (2) More than 10 percent of the debt service on the bonds 
is secured by an interest in property to be used in a private 
business use or to is be derived from payments in respect of 
such property.\158\
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    \158\ The 10-percent private use and payment limits are reduced to 
an amount equal to the lesser of 5 percent or $5 million in the case of 
loans. Present law further includes a more restrictive rule limiting 
the amount of governmental bond proceeds that may be used to finance 
private business activities that are unrelated to governmental 
activities also being financed with a bond.
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    In the case of public power bonds, the maximum amount of 
private business use is limited to the lesser of 10 percent of 
the bond proceeds or $15 million per facility. All outstanding 
bonds are included in calculating the $15 million limit. This 
per-facility limit is more restrictive than the general per-
bond-issue limit on private business use for bonds for other 
governmental activities. Because power facilities such as 
generating plants are costly, the substantive effect of the $15 
million limit is to reduce the otherwise permitted amount of 
private business use of those facilities.
    The Statement of Managers accompanying the 1986 Act states 
that ``. . . trade or business use by all persons on a basis 
different from the general public is aggregated in determining 
if the 10-percent threshold for being a private activity bond 
is satisfied.'' See, H. Rept. 99-841, p. II-688. The General 
Explanation of the Tax Reform Act of 1986 \159\ further 
amplified this rule, as follows:
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    \159\ Joint Committee on Taxation (JCS-10-87), May 4, 1987, p. 
1160.

          The determination of who uses bond proceeds or bond-
        financed property generally is made by reference to the 
        ultimate user of the proceeds or property. . . . [B]ond 
        proceeds used to satisfy contractual obligations 
        undertaken in connection with general governmental 
        operations, such as payment of government salaries, or 
        to pay legal judgments against a governmental unit, are 
        not treated as used in the business of the payee. This 
        is to be contrasted with the indirect nongovernmental 
        use of bond proceeds that occurs when a government 
        contracts with a nongovernmental person to supply that 
        person's trade or business with a service (e.g., 
        electric energy) on a basis different from that on 
        which the service is provided to the public generally 
        or to finance property used in that person's business 
        (e.g., a manufacturing plant). In both of these 
        instances a nongovernmental person is considered to use 
        the bond proceeds other than as a member of the general 
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        public.

    The 1986 Act included only four relevant exceptions to the 
general rule that all business use by a private person on a 
basis different from that available to other members of the 
general public is counted under the private business use test. 
First, a general exception for all governmental bonds provides 
that management of governmental facilities by private 
businesses is disregarded if the management is pursuant to 
contracts having specified terms limiting the duration of the 
arrangement and the fees paid to the private business. Second, 
the legislative history to the 1986 Act provided three 
exceptions that are unique to public power. These exceptions 
allow spot sales of excess power capacity for temporary periods 
not exceeding 30 days, and disregard the presence of a 
nongovernmental person acting solely as a conduit for power-
sharing among governmentally owned and operated utilities. They 
further allow ``power-swapping'' arrangements between public 
power and privately owned electric utilities if (1) the 
arrangements are designed to enable the respective utilities to 
satisfy differing peak load demands or to accommodate temporary 
outages, (2) the swapped power between the parties is 
approximately equivalent determined over periods of one year or 
less, and (3) no output-type contracts are involved.
    The determination of whether interest on State or local 
government bonds is tax-exempt initially is made when the bonds 
are issued. That is, the determination is made by reference to 
how the bond proceeds are ``to be used.'' Deliberate acts 
within the control of the issuer that are taken after the date 
of issuance to use bond-financed facilities (indirectly a use 
of bond proceeds) in a manner not qualifying for tax exemption 
may render interest on the bonds taxable, retroactive to the 
date of issuance (the ``change in use rules''). A transaction 
giving rise to a prohibited change in use may be illustrated by 
a post-bond-issuance sale of public power electric output to 
private businesses in a manner not qualifying for tax-exemption 
(e.g., an output-type contract with a private business for a 
period in excess of the 30 days provided for in the 1986 Act 
legislative history).
    Both before and after 1986, the Treasury Department 
administratively has provided alternative sanctions to 
retroactive loss of tax-exemption for post-issuance changes in 
use in certain cases when the change was not reasonably 
expected at the time the bonds were issued. These alternative 
sanctions require immediate surrender of the benefits of tax-
exempt financing by redemption of outstanding bonds, or if 
immediate redemption is precluded by pre-existing bond terms, 
by immediate defeasance of the bonds through establishment of 
an escrow account funded with taxable debt, and generally after 
1993, accompanied by redemption on the first possible date.

Temporary and proposed treasury regulations affecting public power 
        bonds

    On January 21, 1998, the Treasury Department issued 
temporary and proposed regulations (T.D. 8757) affecting tax-
exempt bonds of public power entities that participate in 
electric industry open access arrangements. These regulations 
are scheduled to expire three years after they were issued. The 
regulations include a general rule that, if an arrangement 
provides a private business user with rights to bond-financed 
property that are different from rights of the general public 
(i.e., transfers the benefits and burdens with respect to the 
property), the private use is counted under the 10-percent (and 
$15 million) limits described above. However, in the case of 
public power bonds, the regulations create special exceptions 
pursuant to which certain transactions entered into to 
facilitate an issuer's participation in open access 
arrangements are not treated as giving rise to private business 
use or as deliberate actions increasing the amount of private 
business use beyond that allowed under the Code.
    The first such exception provides that contracts of up to 
three years duration for the sale to a nongovernmental person 
of excess electric output resulting from participation in an 
open access arrangement are not treated as private business use 
under certain circumstances. (Treas. Reg. sec. 1.141-7T(f)(4).) 
The purpose of the sale must be to mitigate costs of existing 
generating plants that the utilities no longer can recover as a 
result of competition (``stranded costs''). Issuers benefiting 
from the rule may not make tax-exempt-bond-financed 
expenditures to increase the generating capacity of their 
systems during the term of the contract; however, they may 
continue to benefit both from all of their outstanding tax-
exempt bonds and newly issued bonds if the newly issued bonds 
are not used to increase capacity. Further conditions of this 
output contract exception are that issuers must offer non-
discriminatory open access transmission tariffs for the use of 
their system under Federal Energy Regulatory Commission 
(``FERC'') rules, and they must use any stranded cost recovery 
under the contracts to redeem bonds ``as promptly as is 
reasonably practical.''
    The regulations also create two new exceptions under which 
private business use of public power transmission facilities is 
disregarded in determining whether a prohibited change in use 
has occurred. The first of these provides that the use of 
public power transmission facilities pursuant to contracts 
entered into in response to wheeling required (or expected to 
be required) under sections 211 and 212 of the Federal Power 
Act or comparable State laws is not treated as a post-issuance 
deliberate action violating the private business tests. (Treas. 
Reg. sec. 1.141-7T(f)(5)(i).) This regulatory exception mirrors 
a separate, statutory provision in Code section 142(f)(2). The 
statutory provision, enacted as part of the Energy Policy Act 
of 1992 (P.L. 102-486), applies only to private activity tax-
exempt bonds for the local furnishing of electricity. The 
second exception for transmission facility bonds provides that 
other actions taken by public power entities to implement non-
discriminatory, open access plans of FERC or a State are not 
treated as deliberate actions in determining whether the 
private business tests are violated with regard to outstanding 
tax-exempt bonds. (Treas. Reg. sec. 1.141-7T(f)(5)(ii).) There 
is no requirement in the second exception that the action be 
taken in response to or in anticipation of a requirement by the 
Federal Government or a State government.
    In addition to preserving tax-exemption for previously 
issued public power transmission bonds under the circumstances 
described, the regulations permit public power to refund that 
debt with new bonds, notwithstanding violation of the general 
tax-exempt bond rule that tax-exempt refunding bonds may only 
be issued if the private business tests (and all other 
requirements for tax exemption) are satisfied on the date the 
refunding occurs. (Treas. Reg. sec. 1.141-7T(f)(5)(iii).)
    Finally, the regulations provide that a ``wholesale 
requirements'' contract may violate the private business tests 
if the contract substantively results in private business use 
in excess of that allowed under the Code. (Treas. Reg. sec. 
1.141-7T(c)(4).) A wholesale requirements contract is a 
contract under which the purchaser agrees to purchase all or a 
portion of its requirements from the seller. The regulations 
provide three primary factors that are to be used to establish 
whether requirements contracts violate the private business 
tests. Two of these factors describe attributes of investor-
owned utilities (i.e., diverse customer base (including 
residential customers) and historical as opposed to projected 
requirements). Most proposed electric restructuring 
arrangements anticipate significant sales of electricity by 
independent power brokers (much like stock or commodities 
traders). These traders would not be expected to have customer 
bases similar to those of traditional electric utilities. The 
regulations specifically provide that use of property by a 
power broker is treated as private business use under the 1986 
Act exception for power-swapping arrangements (Treas. Reg. sec. 
1.141-7T(f)(6)).

                        Description of Proposal

    In conjunction with legislative consideration of the 
Administration's Comprehensive Electricity Competition 
Plan,\160\ the Administration would propose that tax-exempt 
bonds be allowed to be used in certain cases by public power 
entities participating in open access arrangements to finance 
new distribution facilities (including functionally related and 
subordinate property). No new electric generation or new 
transmission facilities could be financed with tax-exempt bonds 
by such entities. Distribution facilities would be defined as 
facilities operating at 69 kilovolts or less (including 
functionally related and subordinate property).
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    \160\ The Comprehensive Electricity Competition Plan was announced 
on March 24, 1998 by the Department of Energy.
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    The proposal also would provide that bonds outstanding on 
the date of enactment would not lose their tax-exempt status if 
the bonds were used to finance: (1) transmission facilities the 
private use of which results from action pursuant to a FERC 
order requiring non-discriminatory open access to those 
facilities; or (2) generation or distribution facilities the 
private use of which results from retail competition or from 
the issuer entering into a contract for the sale of electricity 
or the use of its distribution property that will become 
effective after implementation of retail competition.
    Sales of facilities financed with tax-exempt bonds to 
private entities would continue to constitute a change of use.
    The proposal would permit current refunding, but not 
advance refunding, of bonds issued before the date of 
enactment.

                             Effective Date

    The proposal would be effective on the date of enactment of 
the Administration's Comprehensive Electricity Competition 
Plan.

                              Prior Action

    No prior action.

                                Analysis

    The ability to finance capital and operating costs with 
tax-exempt bonds may substantially reduce the cost of debt 
finance. To illustrate, assume the interest rate on taxable 
debt is 10 percent. If an investor in the 36-percent marginal 
income tax bracket purchased a taxable debt instrument, his 
after-tax rate of return would be the 10-percent interest less 
a tax of 36 percent on the interest received for a net return 
of 6.4 percent. If as an alternative this investor could 
purchase a tax-exempt bond, all other things such as credit-
worthiness being equal, he would earn a better after-tax return 
by accepting any yield greater than 6.4 percent.\161\ In the 
market, the yield spread between a tax-exempt bond and 
comparable taxable bond is determined by the marginal buyer of 
the bonds; in today's market, yield spreads are generally less 
than 28 percent.\162\ Because the yield spread arises from 
forgone tax revenue, economists say that tax-exempt finance 
creates an implicit subsidy to the issuer. However, with many 
investors in different tax brackets, the loss of Federal 
receipts is greater than the reduction in the tax-exempt 
issuers' interest saving.\163\ The difference accrues to 
investors in tax brackets higher than those that would be 
implied by the yield spread between taxable and tax-exempt 
bonds.
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    \161\ More generally, if the investor's marginal tax rate is t and 
the taxable bond yields r, the investor is indifferent between a tax-
exempt yield, re, and (1-t)r.
    \162\ For example, while not comparable in security, market trading 
recently has priced 30-year U.S. Treasuries to have a yield to maturity 
of approximately 5.4 percent. Prices for an index of long-term tax-
exempt bonds have produced a yield to maturity of approximately 5.0 
percent. See, The Bond Buyer, 327, February 12, 1999, p. 39. Again 
ignoring differences in risk or other non-tax characteristics of the 
securities, the yield spread implies that an investor with a marginal 
tax rate of 10 percent would be indifferent between the Treasury bond 
and the average high-yield tax-exempt bond.
    \163\ The Federal income tax has graduated marginal tax rates. 
Thus, $100 of interest income forgone to a taxpayer in the 31-percent 
bracket costs the Federal Government $31, while the same amount of 
interest income forgone to a taxpayer in the 28-percent bracket costs 
the Federal Government $28. If a taxpayer in the 28-percent bracket 
finds it profitable to hold a tax-exempt security, a taxpayer in the 
31-percent bracket will find it even more profitable. This conclusion 
implies that the Federal Government will lose more in revenue than the 
tax-exempt issuer gains in reduced interest payments.
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    Electric industry restructuring might have two distinct 
effects on public power and investor-owned utilities (``IOUs'') 
that qualify for tax-exempt financing as local furnishers. 
First, if these utilities must use taxable bonds to finance 
generation facilities, their cost of capital is likely to 
rise.\164\ Because competitors attempt to price their services 
to recover their capital costs, in the long run, prices of 
electricity provided by these generators might rise. In 
addition, because tax-exempt financing lowers the cost of debt 
capital, electric service providers that receive tax-exempt 
bond financing may rely more heavily on debt finance than other 
providers. Loss of the ability to use tax-exempt financing may 
cause the affected entities to adjust their financial structure 
in the long run. In the short run, investors may view such 
providers as riskier investments than others because of their 
higher leverage ratios.
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    \164\ Restructuring could cause outstanding bonds to lose their tax 
exemption. In practice, when an outstanding tax-exempt bond becomes 
taxable the issuer typically pays the Federal Government a negotiated 
settlement amount. Such payments would not raise the total interest 
expense to that incurred by an issuer who has issued taxable bonds 
unless the negotiated settlement amount equals the yield spread between 
the formerly tax-exempt bond and a comparable taxable bond. Moreover, 
even in such case, the ``tax'' recovered when an outstanding tax-exempt 
bond becomes taxable is less than the amount of tax that would have 
been paid had the bond initially been sold as a taxable bond offering 
taxable interest for the reasons explained in the preceding footnote.
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    On the other hand, if these electric service providers were 
permitted to retain their ability to receive tax-exempt 
financing, they might have a considerable cost advantage over 
other generators in a deregulated market for generated power. 
The market share of such generators would expand and the 
implicit Federal subsidy to electric generation and certain 
investors might increase. In order to keep these providers from 
exploiting their capital cost advantage, the scope of 
restructuring may have to be smaller, perhaps by not permitting 
such generators to interconnect with the IOUs. Limiting 
interconnection, however, would limit the scope for exploiting 
system rationalization, inter-regional power sales, and 
efficiency gains.
    A second effect that restructuring could have on current 
electric power industry beneficiaries of tax-exempt bonds is 
the so-called stranded cost problem. Analysts usually refer to 
the stranded cost problem in the context of privately owned 
facilities, but the problem can arise for public power as well. 
Bonds outstanding today have financed facilities. The prices 
charged for the electricity produced by these facilities is 
based on a non-competitive market in which the price is 
sufficient to meet the debt service demands of the bond. Under 
restructuring, the wholesale price of electricity may generate 
revenues insufficient to meet the debt service requirements of 
the facilities. In such a situation, to avoid possible default 
on the bonds, the utility may have to draw down reserves or 
devise some method to recover the original investment in the 
facilities.
    Advocates of the President's proposal may argue that it 
ameliorates the stranded costs transition problem by allowing 
much currently outstanding tax-exempt debt to retain its status 
but does not give public power the unfair advantage of tax-
exempt financing in any expansion. Also, they may argue that, 
the benefit is limited in duration because the refinancing may 
not extend the term of the debt beyond 120 percent of the 
economic life of the property being refinanced. Others may 
respond that this transition relief gives public power an 
unfair advantage in the market place by retaining the lower 
cost of capital resulting from their outstanding tax-exempt 
debt. They continue that even the limited duration of this 
financing perpetuates an unequal cost of capital which 
undermines fair competition On a prospective basis, some may 
argue, that the President's proposal correctly allows tax-
exempt financing for distribution facilities (including 
functionally related and subordinate property). They believe 
that these facilities are less likely to be the subject of 
increased competition so there is no unfair competitive 
advantage as a result of this limited tax-exemption. Others 
believe that market competition and the public are the best 
served by eliminating tax-exemption for all new bond issues.

2. Modify treatment of contributions to nuclear decommissioning funds

                              Present Law

    Special rules dealing with nuclear decommissioning reserve 
funds were adopted by Congress in the Deficit Reduction Act of 
1984 (``1984 Act'') when tax issues regarding the time value of 
money were addressed generally. Under general tax accounting 
rules, a deduction for accrual basis taxpayers generally is 
deferred until there is economic performance for the item for 
which the deduction is claimed. However, the 1984 Act contains 
an exception to those rules under which a taxpayer responsible 
for nuclear power plant decommissioning may elect to deduct 
contributions made to a qualified nuclear decommissioning fund 
for future payment costs. Taxpayers who do not elect this 
provision are subject to the general rules in the 1984 Act.
    A qualified decommissioning fund is a segregated fund 
established by the taxpayer that is used exclusively for the 
payment of decommissioning costs, taxes on fund income, payment 
of management costs of the fund, and making investments. The 
fund is prohibited from dealing with the taxpayer that 
established the fund. The income of the fund is taxed at a 
reduced rate of 20 percent \165\ for taxable years beginning 
after December 31, 1995.
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    \165\ As originally enacted in 1984, the fund paid tax on its 
earnings at the top corporate rate and, as a result, there would be no 
present-value tax benefit of making deductible contributions to the 
fund. Also, as originally enacted, the funds in the trust could be 
invested only in certain low risk investments. Subsequent amendments to 
the provision have reduced the rate of tax on the fund to 20 percent, 
and removed the restrictions on the types of permitted investments that 
the fund can make.
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    Contributions to the fund are deductible in the year made 
to the extent that these amounts were collected as part of the 
cost of service to ratepayers. Withdrawal of funds by the 
taxpayer to pay for decommissioning expenses are included in 
income at that time, but the taxpayer also is entitled to a 
deduction at that time for decommissioning expenses as economic 
performance for those costs occurs.
    A taxpayer's contributions to the fund may not exceed the 
amount of nuclear decommissioning costs included in the 
taxpayer's cost of service for ratemaking purposes for the 
taxable year. Additionally, in order to prevent accumulations 
of funds over the remaining life of a nuclear power plant in 
excess of those required to pay future decommissioning costs 
and to ensure that contributions to the funds are not deducted 
more rapidly than level funding, taxpayers must obtain a ruling 
from the IRS to establish the maximum contribution that may be 
made to the fund.
    If the decommissioning fund fails to comply with the 
qualification requirements or when the decommissioning is 
substantially completed, the fund's qualification may be 
terminated, in which case the amounts in the fund must be 
included in income of the taxpayer.

                        Description of Proposal

    The cost of service requirement for deductible 
contributions to nuclear decommissioning funds would be 
repealed. Thus, taxpayers, including unregulated taxpayers, 
would be allowed a deduction for amounts contributed to a 
qualified nuclear decommissioning fund. As under current law, 
however, the maximum contribution and deduction for a taxable 
year could not exceed the IRS ruling amount for that year.

                             Effective Date

    The proposal would be effective for taxable years beginning 
after December 31, 1999.

                              Prior Action

    No prior action.

                                Analysis

    The rationale for the present-law treatment of nuclear 
decommissioning costs is to assure that there is adequate 
funding available for the high cost of decommissioning these 
plants at the end of their useful life. This tax treatment also 
helps to spread the costs of the decommissioning over the life 
of the plant, rather than burdening future ratepayers with the 
entire expense.
    The requirement of present law that the amount deducted 
cannot exceed the amount of nuclear decommissioning costs 
included in the taxpayer's cost of service for rate making 
purposes would imply that no amounts would be deductible for a 
utility that, in a deregulated electric power market, is no 
longer subject to cost of service rate regulation. If the 
rationale for the present-law treatment of nuclear 
decommissioning remains in a competitive environment, it would 
arguably be appropriate to drop the present-law cost of service 
requirement. Thus, regulated and unregulated owners of nuclear 
power plants would be treated equally.\166\
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    \166\ See Joint Committee on Taxation, Federal Income Tax Issues 
Arising in Connection with Proposal to Restructure the Electric Power 
Industry (JCS-20-97), October 17, 1997.

                   II. PROVISIONS INCREASING REVENUES

                       A. Corporate Tax Shelters

1. Modify the substantial understatement penalty for corporate tax 
        shelters

                              Present Law

Substantial understatement penalty
    The accuracy-related penalty,\167\ which is imposed at a 
rate of 20 percent, applies to the portion of any underpayment 
that is attributable to (1) negligence, (2) any substantial 
understatement of income tax, (3) any substantial valuation 
misstatement, (4) any substantial overstatement of pension 
liabilities, or (5) any substantial estate or gift tax 
valuation understatement.
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    \167\ Section 6662.
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    The substantial understatement penalty applies in the 
following manner. If the correct income tax liability of a 
taxpayer for a taxable year exceeds that reported by the 
taxpayer by the greater of 10 percent of the correct tax or 
$5,000 ($10,000 in the case of most corporations), then a 
substantial understatement exists and a penalty may be imposed 
equal to 20 percent of the underpayment of tax attributable to 
the understatement. In determining whether a substantial 
understatement exists, the amount of the understatement is 
reduced by any portion attributable to an item if (1) the 
treatment of the item on the return is or was supported by 
substantial authority, or (2) facts relevant to the tax 
treatment of the item were adequately disclosed on the return 
or on a statement attached to the return and there was a 
reasonable basis for the tax treatment of the item. In no event 
does a corporation have a reasonable basis for its tax 
treatment of an item attributable to a multi-party financing 
transaction if such treatment does not clearly reflect the 
income of the corporation.\168\
---------------------------------------------------------------------------
    \168\ This provision was enacted in section 1028 of the Taxpayer 
Relief Act of 1997.
---------------------------------------------------------------------------
    Special rules apply to tax shelters. With respect to tax 
shelter items of non-corporate taxpayers, the penalty may be 
avoided only if the taxpayer establishes that, in addition to 
having substantial authority for his position, he reasonably 
believed that the treatment claimed was more likely than not 
the proper treatment of the item. This reduction in the penalty 
is unavailable to corporate tax shelters. The reduction in the 
understatement for items disclosed on the return is 
inapplicable to both corporate and non-corporate tax shelters. 
For this purpose, a tax shelter is a partnership or other 
entity, plan, or arrangement a significant purpose \169\ of 
which is the avoidance or evasion of Federal income tax.
---------------------------------------------------------------------------
    \169\ The standard of ``a significant'' purpose was enacted in 
section 1028 of the Taxpayer Relief Act of 1997. Previously, the 
standard was ``the principal'' purpose.
---------------------------------------------------------------------------
    The penalty is not imposed if the taxpayer establishes with 
respect to any item reasonable cause for his treatment of the 
item and that he acted in good faith.
Tax shelter registration
    The Code \170\ requires a promoter of a corporate tax 
shelter to register the shelter with the Secretary. 
Registration is required not later than the next business day 
after the day when the tax shelter is first offered to 
potential users. If the promoter is not a U.S. person, or if a 
required registration is not otherwise made, then any U.S. 
participant is required to register the shelter. An exception 
to this special rule provides that registration would not be 
required if the U.S. participant notifies the promoter in 
writing not later than 90 days after discussions began that the 
U.S. participant will not participate in the shelter and the 
U.S. person does not in fact participate in the shelter.
---------------------------------------------------------------------------
    \170\ Section 6111(d).
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    A corporate tax shelter is any investment, 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 the tax 
shelter promoters may receive total fees in excess of $100,000.
    A transaction is offered under conditions of 
confidentiality if: (1) an offeree (or any person acting on its 
behalf) has an understanding or agreement with or for the 
benefit of any promoter to restrict or limit its disclosure of 
the transaction or any significant tax features of the 
transaction; or (2) the promoter claims, knows or has reason to 
know (or the promoter causes another person to claim or 
otherwise knows or has reason to know that a party other than 
the potential offeree claims) that the transaction (or one or 
more aspects of its structure) is proprietary to the promoter 
or any party other than the offeree, or is otherwise protected 
from disclosure or use. The promoter includes specified related 
parties.
    Registration will require the submission of information 
identifying and describing the tax shelter and the tax benefits 
of the tax shelter, as well as such other information as the 
Treasury Department may require.
    Tax shelter promoters are required to maintain lists of 
those who have signed confidentiality agreements, or otherwise 
have been subjected to nondisclosure requirements, with respect 
to particular tax shelters. In addition, promoters must retain 
lists of those paying fees with respect to plans or 
arrangements that have previously been registered (even though 
the particular party may not have been subject to 
confidentiality restrictions).
    All registrations are treated as taxpayer information under 
the provisions of section 6103 and are therefore not subject to 
any public disclosure.
    The penalty for failing to timely register a corporate tax 
shelter is the greater of $10,000 or 50 percent of the fees 
payable to any promoter with respect to offerings prior to the 
date of late registration (i.e., this part of the penalty does 
not apply to fee payments with respect to offerings after late 
registration). A similar penalty is applicable to actual 
participants in any corporate tax shelter who were required to 
register the tax shelter but did not. With respect to 
participants, however, the 50-percent penalty is based only on 
fees paid by that participant. Intentional disregard of the 
requirement to register by either a promoter or a participant 
increases the 50-percent penalty to 75 percent of the 
applicable fees.
    The tax shelter registration provision applies to any tax 
shelter offered to potential participants after the date the 
Treasury Department issues guidance with respect to the filing 
requirements. As of February 18, 1999, the requisite guidance 
has not yet been issued; accordingly, this new tax shelter 
registration provision is not yet effective.

                        Description of Proposal

    The proposal would make three modifications to the 
substantial understatement penalty as it applies to corporate 
tax shelters. First, the rate of the penalty would be increased 
from 20 percent to 40 percent with respect to any item 
attributable to a corporate tax shelter. Second, that 40 
percent rate would be reduced to 20 percent if the corporation 
fulfilled specified disclosure requirements. Third, the 
reasonable cause exception from the substantial understatement 
penalty would be unavailable with respect to any item 
attributable to a corporate tax shelter.
    To fulfill the specified disclosure requirements, the 
corporate taxpayer must: (1) disclose (within 30 days of 
closing the transaction) to the National office of the IRS 
appropriate documents describing the transaction; (2) file a 
statement with the corporation's tax return verifying that this 
disclosure has been made; and (3) provide adequate disclosure 
on the corporation's tax returns as to the book/tax differences 
resulting from the corporate tax shelter item for all taxable 
years in which the tax shelter transaction applies.
    The proposal would also provide a new statutory definition 
of a corporate tax shelter. A corporate tax shelter 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 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).\171\
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    \171\ This proposal is intended to interact with the proposal 
expanding section 269 through the denial of certain tax benefits to 
persons avoiding income tax as a result of tax avoidance transactions 
in the following manner. The section 269 proposal would expand the 
range of transactions where tax benefits are denied because it is a tax 
avoidance transaction. Consequently, the range of prohibited 
transactions subject to this penalty proposal would also be expanded.
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    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.
    The proposal would give the Secretary the authority to 
prescribe regulations necessary to carry out the purposes of 
the provision.

                             Effective Date

    The proposal would be effective for transactions occurring 
on or after the date of first committee action.

                              Prior Action

    No prior action, except that the abolition of the 
reasonable cause exception may be contrasted with a 1997 
Administration proposal to provide a uniform reasonable cause 
exception for penalties.\172\
---------------------------------------------------------------------------
    \172\ See page 1 of Department of the Treasury, Taxpayer Bill of 
Rights 3 and Tax Simplification Proposals, April 1997. This proposal 
was enacted as section 1281 of the Taxpayer Relief Act of 1997.
---------------------------------------------------------------------------

                                Analysis

    Some observers have noted that there appears to be a 
substantial increase in corporate tax shelter activity 
recently. These observers are concerned about serious, adverse 
consequences to the income tax from this activity. One adverse 
consequence could be the erosion of the corporate tax base. 
Another adverse consequence could be a decrease in voluntary 
compliance by many taxpayers (whether individuals or 
corporations), who could view the tax system as fundamentally 
unfair if large, well-advised corporations are able to 
substantially reduce or eliminate their tax liability through 
techniques unavailable to the general public. A third adverse 
consequence could be an increase in inefficiency in the economy 
generally through the diversion of capital (both intellectual 
and real) into nonproductive activities. Accordingly, some 
observers believe that it is appropriate to undertake 
significant initiatives to slow the spread of corporate tax 
shelters generally.
    Some commentators have noted that the present-law rule that 
makes disclosure inapplicable in obtaining a reduction in the 
penalty with respect to tax shelter items may give taxpayers 
who engage in these transactions no reason not to conceal the 
transactions in their tax returns, which in turn may make it 
significantly more difficult for the IRS to audit the 
transaction. Some may question, however, whether doubling the 
penalty and then reducing it back to present-law levels with 
disclosure is the most appropriate mechanism to encourage 
greater disclosure and accordingly remedy this perceived defect 
in present law.
    On the other hand, this concern may be less relevant if the 
intent of the proposal is to deter corporate tax shelter 
transactions from occurring, rather than just encouraging more 
disclosure. Those who are troubled by the recent growth of 
corporate tax shelters may expect the proposal to stop abusive 
transactions from occurring at all, rather than increasing 
disclosure.
    Some observers have questioned whether the proposal's 
definition of a corporate tax shelter is too broad and fails to 
provide sufficient specificity for taxpayers to be on notice as 
to which transactions may be subject to these rules. Proponents 
might respond that the definition is intended to correlate with 
current case law, and so is not wholly new.\173\ To the extent 
the proposal's definition of tax shelter is vague, some 
transactions for which disclosure is desirable may not be 
disclosed, while other transactions for which disclosure is not 
useful may be subject to disclosure. This could impose an 
unnecessary burden on taxpayers and could distract the IRS from 
pursuing the most significant transactions. In addition, it is 
unclear how the proposal's definition of a tax shelter would 
apply to certain corporate restructuring transactions where 
there is no profit motive, or to multi-step transactions, which 
can be viewed as separate transactions that may not have 
sufficient pre-tax profits unless viewed in the aggregate.
---------------------------------------------------------------------------
    \173\ See, e.g., ACM v. Commissioner, 157 F. 3d 231 (1998).
---------------------------------------------------------------------------
    On the other hand, new types of transactions are 
continuously being created and marketed as corporate tax 
shelters. This continuing innovation may make it difficult to 
craft a definition of a corporate tax shelter that is 
sufficiently specific and that at the same time retains long-
term viability. The proposal could be viewed as a first step 
towards a more workable definition of a corporate tax shelter.
    There may be significant overlap between the proposal's 
disclosure provisions and the tax shelter registration 
provisions enacted in 1997. The proposal does not address 
possible resolutions of this overlap. Some have observed that 
the tax shelter registration provision is not yet effective 
because Treasury has not yet issued the guidance required by 
the statute before the provision is to become effective. 
Accordingly, it may be premature to propose new measures to 
deal with corporate tax shelters when provisions have already 
been enacted that are intended to do 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.
    Proponents of the proposal might respond in two ways. 
First, they believe that the proposal may be more narrowly 
targeted at inappropriate transactions than was the 
registration proposal, which may make it more efficacious at 
eliminating undesired behavior. Second, they believe that the 
apparently unabated level of corporate tax shelter activity 
requires additional legislative action beyond that already 
enacted.
    The proposal would eliminate the reasonable cause exception 
with respect to corporate tax shelters. All of the major civil 
penalties in the Code contain a reasonable cause 
exception.\174\ Accordingly, some might question whether it is 
appropriate to eliminate this reasonable cause exception, in 
light of the Code's complexity and the significant areas of 
uncertainty in its interpretation. On the other hand, the 
taxpayers involved in corporate tax shelters may be well 
equipped to deal with the complexity and uncertainty in the 
Code; in fact, many corporate tax shelter transactions are 
designed to take advantage of complex or uncertain provisions, 
as well as aggressive interpretations of the reasonable cause 
exception.
---------------------------------------------------------------------------
    \174\ The estimated tax penalties (secs. 6654 and 6655) do not 
contain reasonable cause exceptions, but these penalties are very 
similar to an interest charge, in that they are computed by applying 
the generally applicable underpayment interest rate to the amount of 
the underpayment for the period of the underpayment.
---------------------------------------------------------------------------
    It is also possible that eliminating the reasonable cause 
exception could have unintended consequences, in that the 
reasonable cause exception provides a ``relief valve'' for the 
penalty administration system (in addition to other functions) 
by permitting the elimination of the penalty in instances where 
the Service believes that it is reasonable and appropriate to 
do so. Accordingly, eliminating the explicit reasonable cause 
exception may cause Service personnel to in effect provide one 
through less formal means (such as negotiating a lower total 
amount due) where the Service believes that imposition of the 
penalty is not reasonable. Causing Service personnel to provide 
relief they believe to be appropriate through non-statutory, 
less formal mechanisms may decrease uniformity in the 
administration of this penalty. However, it may be less 
difficult to provide uniformity when dealing with a relatively 
small universe of corporations that engage in tax shelter 
transactions and with a penalty that is subject to the routine 
deficiency procedures of the Code.
    In addition, if the Service does not believe that it is 
reasonable and appropriate to eliminate the penalty, the 
presence of the reasonable cause exception does not require the 
Service to do so. Accordingly, some might infer that 
elimination of the reasonable cause exception is designed to 
relieve individual IRS personnel of the burden of exercising 
sound judgment in penalty cases involving corporate tax 
shelters. Proponents of the proposal might argue that 
eliminating the reasonable cause exception is appropriate, in 
that, by definition, there can be no reasonable cause for 
entering into transactions that satisfy the definition of a 
corporate tax shelter and that sound judgment will still be 
essential to the administration of the penalty. The force of 
this argument may be dependent upon the relative specificity, 
clarity, and objectivity contained in that definition.
2. Deny certain tax benefits to persons avoiding income tax as a result 
        of tax avoidance transactions

                              Present Law

    Generally on a complete liquidation of a controlled 
subsidiary, the acquiring corporation succeeds to its tax 
attributes, including net operating loss carryovers and other 
carryover items. When control of a corporation is acquired, or 
a corporation acquires property with a carryover basis from 
another corporation not controlled by the acquiring corporation 
or its shareholders, carryovers and other tax benefits may be 
disallowed if the principal purpose of the acquisition is tax 
avoidance or evasion (sec. 269). This disallowance provision 
also applies when a purchased subsidiary corporation with 
unexpired carryforward items is liquidated into the acquiring 
corporation, by authorizing the disallowance of carryover and 
other tax benefits of the subsidiary corporation acquired in a 
qualified stock purchase with respect to which an election of 
asset acquisition treatment is not made, if the subsidiary 
corporation is liquidated pursuant to a plan adopted within two 
years of the acquisition date and the principal purpose of the 
liquidation is tax avoidance or evasion.

                        Description of Proposal

    The proposal would expand this anti-avoidance provision by 
authorizing the Secretary to disallow a deduction, credit, 
exclusion, or other allowance obtained in a tax avoidance 
transaction. The definition of a tax avoidance transaction for 
purposes of this proposal would be the same as the definition 
proposed as part of the 40-percent substantial understatement 
penalty. No inference is intended as to the treatment of these 
transactions under present law.

                             Effective Date

    The proposal would be effective for transactions entered 
into on or after the date of first committee action.

                              Prior Action

    No prior action.

                                Analysis

    Section 269 of present law was primarily directed at a 
relatively narrow range of situations involving corporate 
combinations or acquisitions where one corporation acquires 
losses, credits, or other benefits of another corporation as 
``the principal purpose'' of the acquisition. The standard 
requiring that ``the principal purpose'' be to avoid tax has 
been difficult to administer as there is often a showing of 
some business or non-tax avoidance purpose. Furthermore, 
allowing the Secretary to disallow a tax benefit is not always 
a self-enforcing standard, since some taxpayers may decide to 
take a contrary position and play the ``audit lottery.'' Other 
later-enacted Code sections, such as section 382, utilize a 
more objective standard to limit losses and credits of 
corporations following certain ownership changes. Consequently, 
those provisions are more administrable by the IRS and their 
impact on taxpayers is more certain. However, provisions that 
involve ``bright line'' rules may be subject to potential 
manipulation by taxpayers who aggressively interpret those 
rules.
    The proposal explicitly expands the scope of present-law 
section 269 to any type of tax-avoidance transaction involving 
a corporation, not merely corporate acquisitions. It also 
expands the types of ``tax avoidance transactions'' with 
respect to which the Secretary is given the authority to 
disallow any tax benefits. Some have argued that this expanded 
authority is needed to address inappropriate corporate tax 
shelter activity. On the other hand, the definition proposed by 
the Administration is both broad and subjective (although 
proponents might argue that the definition is neither broader 
nor more subjective that either present-law section 269 or case 
law) . Some would argue that it is not appropriate to provide 
such broad authority to the Secretary in the absence of 
clearer, more objective standards. This is the case in part 
because this may be an inappropriate delegation of authority to 
the Secretary and in part because the definition may lead to 
substantial uncertainty on the part of taxpayers as to the 
eventual tax treatment of transactions that they are 
contemplating. Some fear that this broad power could be abused, 
such as by being used to threaten taxpayers to settle unrelated 
tax issues that may arise during an IRS audit.
3. Deny deductions for certain tax advice and impose an excise tax on 
        certain fees received

                              Present Law

    In general, taxpayers may deduct all the ordinary and 
necessary expenses paid or incurred during the taxable year in 
carrying on a trade or business. Accordingly, fees paid for 
advice in connection with a corporate tax shelter are generally 
deductible.
    No Federal excise tax is imposed on fees received in 
connection with the purchase or implementation of corporate tax 
shelters. Few such excise taxes exist in other areas of the 
Internal Revenue Code for similar payments (see, however, Code 
section 5881, which imposes a 50-percent excise tax on a person 
who receives greenmail).

                        Description of Proposal

    The proposal would deny a deduction to a corporation for 
fees paid or incurred in connection with the purchase and 
implementation, as well as the rendering of tax advice related 
to, a corporate tax shelter. The proposal would also impose a 
25-percent excise tax on fees (such as underwriting fees) paid 
or incurred in connection with the purchase and implementation, 
as well as the rendering of tax advice related to, a corporate 
tax shelter.
    Several special rules would apply. First, the proposal 
would not apply to expenses incurred to represent the taxpayer 
before the IRS or a court. Second, if a taxpayer claimed a 
deduction that would otherwise be denied under the proposal, 
the deduction would be considered to be in connection with a 
corporate tax shelter for purposes of the proposed 40-percent 
substantial understatement penalty. Third, the definition of 
corporate tax shelter for purposes of this proposal would be 
the same as the definition proposed as part of the 40-percent 
substantial understatement penalty.

                             Effective Date

    The proposal would be effective for fees paid, incurred, or 
received on or after the date of first committee action.

                              Prior Action

    No prior action.

                                Analysis

    Some observers are troubled by the apparent recent increase 
in corporate tax shelter activity. One element of this appears 
to be the rise in the marketing of these transactions by 
parties with no prior connections with the taxpayer involved. 
These observers may believe that this may be an indicia of tax 
motivation for these transactions. Accordingly, denying a 
deduction and imposing an excise tax may be a way to lessen 
behavior that may be viewed as undesirable. Opponents of the 
proposal might respond that denying a deduction for what have 
heretofore been considered ordinary and necessary business 
expenses may be viewed as a disproportionate response to 
corporate tax shelters.
    The effective date proposed could, if enacted, cause this 
proposal to apply to fees in connection with transactions that 
have already occurred. Some might view this aspect of the 
proposal as retroactive in its impact. Proponents of the 
proposal might respond that it is not retroactive in that it 
applies only to fees paid, incurred, or received after the date 
of first committee action.
    Some might argue that it is unclear what incremental impact 
the proposal would have beyond that of the other proposals 
related to corporate tax shelters, particularly the substantial 
understatement penalty modifications. It does not appear that 
there are any corporate tax shelters that would be subject to 
this proposal that would not be subject to the substantial 
understatement proposal.\175\ Accordingly, it may be more 
efficacious to accomplish the intended policy goal through one 
proposal rather than through two. On the other hand, proponents 
of the proposal might note that, although there is substantial 
overlap among the transactions covered by the two proposals, 
this proposal affects entirely different types of participants 
in those transactions than does the proposal related to the 
substantial understatement penalty. The penalty proposal 
affects the parties to the transaction, while this proposal 
affects persons who are not parties to the transaction but who 
are giving advice with respect to the transaction. Proponents 
might argue that it is appropriate to subject promoters of 
corporate tax shelters to an excise tax in order to provide a 
front-end disincentive to the development of corporate tax 
shelters by such persons.
---------------------------------------------------------------------------
    \175\ There are, however, corporate tax shelters (such as those 
developed in-house, without the participation of outside advisors) that 
would be subject to the substantial understatement proposal that would 
not be subject to this proposal.
---------------------------------------------------------------------------
    It may not be clear under the proposal upon which party the 
excise tax is actually imposed: upon the corporation when it 
makes a payment, or upon the recipient of the payment. If it is 
imposed upon the recipient of the payment, that person may have 
no legal standing to enter into disputes between the actual 
taxpayer and the IRS as to the substance of the transaction, 
such as whether a transaction is or is not a tax shelter. If it 
is imposed on the corporation when it makes a payment, there 
may be, from an economic standpoint, no substantive difference 
between denying the deduction to the corporation and imposing 
an excise tax (aside from the higher rate). If the excise tax 
is imposed on the corporation and if this proposal is 
considered in conjunction with the substantial understatement 
penalty proposal (discussed above), the net tax effect on the 
corporation could exceed the value of tax benefits that might 
be derived from these transactions.
4. Impose excise tax on certain rescission provisions and provisions 
        guaranteeing tax benefits

                              Present Law

    Corporations that contemplate entering into tax shelter 
transactions may employ several mechanisms to minimize their 
losses if the transaction cannot be successfully implemented. 
One mechanism is to provide for unwinding the entire 
transaction through a rescission clause. Another mechanism is 
to require a guarantee of the legal basis of the tax benefits. 
Another is to obtain insurance from a third party.
    The Code does not impose an excise tax on any of these 
types of mechanisms. Few such excise taxes exist in other areas 
of the Internal Revenue Code for similar payments (see, 
however, Code section 5881, which imposes a 50-percent excise 
tax on a person who receives greenmail).

                        Description of Proposal

    The proposal would impose an excise tax of 25 percent on 
the maximum payment that might be made under a tax benefit 
protection arrangement. The excise tax is imposed at the time 
the benefit protection arrangement is entered into, regardless 
of whether benefits may actually be paid in the future or not. 
A tax benefit protection arrangement would include a rescission 
clause, a guarantee of the legal basis of the benefits, 
insurance, or any other arrangement that has the same economic 
effect. The definition of corporate tax shelter for purposes of 
this proposal would be the same as the definition proposed as 
part of the 40-percent substantial understatement penalty. The 
Secretary would have the authority to provide that specified 
transactions would not be subject to the proposal.

                             Effective Date

    The proposal would apply to arrangements entered into on or 
after the date of first committee action.

                              Prior Action

    No prior action.

                                Analysis

    An increasingly common feature of recent corporate tax 
shelter activity has been the utilization of rescission or 
guarantee mechanisms that apply if the transaction cannot be 
successfully implemented. Although guarantees as to the factual 
basis of a transaction have long been a part of routine 
transactions, guarantees as to a specific legal outcome have 
been less common. Some observers are troubled by the increased 
utilization of these mechanisms, in that they may reflect a 
lack of independent economic viability apart from the tax 
aspects of the transaction. An excise tax is one mechanism that 
has been used in the past to deter specific types of activities 
that are disfavored (such as greenmail payments under section 
5881).
    Some might argue that it is unclear what incremental impact 
the proposal would have beyond that of the other proposals 
related to corporate tax shelters, particularly the substantial 
understatement penalty modifications. It does not appear that 
there are any corporate tax shelters that would be subject to 
this proposal that would not be subject to the substantial 
understatement proposal.\176\ Accordingly, it may be more 
efficacious to accomplish the intended policy goal through one 
proposal rather than through two.
---------------------------------------------------------------------------
    \176\ There are, however, corporate tax shelters (such as those 
without a rescission (or similar) clause) that would be subject to the 
substantial understatement proposal that would not be subject to this 
proposal.
---------------------------------------------------------------------------
    Under some benefit protection arrangements, such as 
rescission clauses, it may be difficult for the taxpayer to 
determine, at the point the arrangement is entered into, the 
maximum payment that might ultimately be made under the 
arrangement. This could lead to factual disputes between 
taxpayers and the IRS. Opponents of the proposal have 
questioned whether the excise tax should only apply at the 
point (if ever) when the arrangement ultimately becomes 
effective. Otherwise, the proposal could be considered to be 
penalizing activities that may never occur. Similarly, applying 
the excise tax to the maximum payment possible under the 
arrangement (as contrasted with the actual amount of any 
ultimate payment) could lead to a penalty that exceeds the 
amount of the transaction itself. Proponents of the proposal 
might respond that the proposal is intended to discourage 
benefit protection arrangements, whether or not they are 
ultimately utilized, because the mere existence of those 
arrangements may call into question the independent economic 
viability of the transaction.
    It could also be questioned whether the proposed excise tax 
should apply in circumstances where a taxpayer has applied for 
a private letter ruling and includes a benefit protection 
arrangement in a transaction while the taxpayer awaits an 
answer from the IRS. Some might consider it inappropriate to 
apply the excise tax in situations like this where there is 
significant uncertainty as the proper application of the tax 
law to specific transactions. On the other hand, it may be 
argued that few (if any) taxpayers request a private letter 
ruling from the IRS with respect to a corporate tax shelter.
5. Preclude taxpayers from taking tax positions inconsistent with the 
        form of their transactions

                              Present Law

    Taxpayers may enter into transactions and then assert that 
the form of the transaction should be disregarded because its 
economic substance is not reflected by the form of the 
transaction. In light of the fact that in general taxpayers 
control the form in which the transaction occurs, the IRS 
generally opposes attempts by taxpayers to disregard the form 
the taxpayers themselves chose for a transaction. The IRS may, 
however, seek to disregard the form of a transaction that 
taxpayers wish to defend if the IRS believes that the form of 
the transaction does not reflect the transaction's economic 
substance.
    There are two provisions in the Code that restrict the 
ability of taxpayers to take positions inconsistent with the 
form of their transactions. Section 385(c) provides that the 
characterization (as of the time of issuance) of a corporate 
instrument as stock or debt by the corporate issuer is binding 
on the issuer and on all holders. This characterization, 
however, is not binding on the Secretary of the Treasury. 
Except as provided in regulations, a holder who treats such 
instrument in a manner inconsistent with such characterization 
must disclose the inconsistent treatment on such holder's tax 
return. Section 1060(a) provides that a written agreement 
regarding the allocation of consideration to, or the fair 
market value of, any of the assets in an applicable asset 
acquisition will be binding on both parties for tax purposes, 
unless the Secretary determines that such allocation (or fair 
market value) is not appropriate.
    Aside from these two provisions, the legal standard that 
taxpayers must meet in order to overturn successfully the form 
of a transaction is not specified in the Code; rather, it has 
been judicially established. Accordingly, there has been some 
variation among the courts that have considered this issue as 
to the precise contours of this legal standard.
    One important delineation of this legal standard is in 
Danielson v. Commissioner.\177\ That standard is:
---------------------------------------------------------------------------
    \177\ 378 F.2d 771 (3d Cir. 1967); cert. denied, 389 U.S. 858 
(l967).

        a party can challenge the tax consequences of his 
        agreement as construed by the Commissioner only by 
        adducing proof which in an action between the parties 
        to the agreement would be admissible to alter that 
        construction or to show its unenforceability because of 
        mistake, undue influence, fraud, duress, etc.\178\
---------------------------------------------------------------------------
    \178\ 378 F.2d 771, 775.

    There have been two fundamental issues that court cases 
have discussed regarding the Danielson rule. The first is 
whether to adopt it at all. While the majority of circuit 
courts of appeal that have considered this issue have adopted 
the Danielson rule, some have not.\179\ Also, the Tax Court has 
not adopted the Danielson rule, but has instead adopted a 
``strong proof'' standard that is somewhat easier for taxpayers 
to meet than the Danielson rule.\180\ The second fundamental 
issue is under what circumstances is adoption of the rule 
appropriate. The Danielson rule originated ``with respect to 
agreed allocations of the sales price in contracts for the sale 
of a going business or the stock of an incorporated enterprise, 
when accompanied by a covenant not to compete.''\181\ 
Additionally, the contract must be written unambiguously with 
respect to this issue. The policy reasons underlying this 
higher burden of proof are: ``(1) reducing uncertainty about 
tax effects of contracts; (2) the tax polarity of the parties; 
(3) the possibility of denying a bargained-for tax advantage to 
the taxpayer's opposite number; (4) the administrative burden 
imposed on the IRS, which may have to litigate with both 
taxpayers and may be whipsawed by inconsistent decisions; and 
(5) the difficulty of placing separate values on items that 
would not have been sold in isolation.''\182\ These factors may 
apply in many other situations. Accordingly, some commentators 
have argued for extending this rule to all contracts.\183\ 
Others are more cautious about whether extension is 
appropriate.\184\
---------------------------------------------------------------------------
    \179\ See Bailoff, ``When (and Where) Does the Danielson Rule Limit 
Taxpayers Arguing 'Substance Over Form'?,'' 82 J. Taxation 362 (June 
1995) for a detailed discussion of this issue.
    \180\ Schmitz v. Commissioner, 51 T.C. 306 (1968), aff'd. 457 F.2d 
1022 (9th Cir., 1972).
    \181\ Bittker and Lokken, Federal Taxation of Income, Estates, and 
Gifts (Third Ed.) 4.4.6 (1999).
    \182\ Id.
    \183\ Id.; also, see Lozich, ``The Continuing Application of the 
Danielson Rule,'' 49 Tax Lawyer 769 (1996).
    \184\ Smith, ``Substance and Form,'' 44 Tax Lawyer 137 (1990); 
Blatt, ``Lost on a One-Way Street: The Taxpayer's Ability to Disavow 
Form,'' 70 Oregon L. Rev. no. 2 (1991).
---------------------------------------------------------------------------

                        Description of Proposal

    The proposal would preclude a corporate taxpayer from 
taking any position on a return or claim for refund that the 
income tax treatment of a transaction is different from that 
required by its form if a tax indifferent party has a direct or 
indirect interest in the transaction. Several exceptions would 
apply. First, this rule would not apply if the taxpayer 
discloses the inconsistent position on its timely filed, 
original tax return for the taxable year that includes the date 
on which the transaction was entered into. Second, this rule 
would not apply if reporting the substance of the transaction 
more clearly reflects the income of the taxpayer (to the extent 
this exception is permitted in regulations). Third, this rule 
would not apply to transactions that are identified in 
regulations.
    Several special rules and definitions would apply. First, 
the form of a transaction is to be determined based on all 
facts and circumstances, including the treatment that would be 
given the transaction for regulatory or foreign law purposes. 
Second, a tax indifferent party would be defined as a foreign 
person, a Native American tribal organization, a tax-exempt 
organization, or a domestic corporation with expiring loss or 
credit carryforwards.\185\ Third, the Secretary would have the 
authority to prescribe regulations to carry out the purposes of 
the rule, including a definition of the ``form'' of a 
transaction. Fourth, nothing in the proposal is intended to 
prevent the Secretary from asserting the substance-over-form 
doctrine or imposing any applicable penalties. Fifth, no 
inference is intended as to the extent to which a corporate 
taxpayer can disavow the form of its transactions under present 
law.
---------------------------------------------------------------------------
    \185\ Loss and credit carryforwards would generally be treated as 
expiring if the carryforward is more than three years old.
---------------------------------------------------------------------------

                             Effective Date

    The proposal would be effective for transactions entered 
into on or after the date of first committee action.

                              Prior Action

    No prior action.

                                Analysis

    Some might observe that the lengthy development of judicial 
principles to deal with this issue, as well as the continuing 
controversies between taxpayers and the IRS on this issue, make 
it ripe for additional legislative resolution. Others might 
counter that the judicial principles are sufficiently developed 
at this point that additional legislative action might (at 
least in the short term) increase, rather than decrease, 
uncertainty in this area.
    Proponents of codification of the Danielson rule would 
argue that it is a clear, easily applicable rule of long 
standing that has been widely adopted. Opponents of 
codification of the Danielson rule would argue that Danielson 
has not been universally adopted, both because of its rigid 
nature and because it imposes a more difficult standard for 
taxpayers to meet than any of the competing alternative rules.
    The proposal essentially codifies the Danielson rule, but 
with several important modifications. First, the proposal does 
not codify the Danielson exceptions for fraud or duress (except 
indirectly, through either the disclosure rule or a possible 
regulatory exception). It is not clear whether omission of the 
explicit fraud or duress exception was necessary to achieve a 
policy goal or was inadvertent.
    The second important way in which the proposal differs from 
Danielson is that the proposal limits codification of this rule 
to situations where a tax indifferent party has a direct or 
indirect interest in the transaction. Several of the rationales 
underlying the Danielson rule presuppose that both parties to a 
transaction are taxable. Some might argue that so limiting this 
codification of the Danielson rule is inappropriate.
6. Tax income from corporate tax shelters involving tax-indifferent 
        parties

                              Present Law

    The United States imposes tax on nonresident alien 
individuals and foreign corporations (collectively, foreign 
persons) only on income that has a sufficient nexus to the 
United States. Foreign persons are subject to U.S. tax on 
income that is effectively connected with the conduct of a 
trade or business within the United States (secs. 871(b) and 
882). Such income generally is taxed in the same manner and at 
the same rates as income of a U.S. person.
    Foreign persons also are subject to a 30-percent gross 
basis tax, collected by withholding, on certain U.S.-source 
income, such as interest, dividends and other fixed or 
determinable annual or periodical (``FDAP'') income, that is 
not effectively connected with a U.S. trade or business. This 
30-percent withholding tax may be reduced or eliminated 
pursuant to an applicable tax treaty. Foreign persons generally 
are not subject to U.S. tax on foreign-source income that is 
not effectively connected with a U.S. trade or business.
    Tax-exempt organizations (such as sec. 501(c) nonprofit 
organizations and pension plans) generally are not subject to 
Federal income tax, for example, on dues and contributions they 
receive from their members, as well as other income from 
activities that are substantially related to the purpose of 
their tax exemption. However, tax-exempt organizations are 
subject to the unrelated business income tax (``UBIT'') on 
income derived from a trade or business regularly carried on 
that is not substantially related to the performance of the 
organization's tax-exempt functions (secs. 511-514). In 
addition, Native American Indian tribes, as well as wholly 
owned tribal corporations chartered under Federal law, 
generally are not subject to Federal income taxes.\186\
---------------------------------------------------------------------------
    \186\ See Rev. Rul. 94-65, 1994-2 C.B. 14; Rev. Rul. 94-16, 1994-1 
C.B. 19; Rev. Rul. 81-295, 1981-2 C.B. 15; Rev. Rul. 67-284, 1967-2 
C.B. 55. The Internal Revenue Service recently clarified that tribal 
corporations chartered under tribal law also can qualify for exemption 
as section 501(c)(3) organizations. See General Information Letter to 
First Nations Development Institute (September 8, 1998).
---------------------------------------------------------------------------
    Specific rules apply for purposes of allowing U.S. 
corporations to carryback or carryforward losses or credits. 
For example, net operating losses may be carried back two years 
and forward twenty years (sec. 172). Capital losses in excess 
of capital gains for a year may be carried back three years and 
forward five years (sec. 1212(a)). Business credits may be 
carried back one year and forward twenty years (sec. 39). 
Foreign tax credits may be carried back two years and forward 
five years (sec. 904(c)). Detailed rules apply to limit the use 
of such loss and credit carrybacks and carryforwards (secs. 381 
through 384).

                        Description of Proposal

    The proposal would provide that any income allocable to a 
tax-indifferent party with respect to a corporate tax shelter 
is taxable to such tax-indifferent party. The U.S. tax imposed 
on the income allocable to the tax-indifferent party would be 
determined without regard to any statutory, regulatory, or 
treaty exclusion or exception. The proposal also would provide 
that any other participants in the corporate tax shelter (i.e., 
any participant other than the tax-indifferent party in 
question) would be jointly and severally liable with the tax-
indifferent party for taxes imposed.
    For these purposes, 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 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) from 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 include certain 
transactions involving the improper elimination or significant 
reduction of tax on economic income.
    The proposal would define a ``tax-indifferent party'' as a 
foreign person (i.e., a nonresident alien individual or a 
foreign corporation), a Native American tribal organization, a 
tax-exempt organization, and U.S. corporations with expiring 
loss or credit carryforwards. For these purposes, loss and 
credit carryforwards generally would be treated as expiring if 
the carryforward is more than three years old.
    In the case of a foreign person, U.S. tax on the income or 
gain allocable to such person would be determined without 
regard to any exclusion or exception, provided in a treaty or 
otherwise. Any such income or gain that is not U.S.-source FDAP 
income would be treated as effectively connected with a U.S. 
trade or business without regard to whether such income is 
U.S.- or foreign-source. If the foreign person properly claims 
the benefit of an income tax treaty, the U.S. tax otherwise 
owed by such foreign person would be collected from the other 
participants in the corporate tax shelter transaction who are 
not exempt from U.S. tax. It is understood that present-law 
standards (e.g., under sec. 6114) would apply in determining 
whether a foreign person ``properly claims'' the benefit of a 
treaty for these purposes. It also is understood that in no 
event would such foreign person be liable for taxes with 
respect to such transaction in excess of U.S. taxes (if any) 
not reduced or eliminated pursuant to the applicable income tax 
treaty for which relief is claimed.
    In the case of a Native American tribal organization, the 
tax on the income allocable to such person would be determined 
without regard to any exclusion or exception. However, the tax 
would be collected only from participants of the corporate tax 
shelter transaction who are not exempt from U.S. tax.
    In the case of a tax-exempt organization, the income would 
be characterized as income that is subject to UBIT. In the case 
of a U.S. corporation with expiring loss or credit carryovers, 
the tax on the income allocable to such corporation would be 
computed without regard to such losses or credits.

                             Effective Date

    The proposal would be effective for transactions entered 
into on or after the date of first committee action.

                              Prior Action

    No prior action.

                                Analysis

    The proposal is intended to address corporate tax shelter 
transactions involving a timing mismatch, or separation of 
income or gains from deductions or losses, through the use of 
tax-indifferent parties. The Administration's proposal does not 
contain specific examples of such transactions, but generally 
describes the transactions as involving the absorption of 
income or gain generated in the transaction by a tax-
indifferent party, leaving a corresponding deduction or loss to 
taxable corporate entities. Tax-indifferent parties may agree 
to engage in such transactions in exchange for an enhanced 
return on their investment or for an accommodation fee.
    Some argue that taxable U.S. corporations should not be 
permitted to ``purchase'' the special tax status of tax-
indifferent parties in order to generate U.S. tax benefits. 
Imposing tax on income allocated to tax-indifferent parties is 
expected to limit their participation in corporate tax shelter 
transactions and, thus, limit the ``sale'' of their special tax 
status. In addition, requiring the other participants in such 
transactions to be jointly and severally liable for the tax 
would create further disincentives for participation in such 
transactions, as well as facilitating the collection of the 
tax.
    On the other hand, the proposal would represent a 
significant departure from the manner in which the United 
States taxes foreign persons and certain other tax-exempt 
entities. For example, in the case of foreign persons, the 
proposal would expand the scope of the U.S. taxing jurisdiction 
to allow the United States to tax foreign persons on foreign-
source income that has no economic nexus to the United States. 
This approach could result in, among other things, potential 
double taxation with respect to such income, because the United 
States generally does not allow foreign persons to claim 
foreign tax credits (although double taxation could be 
mitigated under an applicable tax treaty). In addition, because 
the proposal would treat foreign-source income allocable to a 
foreign person in a corporate tax shelter transaction as income 
effectively connected with a U.S. trade or business, foreign 
persons with no connection to the United States would be 
required to file a U.S. tax return to report income and pay tax 
with respect such transactions; however, requiring such 
reporting and collecting the tax from such foreign persons may 
be difficult to enforce in practice. The proposal could lead to 
retaliation from other foreign countries (perhaps through the 
enactment of similar rules that would tax U.S. persons on 
certain income having no economic nexus to that country).
    The proposal would provide that tax on income or gain 
allocable to a foreign person would be determined without 
regard to applicable treaties, raising treaty override issues. 
However, the proposal would provide that if the foreign person 
properly claims the benefit of a treaty, the tax otherwise 
owing by such foreign person would be collected from the other 
parties participating in the corporate tax shelter transaction, 
and not such foreign person. It is understood that foreign 
persons would not be liable for taxes with respect to such 
transaction in excess of any U.S. taxes not reduced or 
eliminated pursuant to the applicable income tax treaty for 
which relief is claimed. Thus, it is asserted that a foreign 
person should not be denied treaty benefits as a result of the 
proposal.
    The proposal would treat as a tax-indifferent party U.S. 
corporations with expiring loss or credit carryforwards, 
generally defined to mean loss or credit carryforwards that are 
more than three years old. Some have observed that this three-
year threshold is arbitrary and perhaps unduly harsh, 
particularly in the case of losses or credits that may be 
carried forward twenty years (e.g., net operating losses and 
business credits). Some also might argue that U.S. corporations 
with expiring losses or credits should be distinguished from 
tax-exempt entities.
    Some have observed that the definition of ``corporate tax 
shelter'' and other defined terms in the proposal may be viewed 
as being too vague or overly broad, and may not provide 
sufficient specificity for taxable or tax-indifferent parties 
to be on notice as to which transactions may be subject to 
these rules. This approach could be criticized as creating an 
environment of uncertainty for such parties in making business 
and investment decisions.
7. Require accrual of time value element on forward sale of corporate 
        stock

                              Present Law

    A corporation generally recognizes no gain or loss on the 
receipt of money or other property in exchange for its own 
stock (including treasury stock) (sec. 1032). Furthermore, a 
corporation does not recognize gain or loss when it redeems its 
stock, with cash, for less or more than it received when the 
stock was issued.
     In general, a forward contract means a contract to deliver 
at a set future date (the ``settlement date'') a substantially 
fixed amount of property (such as stock) for a substantially 
fixed price. Gains or losses from forward contracts generally 
are not taxed until the forward contract is closed. A 
corporation does not recognize gain or loss with respect to a 
forward contract for the sale of its own stock. A corporation 
does, however, recognize interest income upon the current sale 
of its stock for a deferred payment.
    With respect to certain ``conversion transactions'' 
(transactions generally consisting of two or more positions 
taken with regard to the same or similar property, where 
substantially all of the taxpayer's return is attributable to 
the time value of the taxpayer's net investment in the 
transaction), gain recognized that would otherwise be treated 
as capital gain may be recharacterized as ordinary income (sec. 
1258).

                        Description of Proposal

    The proposal would require a corporation that enters into a 
forward contract for the sale of its own stock to treat a 
portion of the payment received with respect to the forward 
contract as a payment of interest.

                             Effective Date

    The proposal would be effective for forward contracts 
entered into on or after the date of first committee action.

                              Prior Action

    No prior action.

                                Analysis

    Under a traditional forward contract, the purchase price 
generally is determined by reference to the value of the 
underlying property on the contract date and is adjusted (1) 
upward to reflect a time value of money component to the seller 
for the deferred payment (i.e. for holding the property) from 
the contract date until the settlement date and (2) downward to 
reflect the current yield on the property that will remain with 
the seller until the settlement date. Strategies have been 
developed whereby a corporation can obtain favorable tax 
results through entering into a forward sale of its own stock, 
which results could not be achieved if the corporation merely 
sold its stock for a deferred payment. One such strategy that 
might be used to exaggerate a corporation's interest deductions 
could involve a corporation borrowing funds (producing an 
interest deduction) to repurchase its own stock, which it 
immediately sells in a forward contract at a price equal to the 
principal and interest on the debt for settlement on the date 
that the debt matures. Although the interest would be 
deductible on the debt, any gain from the forward contract 
(including any interest component) would not be taxable to the 
corporation (sec. 1032).
    Advocates of the proposal argue that there is little 
substantive difference between a corporation's current sale of 
its own stock for deferred payment (upon which the corporate 
issuer would accrue interest) and the corporation's forward 
sale of the same stock. The primary difference between the two 
transactions is the timing of the stock issuance. In a current 
sale, the stock is issued at the inception of the transaction, 
while in a forward sale, the stock is issued at the time the 
deferred payment is received. In both cases, a portion of the 
deferred payment economically compensates the corporation for 
the time value of the deferred payment. Proponents of the 
proposal argue that these two transactions should be treated 
the same. Additionally, some would argue that the proposal is a 
logical extension of the conversion rules of section 1258 which 
treat as ordinary income the time-value component of the return 
from certain conversion transactions.
    Opponents of the proposal argue that there is a substantive 
difference between a corporation's forward sale of its stock 
and a current sale. Under a forward sale, the stock is not 
outstanding until it is issued on the settlement date. The 
purchaser has no current dividend rights, voting rights or 
rights in liquidation. Additionally, any forward sale by its 
very nature has a time value component: that feature is not 
unique to a corporate issuer of its own stock. The time value 
component should compensate the holder for its carrying costs 
with respect to the property. The proposal would treat 
differently a forward sale of stock and an issuance in the 
future of stock for the same price on the same date as the 
settlement date.
    Some also might argue that the policy rationale underlying 
the conversion rules is not present with respect to the 
issuance of corporate stock because there is no conversion of 
ordinary income to capital gain. For example, assume a taxpayer 
buys gold today for $100 and immediately enters into a forward 
contract to sell that gold in the future for $110 ($10 of which 
represents the time value of money). Upon closing of the 
forward sale, the taxpayer (and its shareholders if it is a 
corporation) would recognize an economic gain of $10. Absent 
the conversion rules (sec. 1258), the $10 gain on that 
transaction may be treated as capital gain notwithstanding that 
substantially all of the taxpayer's return is with respect to 
the time value of money. The taxpayer is in the economic 
position of a lender with an expectation of a return from the 
transaction that is in the nature of interest and with no 
significant risks other than those typical of a lender. That 
arguably is not the case (at least with respect to the economic 
position of the existing shareholders) with respect to a 
corporation that enters into a forward sale of its own stock. A 
corporation's ownership of its own stock arguably has no 
economic significance to the corporation or its shareholders. 
The purchase or issuance by a corporation of its own stock at 
fair market value does not affect the value of the 
shareholders' interests in the corporation. The economic gain 
or loss, if any, to the existing shareholders of the 
corporation on the forward sale of its stock would depend on 
the fair market value of the corporation's stock on the 
settlement date. If the fair market value of the corporation's 
stock on the settlement date equals the contract price under 
the forward sale, then there is no economic gain or loss to the 
corporation or its shareholders.
    Finally, some would argue that the provision narrowly 
focuses on one type of derivative contract with respect to a 
corporation's own stock and that a broader approach addressing 
the treatment under section 1032 of derivative contracts and 
other techniques for using a corporation's own stock would be 
more appropriate.
8. Modify treatment of built-in losses and other attribute trafficking

                              Present Law

    U.S. persons are subject to U.S. tax on their worldwide 
income. Foreign persons are subject to U.S. tax, calculated in 
the same manner and at the same graduated rates as the U.S. tax 
on U.S. persons, on income that is effectively connected with 
the conduct of a U.S. trade or business (``U.S.-effectively 
connected income''). Foreign persons also are subject to a U.S. 
30-percent withholding tax on the gross amount of certain U.S.-
source income that is not U.S.-effectively connected income.
    Tax-exempt organizations (such as sec. 501(c) nonprofit 
organizations and pension plans) generally are not subject to 
Federal income tax, for example, on dues and contributions they 
receive from their members, as well as other income from 
activities that are substantially related to the purpose of 
their tax exemption. However, tax-exempt organizations are 
subject to the unrelated business income tax (``UBIT'') on 
income derived from a trade or business regularly carried on 
that is not substantially related to the performance of the 
organization's tax-exempt functions (secs. 511-514). In 
addition, Native American Indian tribes, as well as wholly 
owned tribal corporations chartered under Federal law, 
generally are not subject to Federal income taxes.\187\
---------------------------------------------------------------------------
    \187\ See Rev. Rul. 94-65, 1994-2 C.B. 14; Rev. Rul. 94-16, 1994-1 
C.B. 19; Rev. Rul. 81-295, 1981-2 C.B. 15; Rev. Rul. 67-284, 1967-2 
C.B. 55. The Internal Revenue Service recently clarified that tribal 
corporations chartered under tribal law also can qualify for exemption 
as section 501(c)(3) organizations. See General Information Letter to 
First Nations Development Institute (September 8, 1998).
---------------------------------------------------------------------------
    Detailed rules apply to limit a taxpayer's ability to use 
certain tax attributes, such as net operating losses, built-in 
losses and various credit items (secs. 269 and 381 through 
384). In addition, in determining U.S. taxable income, various 
rules are aimed at preventing U.S. taxpayers from transferring 
appreciated property outside the U.S. taxing jurisdiction to 
escape U.S. tax on the built-in gain with respect to such 
property. Section 367(a) limits the application of 
nonrecognition provisions to corporate reorganizations and 
transfers involving foreign corporations. In addition, under 
section 864(c)(7), the gain with respect to property that was 
used in connection with a U.S. trade or business may be 
considered to be effectively connected with a U.S. trade or 
business, and therefore subject to U.S. tax, even though the 
property is no longer so used at the time of its disposition. 
Moreover, section 877 includes rules to limit the ability of 
former U.S. citizens to avoid U.S. tax on appreciated property.
    The Code does not include analogous provisions specifically 
aimed at preventing taxpayers from transferring property with 
built-in losses, or transferring other favorable tax attributes 
such as deficits in earnings and profits and foreign tax 
credits, into the U.S. taxing jurisdiction. Such built-in 
losses or other tax attributes could be used to offset income 
or gain that otherwise would be subject to U.S. tax.
    Taxpayers also may transfer property with built-in gains or 
other unfavorable tax attributes into the U.S. taxing 
jurisdiction. Such transfers could result in the imposition of 
U.S. taxes. However, many taxpayers can trigger recognition of 
built-in gain assets in a manner that is not subject to U.S. or 
foreign tax, or can obtain a step-up in basis in all of its 
assets through a section 338 election, when such election is 
beneficial and available.

                        Description of Proposal

    The proposal would provide a new regime for assets, 
entities, and attributes that are brought into the U.S. taxing 
jurisdiction. In this regard, the proposal would provide that 
assets would be marked to fair market value and other tax 
attributes would be eliminated, as may be applicable, when 
assets or entities become ``relevant'' for U.S. tax purposes 
(so-called ``fresh start'' rules). An entity would become 
``relevant'' for U.S. tax purposes in two general situations. 
First, an entity would become relevant when a ``tax-exempt 
entity'' becomes a ``taxable U.S. entity'' (as defined). 
Second, an entity would become relevant when a foreign 
corporation that is not a controlled foreign corporation 
(``CFC''), but is a ``taxable U.S. entity,'' becomes a CFC or a 
U.S. person.
    For these purposes, a ``tax-exempt entity'' would include 
an entity that is exempt from tax under section 501, a Native 
American tribal organization, a nonresident alien individual, 
and a foreign corporation that is not a member of a qualified 
group under section 902(b)(2) (i.e., a foreign corporation in 
which there is no U.S. shareholder who would be entitled to 
indirect foreign tax credits). A ``taxable U.S. entity'' would 
be a U.S. person (e.g., a U.S. citizen or resident, a U.S. 
corporation, and a U.S. partnership, but not a section 501 tax-
exempt organization), a foreign corporation that is a member of 
a qualified group under section 902(b)(2) (i.e., a foreign 
corporation in which a U.S. shareholder would be entitled to 
indirect foreign tax credits), and a CFC.
    The proposal thus would apply in several cases where a tax-
exempt entity becomes a taxable U.S. entity, including where: 
(1) a U.S. corporation acquires a 10-percent or greater voting 
interest in the stock of a foreign corporation with no U.S. 
shareholders, (2) a foreign corporation with no U.S. 
shareholders domesticates in an F reorganization, (3) a 
nonresident alien individual becomes a U.S. resident, and (4) a 
section 501 tax-exempt organization loses its tax-exempt 
status. In addition, the proposal would apply where a 
noncontrolled section 902 corporation (a ``10/50 company'') 
becomes a CFC or a U.S. corporation (e.g., through stock 
acquisitions by U.S. persons or through reorganization 
transactions).
    The proposal also would apply to the transfer of assets and 
liabilities by tax-exempt entities to taxable U.S. entities or 
operations. For example, assets or liabilities that are 
transferred by a foreign person to a U.S. corporation (such as 
in a section 351 transaction), or to a business unit that 
generates UBIT or U.S.-effectively connected income, would be 
marked to market at the time of transfer. In addition, the 
proposal would apply to the transfer of assets and liabilities 
by a 10/50 company to a CFC, U.S. resident, or a business unit 
that generates UBIT or U.S.-effectively connected income.
    Several special rules would apply. First, special valuation 
rules would be provided with respect to the transfer of 
intangible assets. Second, the proposal generally would not 
apply to assets or other attributes held by a tax-exempt entity 
to the extent such items were or would be subject to net U.S. 
income tax. Thus, a special rule would be provided to exclude 
from the fresh start rules items that are related to UBIT or 
U.S.-effectively connected income prior to the time an asset or 
its owner becomes relevant for U.S. tax purposes, as well as 
for personal assets in the case of a nonresident alien who 
becomes a U.S. resident.
    Third, special rules would be provided to preserve the tax 
attributes of certain U.S. shareholders who held an interest in 
a foreign corporation before and after a fresh start event. In 
this regard, the proposal would require 10-percent or greater 
(determined by voting power) U.S. shareholders of a foreign 
corporation to maintain a shareholder-level suspense account 
that contains such shareholder's pro rata share of the 
corporation's tax attributes (e.g., earnings and profits and 
foreign taxes) immediately after the marking of assets, but 
prior to the elimination of the tax attributes of the 
corporation. These rules would not affect the attributes of 
other shareholders of the foreign corporation.
    For example, assume that in year one a U.S. corporation 
(``US1'') acquires 20 percent of the stock of a foreign 
corporation with no U.S. shareholders. The acquisition would 
trigger the fresh start rules, causing all of the foreign 
corporation's assets and liabilities to be marked to fair 
market value, and all of such corporation's tax attributes 
(e.g., earnings and profits and taxes) to be eliminated for 
U.S. tax purposes. Assume that in year five an unrelated U.S. 
corporation (``US2'') acquires the remaining 80 percent of the 
foreign corporation's stock from its non-U.S. shareholders. 
This stock acquisition would cause the foreign corporation to 
become a CFC, which would trigger a second fresh start event. 
In year five, all of the foreign corporation's assets and 
liabilities would again be marked to fair market value, and all 
of its tax attributes would be eliminated. However, because US1 
was a 10-percent or greater shareholder in the foreign 
corporation after this fresh start event, a shareholder-level 
suspense account would be created with respect to US1 that 
would reflect US1's pro rata share (i.e., 20 percent) of the 
foreign corporation's earnings and profits (including earnings 
and profits created by the second fresh start) and related 
foreign taxes.
    The proposal would provide the Secretary with authority to 
prescribe regulations to carry out the purposes of the 
proposal, including regulations governing the proper treatment 
of deficits that existed in an entity prior to the elimination 
of attributes and related foreign tax credits, and the 
proposal's interaction with section 367(b) (and the regulations 
thereunder) and the passive foreign investment company regime. 
The proposal also would provide the Secretary with authority to 
prescribe regulations necessary to prevent trafficking in 
favorable tax attributes involving foreign corporations to the 
extent not specifically addressed by the proposal. This would 
include, for example, trafficking in favorable tax attributes 
among CFCs. The proposal further would provide the Secretary 
with authority to identify the circumstances under which 
transfers to partnerships and transfers of partnership 
interests would be subject to these rules. Moreover, the 
proposal would provide the Secretary with authority to 
prescribe regulations in cases in which certain tax-exempt 
entities would not be subject to these rules, such as in the 
case of a section 501(c)(12) corporation that changes between 
taxable and tax-exempt status from year-to-year based on income 
earned.
    No inference would be intended as to the treatment under 
present law of transactions that result in the use for U.S. tax 
purposes of tax attributes arising outside the U.S. taxing 
jurisdiction.

                             Effective Date

    The proposal would be effective for transactions entered 
into on or after the date of enactment.

                              Prior Action

    The President's fiscal year 1999 budget proposal would have 
directed the Secretary of the Treasury to prescribe regulations 
to determine the basis of assets held directly or indirectly by 
a foreign person and the amount of built-in deductions with 
respect to a foreign person or an entity held directly or 
indirectly by a foreign person as may be necessary or 
appropriate to prevent the avoidance of tax.

                                Analysis

    The proposal would represent a fundamental change in the 
manner in which the United States treats assets or entities 
that are brought into the U.S. taxing jurisdiction. In this 
regard, the proposal would apply a mandatory set of rules to 
mark assets to fair market value, and eliminate tax attributes, 
as applicable, upon the occurrence of certain defined events, 
such as when a tax-exempt entity becomes a taxable U.S. entity.
    Some argue that legislative rules are needed to address the 
use of built-in losses and other tax attributes which 
economically accrue outside the U.S. taxing jurisdiction, in 
order to prevent purposeful tax avoidance by U.S. and foreign 
persons. For example, foreign persons investing in the United 
States may reduce U.S. tax on U.S. operations (e.g., U.S. 
subsidiary operations or U.S. branch operations giving rise to 
U.S.-effectively connected income), by importing built-in loss 
assets and other tax attributes, and triggering, for example, 
recognition of losses and deductions to offset U.S. income. 
Similar issues may arise in transactions involving tax-exempt 
organizations or other tax-exempt entities. Taxpayers can 
obtain mark-to-market treatment if desired (e.g., in the case 
of appreciated assets) such that present law can offer, in 
certain cases, selectivity as between gain and loss assets.
    Some also argue that tax attributes which accrue outside 
the U.S. taxing jurisdiction, whether favorable or unfavorable, 
should not affect U.S. tax liability. There also is 
administrative complexity for taxpayers and the government in 
attempting to track tax attributes for U.S. tax purposes that 
accrue outside the U.S. taxing jurisdiction. This includes 
recreating records reflecting tax attributes such as earnings 
and profits under U.S. tax principles that may span several 
years, which could be costly and of questionable accuracy. 
Limiting the use of such tax attributes could reduce 
administrative and compliance burdens under present law.
    On the other hand, the rules would not be limited to 
abusive tax avoidance transactions, but would apply equally to 
legitimate business transactions. In addition, the proposal 
would significantly differ from present-law rules addressing 
trafficking in tax attributes (such as net operating losses 
under secs. 381 through 384), which generally operate to defer 
the use of such attributes for U.S. tax purposes. The proposal 
would eliminate tax attributes altogether in certain cases 
(e.g., in the case of certain entity transfers). Some argue 
that rules addressing trafficking in various tax attributes 
should be similar.
    The proposal would mandate the application of the fresh 
start rules, for example, upon the acquisition by a U.S. 
corporation of at least 10 percent of the voting stock of a 
foreign corporation. Ten percent may be viewed as a relatively 
low threshold for purposes of requiring assets to be marked to 
market and tax attributes to be eliminated. Under present law, 
taxpayers generally can mark to market assets and eliminate tax 
attributes, at the taxpayer's election, only when, among other 
things, 80 percent of the stock of a corporation is acquired 
(sec. 338). On the other hand, some might argue that a 10-
percent threshold is appropriate to identify the first time 
there is meaningful U.S. ownership.
    The proposal would introduce considerable complexity and 
compliance burdens. For example, the fresh start rules would be 
invoked when a 10/50 company becomes either a CFC or a U.S. 
person, resulting potentially in a second separate fresh start 
event (i.e., the first fresh start event occurring when a 
foreign corporation becomes a 10/50 company, and a second fresh 
start event occurring when such 10/50 company becomes either a 
CFC or a U.S. person). In addition, the requirement of 
maintaining shareholder-level suspense accounts to preserve tax 
attributes (whether favorable or unfavorable) for certain 10-
percent or greater U.S. shareholders would introduce further 
complexity.
    Some have observed that mark-to-market events mandated by 
the proposal could give rise to potential adverse consequences, 
such as potential current inclusions to U.S. persons (e.g., 
under the passive foreign investment company rules), or causing 
a foreign corporation to become a passive foreign investment 
company. The proposal would grant regulatory authority to 
address such types of issues. Some argue that these types of 
issues would need to be addressed as part of any proposed 
legislative rules and not through regulatory authority.
9. Modify treatment of ESOP as S corporation shareholder

                              Present Law

    The Small Business and Job Protection Act of 1996 (``1996 
Act'') allowed qualified retirement plan trusts described in 
Code section 401(a) to own stock in an S corporation. The 1996 
Act treated the plan's share of the S corporation's income (and 
gain on the disposition of the stock) as includible in full in 
the trust's unrelated business taxable income (``UBTI''). The 
provision was effective for taxable years beginning after 
December 31, 1997.
    The Tax Relief Act of 1997 (``1997 Act'') repealed the 
provision treating items of income or loss of an S corporation 
as unrelated business taxable income in the case of an employee 
stock ownership plan (``ESOP''), effective for taxable years to 
which the 1996 legislation applied. Thus, the income of an S 
corporation allocable to an ESOP is not subject to current 
taxation. Distributions made to the participants of the ESOP 
are generally taxable.

                        Description of Proposal

    The proposal would repeal the provision of the 1997 Act 
eliminating the inclusion of S corporation income of an ESOP as 
UBTI. Thus, all items of income or loss of an S corporation 
would flowthrough to an ESOP as UBTI. In addition, gain or loss 
on the sale or other disposition (including any distribution to 
a participant) of stock of an S corporation by an ESOP would be 
treated as UBTI.
    An ESOP would be allowed a deduction in computing its UBTI 
from an S corporation for the amount of distributions made to 
participants. The deduction would be allowed only to the extent 
that the ESOP's total distributions after the effective date of 
the proposal exceed the amount of income that was not subject 
to tax by reason of the 1997 Act provision. The deduction would 
be taken into account in computing the ESOP's net operating 
loss so that an ESOP would be allowed a refund or reduction of 
tax when the previously taxed income is distributed to 
participants.

                             Effective Date

    The proposal would be effective for taxable years beginning 
on or after the date of the first committee action. The 
proposal would also be effective with respect to the 
acquisition of S corporation stock or an S corporation election 
made on or after that date.

                              Prior Action

    Prior Congressional action is described under Present Law, 
above.

                                Analysis

    The 1996 Act permitted ESOPs (and certain other tax-exempt 
entities) to hold stock in an S corporation. That Act provided 
that the S corporation income was taxable to the tax-exempt 
shareholders in keeping with the underlying premise of 
subchapter S that all income is subject to tax.\188\
---------------------------------------------------------------------------
    \188\ See H. Rept. 104-281, p. 61.
---------------------------------------------------------------------------
    Under the 1996 Act, the income of an ESOP attributable to S 
corporation stock would have been subject to tax in the hands 
of an ESOP when earned by the S corporation and again in the 
hands of the participants when distributions were made from the 
ESOP. This method of taxation generally would have meant that 
ESOPs holding S corporation stock would have been subject to a 
similar tax burden as ESOPs holding C corporation stock--a 
business tax would have been imposed when income was earned by 
the corporation and another tax would have been imposed on 
participants when distributions were made by the ESOP. This 
would have denied the ESOP and its participants the advantages 
of an S corporation election.\189\ However, the taxable 
shareholders of the S corporation would have retained the 
benefits of subchapter S, allowing more corporations to 
establish ESOPs.
---------------------------------------------------------------------------
    \189\ To the extent the employer securities are distributed to 
participants, any untaxed appreciation may be taxed as long-term 
capital gain.
---------------------------------------------------------------------------
    The 1997 Act eliminated the tax on the income when earned 
by the S corporation in order to reduce the tax burden on the 
ESOP's share of the S corporation's income. However, the 
elimination of the tax on the ESOP has resulted in the ability 
to attain tax deferral unlike that available to other taxable 
income of an S corporation or a C corporation. For example, 
some S corporations may be wholly owned by an ESOP, so that 
none of the S corporation's income is subject to current tax. 
For companies with just one or two employees, transactions 
using the ESOP/S corporation provisions have been described as 
``just a way to take advantage of the law''.\190\ It is also 
possible that the taxable shareholders of the S corporation may 
deflect income to the ESOP and thus reduce their tax by using 
stock options or restricted stock. Transactions have been 
described as providing for a ``five-year tax holiday'' using 
these techniques.\191\ The 1997 Act provision encouraged more 
corporations to establish ESOPs. However, commentators have 
pointed out that the provision may have opened up unwarranted 
tax breaks.
---------------------------------------------------------------------------
    \190\ Employee Ownership Report, November/December 1998, p. 11. The 
article was set forth under the title ``Outrages''.
    \191\ See, for example, Ginsburg, ``The Taxpayer Relief Act of 
1997: Worse Than You Think'' 76 Tax Notes 1790 (September 29, 1997). 
The article describes how tax planning can convert the ESOP provision 
of the 1997 Act into a long-term tax holiday for the S corporation's 
taxable shareholders.
---------------------------------------------------------------------------
    The Administration proposal is a middle ground between the 
provision originally enacted in the 1996 Act and the provision 
in the 1997 Act. It would provide a single tax on the earnings 
of the S corporation that are eventually distributed to the 
ESOP participants. Unlike present law, the tax would be paid 
currently by the ESOP as the S corporation earns income rather 
than deferred until benefits are paid to participants. When it 
made a distribution, the ESOP would be allowed a deduction 
which may allow for a refund of the previously paid tax. The 
participant would include the distribution in income as under 
present law.
    The proposal may restrict the establishment of ESOPs by S 
corporations, by denying the additional deferral incentive 
available under present law. However, there may be a need to 
balance the advantages of establishing additional ESOPs against 
the need to eliminate the tax planning opportunities available 
under present law.
10. Limit tax-free liquidations of U.S. subsidiaries of foreign 
        corporations

                              Present Law

    A U.S. corporation owned by foreign persons is subject to 
U.S. income tax on its net income. In addition, the earnings of 
the U.S. corporation are subject to a second tax, when 
dividends are paid to the corporation's shareholders.
    In general, dividends paid by a U.S. corporation to 
nonresident alien individuals and foreign corporations that are 
not effectively connected with a U.S. trade or business are 
subject to a U.S. withholding tax on the gross amount of such 
income at a rate of 30 percent (secs. 871(a) and 881(a)). The 
30-percent withholding tax may be reduced pursuant to an income 
tax treaty between the United States and the foreign country 
where the foreign person is resident.
    In addition, the United States imposes a branch profits tax 
on U.S. earnings of a foreign corporation that are shifted out 
of a U.S. branch of the foreign corporation. The branch profits 
tax is comparable to the second-level taxes imposed on 
dividends paid by a U.S. corporation to foreign shareholders. 
The branch profits tax is 30 percent (subject to possible 
income tax treaty reduction) of a foreign corporation's 
dividend equivalent amount. (sec. 884(a)). The ``dividend 
equivalent amount'' generally is the earnings and profits of a 
U.S. branch of a foreign corporation attributable to its income 
effectively connected with a U.S. trade or business (sec. 
884(b)).
    In general, U.S. withholding tax is not imposed with 
respect to a distribution of a U.S. corporation's earnings to a 
foreign corporation in complete liquidation of the subsidiary, 
because the distribution is treated as made in exchange for 
stock and not as a dividend. In addition, detailed rules apply 
for purposes of exempting foreign corporations from the branch 
profits tax for the year in which it completely terminates its 
U.S. business conducted in branch form (Temp. Treas. Reg. sec. 
1.884-2T). The exemption from the branch profits tax generally 
applies if, among other things, for three years after the 
termination of the U.S. branch, the foreign corporation has no 
income effectively connected with a U.S. trade or business, and 
the U.S. assets of the terminated branch are not used by the 
foreign corporation or a related corporation in a U.S. trade or 
business.

                        Description of Proposal

    The proposal generally would treat as a dividend any 
distribution of earnings by a U.S. corporation to a foreign 
corporation in a complete liquidation, if the U.S. corporation 
was in existence for less than five years. A coordination rule 
would ensure that a similar result obtains on the termination 
of a U.S. branch of a foreign corporation.

                             Effective Date

    The proposal would be effective for liquidations and 
terminations occurring on or after the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    The proposal is intended to prevent taxpayers from creating 
and subsequently liquidating U.S. businesses with an intention 
of escaping U.S. withholding taxes. For example, foreign 
corporations with U.S. subsidiary operations may establish a 
U.S. holding company (to receive tax-free dividends from U.S. 
operating companies), liquidate the U.S. holding company (to 
distribute the U.S. earnings free of U.S. withholding tax), and 
then re-establish another U.S. holding company. In this manner, 
taxpayers might take the position that the U.S. earnings of 
U.S. operating subsidiaries could be repeatedly distributed in 
serial tax-free liquidations of U.S. holding companies to 
foreign corporations, even though the U.S. subsidiary producing 
the earnings continues in operation. Foreign corporations may 
be able to avoid the branch profits tax in a similar manner 
through terminations of U.S. businesses conducted in branch 
form.
    It is argued that such instances of withholding tax abuse 
would be significantly restricted by requiring the imposition 
of U.S. withholding taxes upon liquidations of U.S. 
corporations created within five years of the liquidation. On 
the other hand, the proposal would not be limited to abusive 
tax avoidance situations, but would apply equally to 
liquidations of U.S. corporations (or terminations of U.S. 
branch operations) done for valid business reasons, but within 
five years of creation of the U.S. business. Such an approach 
would provide certainty but could be criticized as inflexible 
and unduly harsh.
11. Prevent capital gains avoidance through basis shift transactions 
        involving foreign shareholders

                              Present Law

    A shareholder that receives a distribution in redemption of 
stock generally is treated as having sold such stock for the 
amount of the distribution, thereby recognizing either gain or 
loss on the transaction (sec. 302). However, if the redemption 
is essentially equivalent to a dividend, the shareholder must 
report the distribution as dividend income, rather than gain or 
loss. A redemption of stock is considered essentially 
equivalent to a dividend if it does not result in a meaningful 
reduction in the shareholder's proportionate interest 
(determined by reference to stock held directly, indirectly, or 
constructively) in the distributing corporation. In determining 
whether a shareholder's proportionate interest in the 
distributing corporation has been meaningfully reduced, an 
option to acquire stock is treated as stock actually issued and 
outstanding.
    Under Treasury regulations, if an amount received in 
redemption of stock is treated as a dividend, the basis of the 
remaining stock is adjusted (as appropriate) to reflect the 
basis of the stock redeemed (Treas. Reg. sec. 1.302-2(c)).
    A shareholder generally is not required to reduce stock 
basis upon the receipt of a dividend. However, corporate 
shareholders that receive an extraordinary dividend are 
required to reduce their stock basis by the nontaxed portion of 
such dividend (sec. 1059).
    Whether a dividend is ``extraordinary'' is determined by, 
among other things, reference to the size of the dividend in 
relation to the adjusted basis of the shareholder's stock. A 
dividend resulting from a non-pro rata redemption or a partial 
liquidation is automatically considered an extraordinary 
dividend, as is a dividend resulting from a redemption that is 
treated as a dividend due to options being treated as stock. 
The nontaxed portion of a dividend effectively equals the 
amount of the dividend that is reduced by a dividends received 
deduction. If the reduction in stock basis exceeds the total 
basis in the stock with respect to which an extraordinary 
dividend is received, the excess is taxed as gain on the sale 
or disposition of such stock.
    Nonresident aliens and foreign corporations (collectively, 
``foreign persons'') generally are subject to U.S. tax on 
income that is effectively connected with the conduct of a U.S. 
trade or business; the U.S. tax on such income is calculated in 
the same manner and at the same graduated rates as the tax on 
U.S. persons (secs. 871(b) and 882). Foreign persons also are 
subject to a 30-percent gross basis tax, collected by 
withholding, on certain U.S.-source income, such as interest 
and dividends, that is not effectively connected with a U.S. 
trade or business. This 30-percent withholding tax may be 
reduced or eliminated pursuant to an applicable tax treaty. In 
the case of dividends, on portfolio investments, U.S. income 
tax treaties commonly provide for a withholding tax rate of at 
least 15 percent.
    Dividends generally are treated as U.S.-source income if 
the payor is a U.S. corporation. Thus, foreign persons 
generally are subject to U.S. withholding tax on dividends from 
a U.S. corporation. A foreign person generally is not required 
to reduce its stock basis in a U.S. corporation with respect to 
such dividend distributions.
    The United States generally does not tax capital gains of a 
foreign corporation that are not connected with a U.S. trade or 
business. Capital gains of a nonresident alien individual that 
are not connected with a U.S. business generally are subject to 
U.S. withholding tax only if the individual was present in the 
United States for 183 days or more during the year (sec. 
871(a)(2)).
    Tax-exempt organizations (such as sec. 501(c) nonprofit 
organizations and pension plans) generally are not subject to 
Federal income tax, for example, on dues and contributions they 
receive from their members, as well as other income from 
activities that are substantially related to the purpose of 
their tax exemption. However, tax-exempt organizations are 
subject to the unrelated business income tax (``UBIT'') on 
income derived from a trade or business regularly carried on 
that is not substantially related to the performance of the 
organization's tax-exempt functions (secs. 511-514). In 
addition, Native American Indian tribes, as well as wholly 
owned tribal corporations chartered under Federal law, 
generally are not subject to Federal income 
taxes.\191\a
---------------------------------------------------------------------------
    \191\a See Rev. Rul. 94-65, 1994-2 C.B. 14; Rev. Rul. 
94-16, 1994-1 C.B. 19; Rev. Rul. 81-295, 1981-2 C.B. 15; Rev. Rul. 67-
284, 1967-2 C.B. 55. The Internal Revenue Service recently clarified 
that tribal corporations chartered under tribal law also can qualify 
for exemption as section 501(c)(3) organizations. See General 
Information Letter to First Nations Development Institute (September 8, 
1998).
---------------------------------------------------------------------------

                        Description of Proposal

    The proposal would provide that for purposes of section 
1059, the nontaxed portion of a dividend includes the amount of 
a dividend received by a shareholder that is not subject to 
current U.S. tax. Thus, shareholders (e.g., a foreign person or 
a tax-exempt organization such as a section 501(c) nonprofit 
organization) generally would be required to reduce their stock 
basis in a corporation upon receiving extraordinary dividends 
from such corporation that are not subject to current U.S. tax.
    In the event that a treaty between the United States and a 
foreign country reduces (but does not fully exempt) U.S. tax 
imposed on a dividend (and the dividend is not otherwise 
subject to U.S. tax), the proposal would provide that the 
nontaxed portion of a dividend would be determined based on the 
amount of the dividend multiplied by a fraction, the numerator 
of which is the tax rate applicable without reference to the 
treaty less the tax rate applicable under the treaty, and the 
denominator of which is the tax rate applicable without 
reference to the treaty. For example, if a foreign person with 
a stock basis in a U.S. corporation of $100 receives an 
extraordinary dividend of $100 that is subject to a 15 percent 
reduced withholding rate under a tax treaty, the foreign person 
would be required to reduce its stock basis by 50 percent of 
the dividend (the 15 percent reduction from the 30 percent 
withholding tax, divided by 30 percent), or $50.
    For these purposes, the nontaxed portion of a dividend 
would not include dividends that are currently subject to U.S. 
tax, such as dividends that are subject to the full 30-percent 
U.S. withholding tax, UBIT, or the portion of dividends 
received by a controlled foreign corporation, passive foreign 
investment company or a foreign personal holding company that 
are currently included in a U.S. shareholder's taxable income. 
Thus, such dividends generally would not cause a reduction in 
stock basis in a corporation.
    Similar rules would apply in the event that a shareholder 
is not a corporation. No inference is intended as to the 
treatment of such transactions under present law.

                             Effective Date

    The proposal would be effective for distributions on or 
after the date of first committee action.

                              Prior Action

    The President's fiscal year 1999 budget proposal contained 
a related proposal which would have directed the Secretary of 
the Treasury to prescribe regulations to determine the basis of 
assets held directly or indirectly by a foreign person and the 
amount of built-in deductions with respect to a foreign person 
or an entity held directly or indirectly by a foreign person as 
may be necessary or appropriate to prevent the avoidance of 
tax.

                                Analysis

    The proposal would address transactions that might allow 
U.S. persons to create built-in losses in stock through certain 
redemption transactions involving foreign persons. For example, 
assume that a foreign parent corporation owns 100 percent of 
the stock of a foreign subsidiary. Also assume that an 
unrelated U.S. corporation acquires a minimal (e.g., one 
percent) interest in the foreign subsidiary, and an option to 
acquire a majority interest in the foreign parent. If the 
foreign subsidiary subsequently redeems all of its stock held 
by the foreign parent, the amount received by the foreign 
parent in redemption of such stock would be treated as dividend 
(because as a result of the option, the foreign parent is 
treated as owning the stock of the foreign subsidiary held by 
the U.S. corporation). The dividend generally would not be 
subject to U.S. tax; however, taxpayers might take the position 
that the foreign parent's basis in the stock would ``shift'' to 
the U.S. corporation and be added to its stock basis, creating 
a built-in loss with respect to such stock (i.e., a basis in 
excess of fair market value). The U.S. corporation could then 
sell such stock at a loss to offset other U.S. income (e.g., 
capital gains). Variations to this type of transaction might 
achieve the same or similar results.
    Some argue that it is inappropriate to allow U.S. persons 
to create built-in loss property in this manner that may be 
used to reduce U.S. taxable income (e.g., upon a subsequent 
sale of the stock). The proposal would prevent this potential 
result by requiring a shareholder to reduce its stock basis in 
a corporation upon receiving an extraordinary dividend from 
such corporation that is not subject to current U.S. tax. Thus, 
the basis of any remaining shares following such a dividend 
would not be increased to the extent of the dividend amount 
that is not subject to current U.S. tax. In the example above, 
the redemption of the foreign parent's stock in the foreign 
subsidiary generally would be treated as an extraordinary 
dividend that is not subject to current U.S. tax. Under the 
proposal, such a dividend would reduce the foreign parent's 
basis in the foreign subsidiary stock such that the basis could 
not be ``shifted'' to the U.S. corporation as a result of the 
transaction.
    Some have observed that the proposal would apply to 
legitimate business transactions. Such an approach of requiring 
basis adjustments in all such cases would provide greater 
certainty but could be criticized as inflexible.
12. Limit inappropriate tax benefits for lessors of tax-exempt use 
        property

                              Present Law

    Lessors of ``tax-exempt use property'' are limited in their 
ability to claim certain tax benefits. For example, a lessor of 
tax-exempt use property may not use an accelerated method of 
depreciation with respect to that property. Rather, it must use 
the alternative depreciation system which requires it to employ 
a straight-line method (without regard to salvage value) over a 
recovery period that is not less than 125 percent of the lease 
term (sec. 168(g)).
    Tax-exempt use property generally means (1) that portion of 
any tangible property (other than nonresidential real property) 
leased to a tax-exempt entity, or (2) that portion of 
nonresidential real property leased to a tax-exempt entity 
which leases more than 35 percent of the property if certain 
other circumstances in which the lease resembles a financing 
also exist (sec. 168(h)(1)). A ``tax-exempt entity'' for these 
purposes includes the United States, State or local 
governments, tax-exempt organizations, and any foreign person 
or entity (sec. 168(h)(2)).
    Lessors and lessees in certain rental agreements which 
involve either a deferral of a rental amount or an increase in 
the amounts to be paid as rent generally must report rental 
income and deductions using the accrual method of accounting 
(plus interest with respect to any amounts for which the 
payment is deferred beyond the taxable year of accrual) (sec. 
467). Proposed Treasury regulations would expand this rule to 
include prepayments of rent and decreases in amounts to be paid 
as rent (Prop. Treas. Reg. sec. 1.467-1(c)). The amount accrued 
for a particular taxable year generally is the amount allocated 
to that period under the lease. If the transaction is a 
``leaseback'' or a ``long-term agreement,'' however, and a 
principal purpose for the stepping (e.g., increasing or 
decreasing) of rents is tax avoidance, the rents are deemed to 
accrue on a level, present-value basis and interest is deemed 
to accrue on the excess of accrued rents over rents actually 
paid.
    Individuals, estates, trusts, closely held C corporations 
and personal service corporations generally may not deduct 
against other income any losses from passive activities in 
excess of gains from passive activities (sec. 469). Suspended 
losses and credits are carried forward and treated as 
deductions and credits from passive activities in the following 
year. Suspended losses from a passive activity are allowed in 
full upon a taxable disposition of the taxpayer's entire 
interest in the activity. A ``passive activity'' generally 
means any activity which involves the conduct of a trade or 
business and in which the taxpayer does not materially 
participate, and generally includes any rental activity, 
whether or not the taxpayer materially participates.

                        Description of Proposal

    The proposal would provide that a lessor of tax-exempt use 
property would be entitled to recognize losses for the taxable 
year from a ``leasing transaction'' involving tax-exempt use 
property only to the extent of gains from that transaction for 
the year. Suspended losses from a leasing transaction would be 
carried forward to subsequent years and could be used by the 
lessor to offset net gains from the transaction in subsequent 
years. Suspended losses from the leasing transaction that had 
not been previously recognized would be allowed in full in the 
year the leasing transaction terminates.
    A leasing transaction for this purpose would include the 
lease itself and all related agreements (e.g., sales, loans, 
and option agreements) entered into by the lessor with respect 
to the lease of the tax-exempt use property. Thus, for example, 
if a taxpayer purchased property from a foreign government, 
leased the property to the foreign government, financed the 
purchase with a nonrecourse loan from a bank, and entered into 
an option to sell the property to a third party, each of these 
individual transactions would be considered part of the leasing 
transaction.

                             Effective Date

    The proposal would be effective for leasing transactions 
entered into on or after the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    Under present law, taxpayers can enter into certain types 
of leasing transactions involving tax-exempt entities such as 
foreign persons that would allow the lessor to generate U.S. 
tax deductions without any party being subject to U.S. taxation 
on the corresponding income. Such transactions typically do not 
involve a mere lease, but also involve several related 
agreements, all of which would be treated as a ``leasing 
transaction'' under the proposal.
     Advocates of the proposal would argue that taxable U.S. 
corporations should not be permitted to take advantage of the 
special tax status of tax-exempt entities participating in a 
lease in order to generate U.S. tax benefits. Like the timing 
mismatch that is addressed in section 467, the proposal is 
intended to address leasing transactions with tax-exempt 
entities which would create a mismatch in income and 
deductions. Leasing transactions involving tax-exempt entities 
can create timing mismatches in that current deductions such as 
depreciation, rents or interest are generated for the taxable 
lessor in early years with no corresponding current income 
inclusion to the accommodating party because it is exempt from 
tax. This tax benefit eventually is reversed because the 
taxable lessor will have income in the later years, but 
substantial deferral has been achieved. The deductions 
generated in the leasing transaction could be used by the 
taxable lessor to shelter other income.
    The proposal adopts an approach similar to the rules 
addressing passive activity losses for individuals, in that, 
like passive activity losses, net losses from early years are 
deferred until the corresponding income is recognized by the 
taxpayer in later years (or upon termination of the leasing 
transaction). Advocates of the proposal argue that the 
mechanics of the passive activity loss rules provide an 
appropriate model for addressing the timing issues presented by 
leasing transactions with tax-exempt entities.
    Some have observed that the proposal is unclear as to what 
would constitute a ``leasing transaction.'' The proposal may be 
viewed as being overly broad and could inappropriately affect 
legitimate business deductions that may be tangentially related 
to a leasing transaction but are not merely generated to 
shelter income.
    Some might argue that any inappropriate results from such 
leasing transactions are not merely a function of the presence 
of a tax-exempt accommodating party, but rather are related to 
(and therefore guidance should address) whether the leases that 
are part of the abusive transactions are or should be treated 
as leases under the tax law and whether such transactions have 
economic substance. In addition, it can be argued that a 
narrower solution for addressing certain specific mismatching 
problems could better be developed when the proposed Treasury 
regulations under section 467 are finalized. Finally, some 
might also observe that the result which the proposal is 
addressing similarly could be achieved where the accommodating 
party is a U.S. corporation with expiring net operating losses; 
the proposal, however, would not address that situation.
13. Prevent mismatching of deductions and income inclusions in 
        transactions with related foreign persons

                              Present Law

    As a general rule, there is allowed as a deduction all 
interest paid or accrued within the taxable year with respect 
to indebtedness (sec. 163(a)). With respect to debt instruments 
issued after July 1, 1982, this generally includes the 
aggregate daily portions of original issue discount (``OID'') 
of the issuer for the days during such taxable year (sec. 
163(e)(1)). If a debt instrument with OID is held by a related 
foreign person, however, any portion of such OID is not 
allowable as a deduction to the issuer until paid (``related-
foreign-person rule'') (sec. 163(e)(3)). This related-foreign-
person rule does not apply, however, to the extent that the OID 
is effectively connected with the conduct by such foreign 
related person of a trade or business within the United States 
(unless such OID is exempt from taxation or is subject to a 
reduced rate of taxation under a treaty obligation). Treasury 
regulations further modify the related-foreign-person rule by 
providing that in the case of a debt owed to a foreign personal 
holding company (``FPHC''), controlled foreign corporation 
(``CFC'') or passive foreign investment company (``PFIC''), a 
deduction is allowed for OID as of the day on which the amount 
is includible in the income of the FPHC, CFC, or PFIC, 
respectively (Treas. Reg. sec. 1.163-12(b)(3)).
     In the case of unpaid interest and expenses of related 
persons, where, by reason of a payee's method of accounting, an 
amount is not includible in the payee's gross income until it 
is paid but the unpaid amounts would be deductible currently by 
the payor, the amount generally is allowable as a deduction 
when such amount is includible in the gross income of the payee 
(sec. 267(a)(2)). Treasury has been instructed to issue 
regulations to apply this matching principle in the case of 
payments to related foreign persons (sec. 267(a)(3)). With 
respect to interest that is not OID and other expenses owed to 
related foreign corporations, Treasury regulations provide a 
general rule that requires a taxpayer to use the cash method of 
accounting with respect to the deduction of amounts owed to 
such related foreign persons (with an exception for income of a 
related foreign person that is effectively connected with the 
conduct of a U.S. trade or business and that is not exempt from 
taxation or subject to a reduced rate of taxation under a 
treaty obligation) (Treas. Reg. sec. 1.267(a)(3). Additionally, 
as in the case of OID, the regulations provide that in the case 
of amounts owed to a FPHC, CFC, or PFIC, a deduction is allowed 
as of the day on which the amount is includible in the income 
of the FPHC, CFC or PFIC.

                        Description of Proposal

    The proposal would provide that deductions for amounts 
accrued but unpaid (whether by U.S. or foreign persons) to 
related FPHCs, CFCs, or PFICs would be allowable only to the 
extent that the amounts accrued by the payor are, for U.S. tax 
purposes, currently included in the income of the direct or 
indirect U.S. owners of the related foreign person. Deductions 
that have accrued but are not allowable under this provision 
would be allowed when the amounts are paid. The proposal would 
provide an exception for amounts accrued where payment of the 
amount accrued occurs within a short period after accrual, and 
the transaction giving rise to the payment is entered into by 
the payor in the ordinary course of a business in which the 
payor is predominantly engaged. In addition, the proposal would 
grant the Secretary regulatory authority to provide exceptions 
to these rules.
    No inference is intended as to the treatment of such 
payments under present law.

                             Effective Date

    The proposal would be effective for payments accrued on or 
after the date of first committee action.

                              Prior Action

    No prior action.

                                Analysis

    Advocates of the proposal argue that there is no 
justification for mismatching in the case of related party OID 
and similar expenses. The mismatching is created because, under 
Treasury regulations, both U.S. payors and U.S.-owned foreign 
payors arguably might be able to accrue deductions for amounts 
owed to related FPHCs, CFCs or PFICs without the U.S. owners of 
such related entities taking into account for U.S. tax purposes 
a corresponding amount of income. These deductions can be used 
to reduce U.S. income or, in the case of a U.S.-owned foreign 
payor, to reduce earnings and profits which, for example, could 
reduce a CFC's income that would be currently taxable to its 
U.S. shareholders under subpart F.
    The special rules in the Treasury regulations for FPHCs, 
CFCs and PFICs are an exception to the general rule in those 
regulations that unpaid interest and similar expenses owed to a 
related foreign person are deductible when paid (i.e., under a 
cash method). The relief was deemed appropriate in the case of 
FPHCs, CFCs and PFICs because it was thought that there would 
be little material distortion in matching of income and 
deductions with respect to amounts owed to a related foreign 
corporation that is required to determine its taxable income 
and earnings and profits for U.S. tax purposes pursuant to the 
FPHC, subpart F or PFIC provisions.\192\ This premise fails to 
take into account the situation where amounts owed to the 
related foreign corporation are included in the income of the 
related foreign corporation but are not currently included in 
the income of the related foreign corporation's U.S. 
shareholders.
---------------------------------------------------------------------------
    \192\ See Notice of Proposed Rulemaking, 56 FR 11531 (Mar. 19, 
1991) (Preamble to Proposed Treasury Regulations secs. 1.163-12 and 
1.267(a)-3; T.D. 8465, 58 FR 235 (Jan. 5, 1993) (Preamble to Final 
Treasury Regulations secs. 1.163-12 and 1.267(a)-3).
---------------------------------------------------------------------------
    Opponents of the proposal might argue that any potential 
for mismatching of income and deductions with respect to 
accrued but unpaid interest and expenses owed to FPHCs, CFCs, 
and PFICs has been facilitated by Treasury regulations and, 
therefore, a regulatory rather than legislative solution is 
appropriate. Additionally, some might observe that present law 
properly requires FPHCs, CFCs, and PFICs and related persons to 
use the same method of accounting with respect to transactions 
between themselves. The potential for mismatching may result, 
for example, from a disproportionate allocation of income among 
shareholders rather than from the use of different accounting 
methods to which sections 163(e)(3) and, in particular, 
267(a)(3) are targeted. On the other hand, the proposal would 
treat amounts owed to a related FPHC, CFC or PFIC that are not 
included in the income of a U.S. shareholder consistently with 
amounts owed to other related foreign persons (i.e., the 
amounts are deductible when paid) while at the same time 
retaining an exception for accrued amounts owed to FPHCs, CFCs 
and PFICs that are includible in their income and in the income 
of their U.S. shareholders.
14. Restrict basis creation through section 357(c)

                              Present Law

    Present law provides that the transferor of property 
recognizes no gain or loss if the property is exchanged solely 
for qualified stock in a controlled corporation (sec. 351). The 
assumption by the controlled corporation of a liability of the 
transferor (or the acquisition of property ``subject to'' a 
liability) generally will not cause the transferor to recognize 
gain. However, under section 357(c), the transferor does 
recognize gain to the extent that the sum of the assumed 
liabilities, together with the liabilities to which the 
transferred property is subject, exceeds the transferor's basis 
in the transferred property. If the transferred property is 
``subject to'' a liability, Treasury regulations indicate that 
the amount of the liability is included in the calculation 
regardless of whether the underlying liability is assumed by 
the controlled corporation. Treas. Reg. sec. 1.357-2(a). 
Similar rules apply to reorganizations described in section 
368(a)(1)(D).
    The gain recognition rule of section 357(c) is applied 
separately to each transferor in a section 351 exchange.
    The basis of the property in the hands of the controlled 
corporation equals the transferor's basis in such property, 
increased by the amount of gain recognized by the transferor, 
including section 357(c) gain.

                        Description of Proposal

    Under the proposal, the distinction between the assumption 
of a liability and the acquisition of an asset subject to a 
liability generally would be eliminated. Except as provided in 
Treasury regulations, a recourse liability or any portion 
thereof would be treated as having been assumed if, as 
determined on the basis of all facts and circumstances, the 
transferee has agreed to and is expected to satisfy the 
liability or portion thereof (whether or not the transferor has 
been relieved of the liability). Thus, where more than one 
person agrees to satisfy a liability or portion thereof, only 
one would be expected to satisfy such liability or portion 
thereof. Except as provided in Treasury regulations, a 
nonrecourse liability would be treated as having been assumed 
by the transferee of any asset subject to such liability; 
except that the amount treated as assumed would be reduced by 
the amount of such liability which an owner of other assets not 
transferred to the transferee and also subject to such 
liability has agreed with the transferee to, and is expected 
to, satisfy up to the fair market value of such other assets 
(determined without regard to section 7701(g)).
    In determining whether any person has agreed to and is 
expected to satisfy a liability, all facts and circumstances 
would be considered. In any case where the transferee does 
agree to satisfy a liability, the transferee would be expected 
to satisfy the liability in the absence of facts indicating the 
contrary.
    In determining any increase to the basis of property 
transferred to the transferee as a result of gain recognized 
because of the assumption of liabilities under section 357, the 
increase would in no event cause the basis to exceed the fair 
market value of the property (determined without regard to sec. 
7701(g)). In addition, if gain is recognized to the transferor 
as the result of an assumption by a corporation of a 
nonrecourse liability that also is secured by any assets not 
transferred to the corporation, and if no person is subject to 
Federal income tax on such gain, then for purposes of 
determining the basis of assets transferred, the amount of gain 
treated as recognized as the result of such assumption of 
liability would be determined as if the liability assumed by 
the transferee equaled such transferee's ratable portion of the 
liability, based on the relative fair market values (determined 
without regard to sec. 7701(g)) of all assets subject to such 
nonrecourse liability.
    The Treasury Department would have authority to prescribe 
such regulations as may be necessary to carry out the purposes 
of the provision. Where appropriate, the Treasury Department 
also may prescribe regulations which provide that the manner in 
which a liability is treated as assumed under the provision is 
applied elsewhere in the Code.

                             Effective Date

    The provision is effective for transfers on or after 
October 19, 1998. No inference regarding the tax treatment 
under present law is intended.

                              Prior Action

    A similar provision was contained in the President's fiscal 
year 1999 budget proposal, and was contained in the Patient 
Protection Act of 1998, as passed by the House of 
Representatives on July 24, 1998. A substantially identical 
provision was introduced in the House of Representatives by Mr. 
Archer on October 19, 1998 (H.R. 4852) and was contained in the 
Miscellaneous Trade and Technical Corrections Act of 1998 (H.R. 
4856), as passed by the House of Representatives on October 20, 
1998.
    A substantially identical provision was also included in 
the Miscellaneous Trade and Technical Corrections Act of 1999 
(H. R. 435) as passed by the House of Representatives on 
February 10, 1999, and in the Miscellaneous Trade and Technical 
Corrections Act of 1999 (S. 262), as approved by the Senate 
Committee on Finance on January 22, 1999.

                                Analysis

    In general, a taxpayer recognizes income when he or she is 
relieved of a liability. Thus, if a taxpayer transfers an asset 
to a corporation, and the corporation assumes a liability of 
the taxpayer in an amount greater than the taxpayer's basis in 
the asset, present law treats the taxpayer as having sold the 
asset for an amount equal to the relieved liability. Similar 
rules apply if an asset is transferred subject to a liability.
    Present law does not clearly define what ``transferred 
subject to a liability'' means. If the transferor has cross-
collateralized a liability with several assets, it has been 
asserted that each of those assets is literally ``subject to'' 
the entire amount of the liability, even where the transferor 
has not been relieved of the liability. A number of cases have 
applied section 357(c) in a manner or with language suggesting 
that it is not necessary to consider whether, as a practical 
matter, the transferor has been relieved of the transferred 
liability. For example in Rosen v. Commissioner,\193\ the Tax 
Court stated that ``. . . there is no requirement in section 
357(c)(1) that the transferor be relieved of liability.'' 
Similarly, in Owen v. Commissioner,\194\ the Ninth Circuit 
Court of Appeals rejected a claim by the taxpayers that the 
concept of assets ``subject to'' liabilities only applies to 
non-recourse liabilities, and stated that continuing personal 
liability for the loans secured by the transferred equipment 
was irrelevant.
---------------------------------------------------------------------------
    \193\ 62 T.C. 11, 19 (1974), affd. without published opinion 515 
F.2d 507 (3d Cir. 1975).
    \194\ 881 F.2d 832 (9th Cir. 1989).
---------------------------------------------------------------------------
    In Lessinger v. Commissioner,\195\ on the other hand, the 
Second Circuit Court of Appeals construed the language of 
section 357(c) to avoid imposing gain recognition on the 
taxpayer where the taxpayer contributed his own promissory note 
in the amount of the excess of the transferred liabilities over 
the basis of the transferred assets.
---------------------------------------------------------------------------
    \195\ 872 F.2d 519 (2d Cir. 1989); see also Peracchi v. 
Commissioner, 134 F.3d 487 (9th Circ. 1998).
---------------------------------------------------------------------------
    As a result of this uncertainty in present law, some 
taxpayers may be reluctant to engage in legitimate transactions 
or may restructure them, while others may attempt to structure 
transactions to take advantage of different interpretations.
    For example, a taxpayer who has cross-collateralized a 
liability with assets that the taxpayer now, for valid business 
reasons, wants to contribute to one or more corporations, may 
structure the transaction in a manner seeking to take the 
position that some case law supports non-recognition, or may 
contribute additional assets with basis sufficient to avoid 
gain recognition under any of the case law, or may seek to 
obtain a release of the transferred assets from the lender. It 
may be difficult or expensive for a taxpayer to obtain such a 
release.
    On the other hand, taxpayers not concerned about current 
gain recognition (for example, due to losses, credits or status 
as a non-taxable entity) may attempt to structure transactions 
to take advantage of different interpretations. For example, 
assume that transferor A has borrowed $100,000 on a recourse 
basis, secured by two assets. A transfers one asset with a 
basis of $20,000 and a fair market value of $50,000 to a 
controlled domestic corporation, X. Under the literal language 
of section 357(c), it might be argued that A would recognize 
$80,000 of gain on the transfer, and X would hold the asset at 
a basis of $100,000 (A's original basis of $20,000 plus $80,000 
recognized gain). If A is a foreign person or a tax-exempt 
entity or in the position to use expiring loss or credit 
carryovers to offset the gain, X might obtain a stepped-up 
basis in the asset without a tax cost to A. X could benefit 
from this stepped-up basis by increased depreciation deductions 
or reduced gain on the future sale of the asset.
    The proposal is intended to ensure that 357(c) will operate 
in a manner that reflects the economics of the transaction. 
While it may be argued that factual uncertainty will remain 
because this approach involves a test regarding whether the 
transferee is expected to satisfy the liability, which includes 
a facts and circumstances test, it can also be argued that the 
proposal will increase the legal certainty and reduce the 
potential for results that do not conform to the economic 
reality of the extent of actual relief from liability (if any) 
that has occurred in a transfer.
15. Modify anti-abuse rules related to assumption of liabilities

                              Present Law

    Generally, no gain or loss is recognized if property is 
exchanged for stock of a controlled corporation. The transferor 
may recognize gain to the extent other property (``boot'') is 
received by the transferor. The assumption of liabilities by 
the transferee generally is not treated as boot received by the 
transferor. The assumption of a liability is treated as boot to 
the transferor, however, ``[i]f, taking into consideration the 
nature of the liability and the circumstances in the light of 
which the arrangement for the assumption or acquisition was 
made, it appears that the principal purpose of the 
taxpayer...was a purpose to avoid Federal income tax on the 
exchange, or...if not such purpose, was not a bona fide 
business purpose.'' Sec. 357(b). Thus, this exception requires 
that the principal purpose of having the transferee assume the 
liability was the avoidance of tax on the exchange.
    The transferor's basis in the stock of the transferee 
received in the exchange is reduced by the amount of any 
liability assumed, but generally increased in the amount of any 
gain recognized by the transferor on the exchange. However, 
liabilities that would give rise to a future deduction is not 
considered a liability for purposes of basis reductions. 
Similar rules apply in connection with certain tax-free 
reorganizations.

                        Description of Proposal

    The Administration proposes to delete the limitation that 
the assumption of liabilities anti-abuse rule only applies to 
tax avoidance on the exchange itself, and to change ``the 
principal purpose'' standard to ``a principal purpose''. A 
taxpayer may have ``a principal purpose'' of tax avoidance even 
though it is outweighed by other purposes (taken together or 
separately). In addition, a modification to the basis rule 
would be made to require a decrease in the transferor's basis 
in the transferee's stock when a liability, the payment of 
which would give rise to a deduction, is treated as boot under 
the anti-abuse rule.

                             Effective Date

    The proposal would be effective for assumptions of 
liabilities on or after the date of first committee action.

                              Prior Action

    No prior action.

                                Analysis

    The Administration indicates concern that the present law 
anti-abuse provision is inadequate to address certain avoidance 
concerns, given the high standard that must be met before the 
provision is applicable.
    In one transaction discussed by the Administration, 
taxpayers transfer assets with a fair market value basis in 
exchange for preferred stock and the transferee's assumption of 
a contingent liability that is deductible in the future but 
easily valued currently. The transferor claims that its basis 
in the stock it receives is not reduced by the amount of the 
liability because the liability payment would give rise to a 
deduction in the future and such a liability is not generally 
taken into account in determining the amount of liabilities 
assumed, absent application of an anti-abuse rule. The 
transferor may then accelerate the deduction by selling or 
exchanging the high-basis stock at a loss (since the liability 
in fact reduces the value of the subsidiary transferee). The 
transferee further might take the position that it is entitled 
to deduct payments on the liability, effectively duplicating 
the deduction attributable to the same liability.
    Proponents argue that changing the standard for application 
of the anti-abuse rules will expand the types of transactions 
to which the rules of section 357(b) apply, and therefore would 
deter transactions such as those identified by the 
Administration in its description of the intended scope of the 
provision. It is argued that the change in standard could 
reduce the likelihood of various other types of transactions 
and would provide an additional tool to assist the Internal 
Revenue Service in identifying and pursuing problem cases.
    Others might argue that the standard of ``a principal 
purpose'' has not been well developed in case law and may 
produce uncertainty of application.\196\ In situations of 
uncertainty, there may be concern that the effectiveness of the 
provision might be challenged in some situations. It may also 
be contended that ordinary business transactions might be 
deterred.
---------------------------------------------------------------------------
    \196\ The standard has been discussed in certain situations. See, 
e.g., Santa Fe Pacific Corporation v. Central States, Southeast and 
Southwest Areas Pension Fund, 22 F.3d 725 (7th Cir. 1994). Treasury has 
issued regulations dealing with ``a plan, one of the principal purposes 
of which is the avoidance of tax under section 881''. See Treas. Reg. 
Sec. 1.881-3(b)(1).
---------------------------------------------------------------------------
16. Modify company-owned life insurance (COLI) rules

                              Present Law

Exclusion of inside buildup and amounts received by reason of death
    No Federal income tax generally is imposed on a 
policyholder with respect to the earnings under a life 
insurance contract (``inside buildup'').\197\ Further, an 
exclusion from Federal income tax is provided for amounts 
received under a life insurance contract paid by reason of the 
death of the insured (sec. 101(a)).
---------------------------------------------------------------------------
    \197\ This favorable tax treatment is available only if the 
policyholder has an insurable interest in the insured when the contract 
is issued and if the life insurance contract meets certain requirements 
designed to limit the investment character of the contract (sec. 7702). 
Distributions from a life insurance contract (other than a modified 
endowment contract) that are made prior to the death of the insured 
generally are includable in income, to the extent that the amounts 
distributed exceed the taxpayer's investment in the contract; such 
distributions generally are treated first as a tax-free recovery of the 
investment in the contract, and then as income (sec. 72(e)). In the 
case of a modified endowment contract, however, in general, 
distributions are treated as income first, loans are treated as 
distributions (i.e., income rather than basis recovery first), and an 
additional 10 percent tax is imposed on the income portion of 
distributions made before age 59-1/2 and in certain other circumstances 
(secs. 72(e) and (v)). A modified endowment contract is a life 
insurance contract that does not meet a statutory ``7-pay'' test, i.e., 
generally is funded more rapidly than 7 annual level premiums (sec. 
7702A). Certain amounts received under a life insurance contract on the 
life of a terminally or chronically ill individual, and certain amounts 
paid for the sale or assignment to a viatical settlement provider of a 
life insurance contract on the life of a terminally ill or chronically 
ill individual, are treated as excludable as if paid by reason of the 
death of the insured (sec. 101(g)).
---------------------------------------------------------------------------
Interest deduction disallowance
    Generally, no deduction is allowed for interest paid or 
accrued on any indebtedness with respect to one or more life 
insurance contracts or annuity or endowment contracts owned by 
the taxpayer covering any individual (the ``COLI'' rules).
    An exception to this interest disallowance rule is provided 
for interest on indebtedness with respect to life insurance 
policies covering up to 20 key persons. A key person is an 
individual who is either an officer or a 20-percent owner of 
the taxpayer. The number of individuals that can be treated as 
key persons may not exceed the greater of (1) 5 individuals, or 
(2) the lesser of 5 percent of the total number of officers and 
employees of the taxpayer, or 20 individuals. For purposes of 
determining who is a 20-percent owner, all members of a 
controlled group are treated as one taxpayer. Interest paid or 
accrued on debt with respect to a contract covering a key 
person is deductible only to the extent the rate of interest 
does not exceed Moody's Corporate Bond Yield Average--Monthly 
Average Corporates for each month beginning after December 31, 
1995, that interest is paid or accrued.
    This rule was enacted in 1996.
Pro rata disallowance of interest on debt to fund life insurance
    In addition, in the case of a taxpayer other than a natural 
person, no deduction is allowed for the portion of the 
taxpayer's interest expense that is allocable to unborrowed 
policy cash surrender values with respect to any life insurance 
policy or annuity or endowment contract issued after June 8, 
1997. Interest expense is allocable to unborrowed policy cash 
values based on the ratio of (1) the taxpayer's average 
unborrowed policy cash values of life insurance policies, and 
annuity and endowment contracts, issued after June 8, 1997, to 
(2) the sum of (a) in the case of assets that are life 
insurance policies or annuity or endowment contracts, the 
average unborrowed policy cash values, and (b) in the case of 
other assets, the average adjusted bases for all such other 
assets of the taxpayer.
    An exception is provided for any policy or contract \198\ 
owned by an entity engaged in a trade or business, which covers 
one individual who (at the time first insured under the policy 
or contract) is (1) a 20-percent owner of the entity, or (2) an 
individual (who is not a 20-percent owner) who is an officer, 
director or employee of the trade or business. The exception 
for 20-percent owners also applies in the case of a joint-life 
policy or contract under which the sole insureds are a 20-
percent owner and the spouse of the 20-percent owner. A joint-
life contract under which the sole insureds are a 20-percent 
owner and his or her spouse is the only type of policy or 
contract with more than one insured that comes within the 
exception. Any policy or contract that is not subject to the 
pro rata interest disallowance rule by reason of this exception 
(for 20-percent owners, their spouses, employees, officers and 
directors), or by reason of the exception for an annuity 
contract to which section 72(u) applies, is not taken into 
account in applying the ratio to determine the portion of the 
taxpayer's interest expense that is allocable to unborrowed 
policy cash values.
---------------------------------------------------------------------------
    \198\ It was intended that if coverage for each insured individual 
under a master contract is treated as a separate contract for purposes 
of sections 817(h), 7702, and 7702A of the Code, then coverage for each 
such insured individual is treated as a separate contract, for purposes 
of the exception to the pro rata interest disallowance rule for a 
policy or contract covering an individual who is a 20-percent owner, 
employee, officer or director of the trade or business as the time 
first covered. A master contract does not include any contract if the 
contract (or any insurance coverage provided under the contract) is a 
group life insurance contract within the meaning of Code section 
848(e)(2). No inference was intended that coverage provided under a 
master contract, for each such insured individual, is not treated as a 
separate contract for each such individual for other purposes under 
present law. A technical correction so providing was enacted in section 
6010(o) of the Internal Revenue Service Restructuring and Reform Act of 
1998.
---------------------------------------------------------------------------
    This rule was enacted in 1997.

                        Description of Proposal

    The proposal would eliminate the exception under the pro 
rata disallowance rule for employees, officers and directors. 
The exception for 20-percent owners would be retained, however.

                             Effective Date

    The proposal would be effective for taxable years beginning 
after the date of enactment.

                              Prior Action

    The proposal is identical to a proposal contained in the 
President's budget proposal for fiscal year 1999.

                                Analysis

    The proposal is directed to an aspect of the issue 
addressed by Congress in 1996 and 1997: the issue of borrowing 
against life insurance contracts to achieve tax arbitrage. 
Businesses that own life insurance on employees and borrow from 
a third-party lender or from the public may still be able to 
achieve tax arbitrage by deducting interest that funds the tax-
free inside buildup on the life insurance (or the tax-deferred 
inside buildup of annuity and endowment contracts). This 
continued opportunity for tax arbitrage results from the 
exception under the pro rata interest deduction limitation for 
insurance covering employees and others, it is argued. 
Businesses have been able to substitute third-party debt for 
debt that would have been subject to the 1996 Act limitations 
on interest deductibility with respect to insurance on 
employees. This tax arbitrage opportunity is being utilized by 
financial intermediation businesses (and could be utilized by 
other leveraged businesses), which often have a relatively 
large amount of debt in the ordinary course of business. Thus, 
it is argued, the exception should be repealed.
    It can be argued, however, that retaining an exception from 
the pro rata interest disallowance rule for employees, 
officers, and directors is important for small businesses. 
Small businesses might argue that they need access to cash, in 
particular the cash value of life insurance on key employees, 
and that it would be inappropriate to reduce the tax subsidy 
stemming from the exception in their case. They might also 
argue that the proposal should be more targeted, perhaps to 
financial intermediaries or to large employers, or should 
provide for a narrower employee exception structured like the 
20-key-person exception under the 1996 legislation, so as to 
address the tax arbitrage concern without negatively impacting 
their cash needs. On the other hand, it could be countered that 
in most cases the cash needs of small businesses have already 
been addressed by the proposal's continuation of the exception 
for 20-percent owners. In addition, it can be argued that 
insuring the lives of key employees can be accomplished by 
purchasing term life insurance, which is not affected by the 
proposal, and that cash needs arising from loss of a key 
employee can be addressed without the purchase of cash value 
life insurance. Further, because of the extension of the 
average person's expected life span in recent decades, it is 
argued that the purchase of term life insurance on a key 
employee through his or her likely retirement age is no longer 
difficult or expensive.
    Opponents of the proposal argue that the funds borrowed 
under the life insurance contracts are used for tax-advantaged 
pre-funding of expenses such as retiree health benefits and 
supplemental pension benefits. On the other hand, Congress has 
already provided special tax-favored treatment specifically to 
encourage businesses to provide health and pension benefits. It 
was not intended that tax arbitrage with respect to investments 
in COLI be used to circumvent statutory limits that Congress 
enacted for these tax-favored health and pension benefits.
    Opponents might also argue that the proposed effective date 
may be too harsh. The proposal would limit the deduction for 
interest even in the case of insurance contracts that were 
purchased before the effective date, with no explicit phase-in 
rule. By contrast, the 1996 COLI limitations provided a phase-
in rule, and the 1997 COLI limitations generally applied only 
to contracts issued after the effective date. On the other 
hand, it could be argued that purchasers of COLI that would be 
impacted by the proposal were aware of Congress' concern about 
tax arbitrage through leveraging life insurance because of the 
1996 and 1997 legislative activity in the area. It could be 
said that recent COLI purchasers in particular assumed the risk 
of further Congressional action on leveraged life insurance 
products, as well as those whose contractual arrangements 
include provisions to ``unwind'' the transaction in the event 
unfavorable tax rules are enacted. Further, arguably the 
effective date for the proposal merely puts COLI purchasers 
with non-traceable third party debt in the same position they 
would have been in had they been subject to the phase-in rules 
under the 1996 legislation, which is fully phased in by 1999.

                         B. Financial Products

1. Require banks to accrue interest on short-term obligations

                              Present Law

Cash method of accounting
    The taxable income of a taxpayer is computed under the 
method of accounting on the basis which the taxpayer regularly 
computes his income in keeping his books so long as it clearly 
reflects income. A taxpayer generally is permitted to use the 
cash receipts and disbursement method (the ``cash method'') or 
an accrual method (sec. 446).
    Certain corporations engaged in farming (sec. 447) and C 
corporations with average gross receipts of $5 million or more 
are required to use an accrual method of accounting (sec. 448).
Accrual of acquisition discount on short-term obligations
    All taxpayers regardless of their method of accounting are 
required to accrue currently interest attributable to original 
issue discount generally on all debt instruments issued after 
July 1, 1982, with certain exceptions (sec. 1272). One of the 
exceptions where accrual of interest is not required is any 
debt instrument which has fixed maturity date not more than one 
year from the date of issue (``short-term obligations'')(sec. 
1272(b)(2)).
    With respect to obligations acquired after July 18, 1984, 
certain taxpayers are required to accrue currently as interest 
acquisition discount on short-term governmental obligations and 
original issue discount on short-term nongovernmental 
obligations. The taxpayers required to accrue currently 
discount on short-term obligations are (1) accrual basis 
taxpayers, (2) taxpayers holding the obligations primarily for 
sale to customers, (3) banks, (4) regulated investment 
companies (mutual funds) or common trust funds, (5) taxpayers 
holding the obligation as part of a hedging transaction or (6) 
taxpayers who stripped the bond or coupons on the bond (sec. 
1281).
    Courts have held that banks using the cash method of 
accounting are not required to accrue income on discount on 
short-term loans to customers made in the ordinary course of 
the bank's business on the grounds that loans originated by the 
bank did not have acquisition discount (see, e.g., Security 
Bank of Minnesota v. Comm., 994 F. 2d 432 (8th Cir. 1993)).

                        Description of Proposal

    The proposal would clarify that banks must accrue all 
interest, original issue discount, and acquisition discount on 
all short-term obligations, including loans made in the 
ordinary course of the bank's business, regardless of the 
bank's method of accounting.

                             Effective Date

    The proposal would be effective for obligations acquired 
(or originated) after the date of enactment. No inference would 
be intended regarding the tax treatment of obligations acquired 
(or originated) prior to the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    The proposal would affect small banks \199\ that are using 
the cash method of accounting with respect to loans originated 
by the bank that have a maturity of one year or less.
---------------------------------------------------------------------------
    \199\ Banks with average gross receipts of $5 million or more are 
required to use an accrual method of accounting under section 448.
---------------------------------------------------------------------------
    The proposal's proponents argue it would provide identical 
tax treatment to banks that both originate or purchase short-
term loans.
    Opponents of the proposal argue that adoption of the 
proposal may hurt small rural banks and their farmer customers. 
Many of the affected taxpayers would be small rural banks that 
make crop loans to farmers. Such loans often provide for a 
lump-sum repayment of principal and interest early the 
following year after the farmer has had time to harvest and 
sell the crop. Under the proposal, cash method banks making 
such loans would be required to pay tax on the interest 
accruing during the year even if it does not receive any cash 
with which to pay the tax until the following year. Banks 
facing such a situation may require the farmer to pay interest 
during that year or raise their interest rate on such loans to 
compensate for the earlier payment of tax.
    For example, in February, a farmer may borrow funds from a 
local bank with which the farmer will use to buy seed for a 
Spring planting in April and supplies for this year's crop. The 
loan provides that the farmer will pay back the loan with 
interest in the following January after the farmer has had time 
to sell his crop.
2. Require current accrual of market discount by accrual method 
        taxpayers

                              Present Law

    A debt instrument has ``market discount'' if it is acquired 
other than at original issue for a price that is less than the 
principal amount of the debt instrument.\200\ Market discount 
generally arises when a debt instrument has declined in value 
subsequent to its issuance (for example, because of an increase 
in interest rates or a decline in the credit-worthiness of the 
borrower).
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    \200\ In the case of a debt instrument issued with original issue 
discount (``OID''), market discount exists when the debt instrument is 
acquired at a price that is less than its adjusted issue price.
---------------------------------------------------------------------------
    In general, a holder of a debt instrument with market 
discount does not have to recognize any income with respect to 
the market discount until the debt instrument matures or is 
disposed. On the disposition of the debt instrument, the holder 
must treat any gain as ordinary income to the extent of the 
accrued market discount (sec. 1276).\201\ However, when a 
holder receives a partial principal payment on the debt 
instrument, the payment is treated as ordinary income to the 
extent of any accrued market discount. A holder also may elect 
to include the market discount in income as it accrues.\202\
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    \201\ In determining the amount of accrued market discount, the 
holder can elect between treating the discount as accruing (1) ratably, 
or (2) on a constant yield basis. Under a de minimis rule, the market 
discount is considered to be zero if it is less than 1/4 of 1 percent 
of the stated redemption price of the bond multiplied by the number of 
complete years to maturity after the taxpayer acquired the bond.
    \202\ Section 1278(b). Revenue Procedure 92-67, 1992-2 C.B. 429, 
sets forth the procedures for making this election.
---------------------------------------------------------------------------

                        Description of Proposal

    The proposal would require holders that use an accrual 
method of accounting to include market discount in income as it 
accrues. For purposes of determining and accruing market 
discount, the yield would be limited to the greater of (1) the 
original yield-to-maturity of the debt instrument plus 5 
percentage points, or (2) the applicable Federal rate at the 
time the holder acquired the debt instrument plus 5 percentage 
points.

                             Effective Date

    The proposal would be effective for debt instruments 
acquired on or after the date of enactment.

                              Prior Action

    No recent prior action.\203\
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    \203\ The House of Representatives included a similar proposal in 
the Omnibus Budget Reconciliation Act of 1987 (section 10118), but the 
proposal was not adopted by the conference.
---------------------------------------------------------------------------

                                Analysis

    Present law provides a more favorable tax treatment for a 
holder of a debt instrument with market discount than a debt 
instrument with OID, notwithstanding that they are economically 
indistinguishable (i.e., both forms of discount represent 
substitutes for stated interest). The Administration proposal 
would eliminate this disparity.
    The proposal would cap the yield by which the market 
discount would accrue to the greater of (1) the original yield-
to-maturity of the debt instrument plus 5 percentage points, or 
(2) the applicable Federal rate at the time the holder acquired 
the debt instrument plus 5 percentage points. The cap is 
consistent with the policy reflected in the high-yield discount 
obligation rules (that a portion of the holder's return from 
such an instrument, if realized, is more properly viewed as 
gain on an equity investment). Notwithstanding the requirement 
of accrual and the cap on the yield, it is unclear how the 
proposal would apply in situations where a debt instrument is 
acquired at a deep discount because the borrower is in a 
distressed economic position. There is authority for the 
proposition that, in situations where the amount of realizable 
discount is uncertain, the taxpayer may recover his basis in 
the debt instrument before recognizing any market discount 
(i.e., an open-transaction approach).\204\
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    \204\ See, e.g., Liftin v. Comm'r, 36 T.C. 909 (1961), aff'd, 317 
F. 2d 234 (4th Cir. 1963) (``Where a taxpayer acquires at a discount 
contractual obligations calling for periodic payments of parts of the 
face amount of principal due...where it is shown that the amount of the 
realizable discount gain is uncertain or that there is 'doubt whether 
the contract [will] be completely carried out,' the payments should be 
considered as a return of cost until the full amount thereof has been 
recovered, and no allocation should be made as between such cost and 
discount income.''); Underhill v. Comm'r, 45 T.C. 489 (1966) (same). 
See also, Garlock, Federal Income Taxation of Debt Instruments, ch. 10, 
pp. 13-16 (Aspen Law & Business, 1998 Supp.).
---------------------------------------------------------------------------
    One concern with the Administration proposal is the 
additional complexity it may cause. When the market discount 
rules were added to the Code as part of the Deficit Reduction 
Act of 1984, Congress recognized the economic equivalence of 
market discount and original issue discount, yet it enacted a 
different set of rules for market discount. Accordingly, ``the 
Congress appreciated that the theoretically correct treatment 
of market discount, which would require current inclusion in 
the income of the holder over the life of the obligation, would 
involve administrative complexity.'' \205\
---------------------------------------------------------------------------
    \205\ Joint Committee on Taxation, General Explanation of the 
Revenue Provisions of the Deficit Reduction Act of 1984 (JCS-41-84), 
December 31, 1984, p. 93.
---------------------------------------------------------------------------
    The administrative complexity may be a particular concern 
with respect to the computation of market discount where the 
debt instrument was issued with OID; the market discount and 
the OID amounts could involve different computations.\206\ The 
proposal's limited application to holders using an accrual 
method of accounting, however, would restrict the impact of the 
proposal to a class of taxpayers that is more familiar with the 
complexities of reporting income under an accrual method.
---------------------------------------------------------------------------
    \206\ Many of the complexities and uncertainties of the proposal 
exist in present law for taxpayers with OID instruments that elect 
current accrual of market discount. To date, no regulations have been 
issued under the market discount rules.
---------------------------------------------------------------------------
3. Limit conversion of character of income from constructive ownership 
        transactions with respect to partnership interests

                              Present Law

    The maximum individual income tax rate on ordinary income 
and short-term capital gain is 39.6 percent, while the maximum 
individual income tax rate on net long-term capital gain is 
generally 20 percent. Long-term capital gain means gain from 
the sale or exchange of a capital asset held more than one 
year. For this purpose, gain from the termination of a right 
with respect to property which would be a capital asset in the 
hands of the taxpayer is treated as capital gain.\207\
---------------------------------------------------------------------------
    \207\ Section 1234A, as amended by the Taxpayer Relief Act of 1997.
---------------------------------------------------------------------------
    A partnership is not subject to Federal income tax. Rather, 
each partner includes its distributive share of partnership 
income, gain, loss, deduction or credit in its taxable income 
for the partnership's taxable year, regardless of whether a 
distribution was actually made to the partner in that taxable 
year. Generally, the character of the partnership item is 
determined at the partnership level and flows through to the 
partners. Thus, for example, the treatment of income by the 
partnership as ordinary income, short-term capital gain, or 
long-term capital gain retains its character when reported by 
each of the partners.
    Investors may enter into forward contracts, notional 
principal contracts, and other similar arrangements with 
respect to property that provide the investor with the same or 
similar economic benefits as owning the property directly but 
with potentially different tax consequences (as to the 
character and timing of any gain).

                        Description of Proposal

    The proposal would limit the amount of long-term capital 
gain a taxpayer could recognize from arrangements that 
substantially replicate the economic results of direct 
ownership of an partnership interest \208\ during the term of 
the arrangement (a ``constructive ownership transaction''). The 
long-term capital gain would be limited to the amount of long-
term gain the taxpayer would have had if the taxpayer held the 
partnership interest directly during the term of the 
arrangement (the ``net underlying long-term capital gain''). 
Any gain in excess of this amount would treated as ordinary 
income. To the extent that gain is recharacterized as ordinary 
income, an interest charge would be imposed.
---------------------------------------------------------------------------
    \208\ The Administration proposal would not apply to other types of 
pass-through entities.
---------------------------------------------------------------------------
    A taxpayer would be treated as having entered into a 
constructive ownership transaction if the taxpayer (1) holds a 
long position under a notional principal contract with respect 
to a partnership interest, (2) enters into a forward contract 
to acquire a partnership interest, (3) is the holder of a call 
option, and the grantor of a put option, with respect to a 
partnership interest, and the options have substantially equal 
strike prices and substantially contemporaneous maturity dates, 
or (4) to the extent provided in regulations, enters into one 
or more transactions, or acquires one or more other positions, 
that have substantially the same effect as any of the 
transactions described.
    The interest charge is the amount of interest that would be 
imposed under section 6601 had the recharacterized income been 
included in the taxpayer's gross income during the term of the 
constructive ownership transaction. The recharacterized gain is 
treated as having accrued ratably during the term of the 
constructive ownership transaction.
    A taxpayer would be treated as holding a long position 
under a notional principal contract with respect to a 
partnership interest if the person (1) has the right to be paid 
(or receive credit for) all or substantially all of the 
investment yield (including appreciation) on the partnership 
interest for a specified period, and (2) is obligated to 
reimburse (or provide credit) for all or substantially all of 
any decline in the value of the partnership interest. A forward 
contract is a contract to acquire (or provide or receive credit 
for the value of) a partnership interest unless the price or 
quantity is determined solely by reference to the value of the 
partnership interest on the date the partnership interest is to 
be acquired. A forward contract could be cash settled.
    The proposal would allow taxpayers to elect mark-to-market 
treatment for constructive ownership transactions in lieu of 
applying the gain recognition and interest rule.

                             Effective Date

    This proposal would apply to gains recognized on or after 
the date of first committee action.

                              Prior Action

    No prior action. However, a similar proposal (H.R. 3170) 
was introduced in the 105th Congress by Representative Barbara 
Kennelly.

                                Analysis

    Reports have described swap arrangements with respect to 
``hedge funds'' that are designed to replicate the economic 
returns of a direct investment in the hedge fund while (1) 
converting any ordinary income (and short-term capital gain) 
attributable to the fund into long-term capital gain, and (2) 
deferring the tax on the gain until the arrangement is 
terminated.\209\ As a simplified example, assume an investor 
enters into a three-year contract with a securities dealer, 
where the dealer agrees to pay the investor the amount of any 
appreciation in the value of a notional investment of $1 
million in a domestic ``hedge fund'' partnership.\210\ In 
return, the investor agrees to pay the dealer the amount of any 
depreciation in the value of the investment.\211\ After three 
years, assume the value of a $1 million investment in the hedge 
fund would have increased by $200,000, of which $150,000 is 
ordinary income and short-term gain ($50,000 is long-term 
capital gain). The investor receives a termination payment of 
$200,000. Under present law, the investor may take the position 
that the entire $200,000 is long-term capital gain (taxed at a 
20 percent rate) from the termination of a contract right. 
Moreover, the tax is deferred until the contract is terminated. 
Had the investor owned a direct interest in the hedge fund, the 
$200,000 would have been taxed in the year it was earned at the 
applicable rates (generally at a 20 percent rate for the long-
term gain, and up to a 39.6 percent rate on the ordinary income 
and short-term gain).
---------------------------------------------------------------------------
    \209\ See, e.g., Browning, ``Where There's a Tax Cut, Wall Street 
Finds a Way,'' The Wall Street Journal, October 21, 1997, p. C-1; 
Sheppard, ``Constructive Ownership of a Bag of Dead Cats,'' 81 Tax 
Notes 407, October 26, 1998.
    \210\ Assuming the securities dealer purchases the partnership 
interest, the dealer would mark both the partnership interest and the 
contractual arrangement to market under Code section 475, and the 
economic consequences of the two positions would offset each other. 
Therefore, the dealer would not pay tax on the return from the hedge 
fund.
    \211\ For purposes of this example, any interim payments or 
distributions between the parties are ignored.
---------------------------------------------------------------------------
    The proposal would recharacterize $150,000 of the gain as 
ordinary income (the excess of $200,000 of long-term gain over 
$50,000 of net underlying long-term capital gain). For purposes 
of calculating the interest charge, the $150,000 of 
recharacterized income would be allocated ratably over the 
three year-term of the constructive ownership transaction.
    Some would argue that it is inappropriate for an investor 
who engages in a transaction designed to replicate the economic 
returns of owning an interest in a partnership to be taxed in a 
more favorable manner than had the investor actually owned the 
partnership interest. If the investor has assumed substantially 
all of the economic burdens and benefits attributable to the 
partnership interest, then to the extent possible, the investor 
should be taxed in a comparable manner.\212\ These types of 
conversion transactions also could be viewed as inconsistent 
with the objectives underlying the beneficial tax treatment of 
long-term capital gains. Moreover, if these conversion 
transactions could be accomplished via the use of other pass-
through entities, the proposal arguably should cover such 
entities.
---------------------------------------------------------------------------
    \212\ Code section 1259, enacted as part of the Taxpayer Relief Act 
of 1997, embodies a similar economic concept--a taxpayer who has 
substantially eliminated both the risk of loss and opportunity for gain 
on an appreciated investment is treated for Federal income tax purposes 
as if the taxpayer had sold the investment.
---------------------------------------------------------------------------
    Others would argue that a derivative instrument which 
substantially replicates the economic position of direct 
ownership of an equity interest in a partnership is not 
tantamount to direct ownership of the partnership interest and 
should not be taxed as such. The investor does not have the 
legal benefits and burdens of actual ownership of a partnership 
interest. The investor has no actual relationship with the 
partnership and no involvement with respect to the 
partnership's management or operations. Rather, the investor 
has entered into a contractual relationship with his 
counterparty and thus bears the risks that are inherent in such 
a relationship. In addition, there may be non-tax reasons for 
structuring the investment in this manner, such as reduced 
borrowing costs for the investor.
    In addition, treating the recharacterized gain as having 
been recognized ratably over the term of the constructive 
ownership transaction for purposes of imposing the interest 
charge would have the effect of overstating the underpayments 
of tax in the early years and understating them in later years 
relative to true economic accrual. Moreover, the interest rate 
imposed by section 6601 exceeds the interest rate that a 
taxpayer engaging in such a transaction would typically pay on 
a borrowing.\213\ However, the proposal does allow taxpayers to 
avoid this result by electing mark-to-market treatment with 
respect to the constructive ownership transactions.
---------------------------------------------------------------------------
    \213\ New York State Bar Association Tax Section, ``Comments on 
H.R. 3170,'' 98 TNT 136-38 (July 18, 1998).
---------------------------------------------------------------------------
4. Modify rules for debt-financed portfolio stock

                              Present Law

    In general, a corporate shareholder can deduct 70 percent 
of the dividends that it receives from another corporation (80 
percent in the case of dividends received from a 20-percent-
owned corporation and 100 percent in the case of certain 
dividends from affiliated corporations) (sec. 243). A special 
rule, however, reduces the dividends-received deduction on 
``debt-financed portfolio stock'' so that the deduction is 
available, in effect, only with respect to dividends 
attributable to that portion of the stock which is not debt 
financed (sec. 246A). Generally, this is accomplished by 
determining the percentage of the cost of an investment in 
portfolio stock which is debt financed and by reducing the 
otherwise allowable dividends-received deduction with respect 
to any dividends received on that stock by that percentage. 
Debt-financed portfolio stock is defined as any ``portfolio 
stock'' with respect to which there is ``portfolio 
indebtedness'' at any time during the ``base period.''
    Stock held by a corporation generally is portfolio stock 
unless, as of the ex-dividend date for the dividend involved, 
the corporate shareholder holds stock (1) possessing at least 
50 percent of the total combined voting power of all classes of 
stock of such corporation entitled to vote and (2) having a 
value equal to at least 50 percent of the value of all the 
stock of such corporation. Additionally, stock is specifically 
excluded from treatment as portfolio stock if, as of the 
beginning of the ex-dividend date for the dividend involved, 
(1) the taxpayer owns stock of such corporation possessing at 
least 20 percent of the voting power and value of all the stock 
of such corporation and (2) five or fewer corporate 
shareholders own stock of such corporation possessing at least 
50 percent of the voting power and value of all the stock of 
such corporation. The base period with respect to any dividend 
is the shorter of (1) the period beginning on the ex-dividend 
date for the most recent previous dividend on the stock and 
ending on the day before the ex-dividend date for the dividend 
involved, or (2) the one-year period ending on the day before 
the ex-dividend date for the dividend involved.
    Portfolio indebtedness is any indebtedness which is 
``directly attributable'' to an investment in portfolio stock 
with respect to which a dividend is received. The directly 
attributable standard is satisfied if there is a direct 
relationship between the debt and the investment in portfolio 
stock. The directly attributable standard does not incorporate 
any allocation or apportionment formula or fungibility concept. 
If debt is clearly incurred for the purpose of acquiring or 
carrying dividend-paying portfolio stock or is otherwise 
directly traceable to such stock, however, the indebtedness 
would constitute portfolio indebtedness. This would be the 
case, for example, if the corporation incurred a nonrecourse 
loan secured, in whole or in part, by dividend-paying portfolio 
stock, or it purchased portfolio stock by issuing its own 
indebtedness to the seller.

                        Description of Proposal

    The proposal would modify the standard for determining 
whether portfolio stock is debt-financed. Under the proposal, 
the percentage of portfolio stock treated as debt-financed 
would equal the sum of (1) the percentage of stock that is 
directly financed by indebtedness, and (2) the percentage of 
remaining stock that is indirectly financed by indebtedness. A 
pro rata allocation formula would be used to determine the 
percentage of the remaining stock that is indirectly financed 
by indebtedness.

                             Effective Date

    The proposal would be effective for portfolio stock 
acquired on or after the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    The purpose of the dividends-received deduction is to 
reduce multiple corporate-level taxation of income as it flows 
from the corporation that earns it to the ultimate noncorporate 
shareholder. When dividends are paid on debt-financed portfolio 
stock, however, the combination of the dividends-received 
deduction and the interest deduction would enable a corporate 
shareholder to shelter unrelated income. A corporation could 
arbitrage the tax system by having partially tax-exempt income 
on one hand and related fully deductible expenses on the other. 
The debt-financed portfolio stock rule is intended to prevent 
such a result. The reduction may be viewed as a surrogate for 
limiting the interest deduction as is accomplished in other 
areas of the Code in which the potential for such mismatching 
exists (e.g., the interest deduction is limited with respect to 
interest on debt to fund life insurance (sec. 264) and with 
respect to debt incurred to purchase or carry tax-exempt 
obligations (sec. 265)).
    Advocates of the proposal argue that present law is not 
achieving its intended effect because the ``directly 
attributable'' standard is easily avoided. Under present law, a 
corporation may be able to structure indebtedness that is 
designed to purchase or carry the portfolio stock but that does 
not meet the ``directly attributable'' standard. The proposal 
would tighten the standard by including stock that is 
indirectly debt-financed. A pro rata formula (similar to the 
formula used with respect to the allocation of interest expense 
to life insurance policy cash values (sec. 264(f)) and the pro 
rata allocation of interest expense of financial institutions 
to tax-exempt interest (sec. 265(b))) would determine the 
amount of stock indirectly debt-financed. Advocates of the 
proposal might further argue that the allocation formula 
recognizes the economic reality of the fungibility of funds.
     Opponents of the proposal argue that the ``directly 
attributable'' standard is the appropriate standard for 
eliminating tax arbitrage with respect to the dividends-
received deduction for portfolio stock. When debt is incurred 
for the purpose of acquiring dividend-paying portfolio stock or 
is otherwise directly traceable to such an acquisition or 
carrying of that stock, it is appropriate to reduce the 
dividends-received deduction. Introducing an allocation formula 
or fungibility concept, however, is not consistent with the 
underlying purpose of the dividends-received deduction. 
Multiple corporate-level taxation could still exist to the 
extent that unrelated indebtedness is allocated to portfolio 
stock so as to reduce the dividends-received deduction. Under 
the proposal, any corporation that merely issues commercial 
paper from time to time as part of its cash management program 
or that owns mortgaged real estate would inappropriately suffer 
a reduction in its dividends-received deduction with respect to 
unrelated portfolio stock.
5. Modify and clarify certain rules relating to debt-for-debt exchanges

                              Present Law

    In general, if a debt instrument is repurchased by the 
issuer for a price in excess of its adjusted issue price, the 
excess (``repurchase premium'') is deductible as interest for 
the taxable year in which the repurchase occurs. However, in a 
debt-for-debt exchange, where neither debt instrument is 
publicly traded, any repurchase premium is amortized over the 
term of the newly issued debt as if it were original issue 
discount (``OID'').\214\ If the issuer repurchases a debt 
instrument in a debt-for-debt exchange, the repurchase price is 
the issue price of the newly issued debt instrument (reduced by 
any unstated interest under section 483).
---------------------------------------------------------------------------
    \214\ Treas. reg. sec. 1.163-7(c). The regulation overturned the 
result in Great Western Power Company of California v. Commissioner, 
297 U.S. 543 (1936), in which the Supreme Court held any repurchase 
premium in a debt-for-debt exchange must be amortized over the term of 
the new debt rather than deducted immediately.
---------------------------------------------------------------------------
    If a debt instrument is repurchased by the issuer for a 
price which is less than its adjusted issue price, the issuer 
recognizes income from the discharge of indebtedness. If the 
debtor issues a debt instrument in satisfaction of the 
indebtedness, the new debt instrument is treated as having 
satisfied the indebtedness with an amount of money equal to the 
issue price of the new debt instrument (sec. 108(e)(10)). If 
the new debt instrument provides for contingent payments, and 
neither the new debt instrument nor the old debt instrument is 
publicly traded, then the holder includes the fair market value 
of the contingent payments in determining the amount realized 
in the exchange.\215\ The issuer does not include the value of 
the contingent payments in determining the issue price of the 
new debt instrument.\216\
---------------------------------------------------------------------------
    \215\ Treas. reg. sec. 1.1001-1(g)(2)(ii).
    \216\ Treas. reg. sec. 1.1274-2(g).
---------------------------------------------------------------------------
    Under present law, gain is recognized by a shareholder or 
securityholder in a reorganization (or distribution under 
section 355) only to the extent that property other than stock 
or securities in a corporation that is a party to the 
reorganization is received. For purposes of this rule, ``other 
property'' includes the fair market value of the excess of the 
principal amount of securities received over the principal 
amount of any securities surrendered (if any). If the principal 
amount of the securities received and the principal amount of 
the securities surrendered are the same, no gain is recognized.

                        Description of Proposal

    The proposal would require an accrual basis taxpayer to 
amortize any repurchase premium in a debt-for-debt exchange 
over the term of the new debt instrument as if it were OID. The 
proposal would clarify that where the new debt is contingent 
and neither the new debt nor the old debt is publicly traded, 
in applying the debt-for-debt exchange rule to the debtor, the 
fair market value of any contingent payments would be added to 
the issue price of the new debt.
    The proposal also would provide that for purposes of 
determining the amount of gain recognized to a securityholder 
in a reorganization (or a section 355 distribution), the excess 
of the issue price of the securities received over the adjusted 
issue price of the securities surrendered would be treated as 
``other property.'' If securities are received and none are 
surrendered, the issue price of the securities received would 
be treated as other property. However, if either the securities 
surrendered or the securities received is publicly traded, the 
amount treated as ``other property'' would be limited to the 
excess of the issue price of the securities received over the 
fair market value of the securities surrendered.

                             Effective Date

    The proposal would apply to debt-for-debt exchanges 
occurring on or after the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    The proposal would require an accrual basis taxpayer to 
amortize any repurchase premium in a debt-for-debt exchange 
over the life of the new debt. This proposal is consistent with 
the rationale in the U.S. Supreme Court decision in Great 
Western Power which ruled that these expenses are properly 
allocated to the cost of obtaining a new loan rather than a 
cost of terminating the old loan, and thus amortizable over the 
life of the new loan. This differs from the result that would 
occur if the transactions are viewed as separate transactions 
in which the old debt is first repurchased for money and then 
new debt is separately incurred (in which case the repurchase 
premium would be immediately deductible).
    The proposal would result in the asymmetrical treatment of 
repurchase premium--a holder would include the premium as 
income in the year of the exchange, while the issuer would be 
required to amortize the premium over the life of the new debt. 
Opponents of the proposal may question the appropriateness of 
this treatment. However, present law already provides 
inconsistent treatment as to the character of the repurchase 
premium. Thus, the holder deducts the repurchase premium as 
interest while the holder treats the premium as capital 
gain.\217\
---------------------------------------------------------------------------
    \217\ GCM 39543 (August 8, 1986).
---------------------------------------------------------------------------
    Where a contingent payment debt instrument is issued in 
exchange for a debt instrument and neither the new debt nor the 
old debt is publicly traded, the debtor excludes this amount 
for purposes of determining the issue price of the debt 
instrument under sec. 108(e)(10). This treatment could result 
in an overstatement of the debtor's discharge of indebtedness 
income and thereby fail to reflect the true economics of the 
exchange. The proposal would require both parties to take into 
account the fair market value of the contingent payments.
    The present law rules measuring the amount of ``other 
property'' received in an exchange of securities relies on the 
principal amount of the securities. The principal amount rule 
acts as a safe harbor; the securityholder does not have to 
determine the fair market value of the securities unless the 
principal amount of securities received exceeds the principal 
amount of any securities surrendered. However, because the 
principal amount may include amounts otherwise treated as 
interest for other purposes of the Code, the ``principal 
amount'' may not properly measure whether a creditor receives 
additional debt in an exchange. Indeed, some commentators 
believe that ``principal amount'' in present law could refer to 
amounts that are treated as principal for purposes of the OID 
rules.\218\ The proposal would explicitly adopt this approach. 
In the case of publicly traded debt, the proposal would rely on 
fair market value as the indicator of whether other property 
was received; in the case of other debt, the proposal would 
rely on the issue price of each security.
---------------------------------------------------------------------------
    \218\ See, e.g., Bittker & Eustice, Federal Income Taxation of 
Corporations and Shareholders, para. 12.27[4][b] at p. 113-114 (Warren, 
Gorham & Lamont, 6th ed. 1998); Garlock, Federal Income Taxation of 
Debt Instruments, ch. 17, pg. 120 at note 367 (Aspen Law & Business, 
1998 Supp.).
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6. Modify and clarify straddle rules

                              Present Law

    A ``straddle'' generally refers to offsetting positions 
with respect to actively traded personal property. Positions 
are offsetting if there is a substantial diminution in the risk 
of loss from holding one position by reason of holding one or 
more other positions in personal property. When a taxpayer 
realizes a loss with respect to a position in a straddle, the 
taxpayer may recognize that loss for any taxable year only to 
the extent that the loss exceeds the unrecognized gain (if any) 
with respect to offsetting positions in the straddle (sec. 
1092). Deferred losses are carried forward to the succeeding 
taxable year and are subject to the same limitation with 
respect to unrecognized gain in offsetting positions.
    The straddle rules generally do not apply to positions in 
stock. However, the straddle rules apply to straddles where one 
of the positions is stock and at least one of the offsetting 
positions is either (1) an option with respect to the stock or 
(2) a position with respect to substantially similar or related 
property (other than stock) as defined in Treasury regulations. 
In addition, the straddle rules apply to stock of a corporation 
formed or availed of to take positions in personal property 
which offset positions taken by any shareholder.
    Taxpayers are required to capitalize certain otherwise 
deductible expenditures allocable to personal property which is 
part of a straddle (sec. 263(g)). Such amounts must be charged 
to the capital account of the property to which the 
expenditures relate. Expenditures subject to this requirement 
are interest on indebtedness incurred or continued to purchase 
or carry property (including any amount paid or incurred in 
connection with personal property used in a short sale) as well 
as all other amounts paid or incurred to carry the property, 
including insurance, storage, or transportation charges 
(``carrying charges''). The amount of the expenditures to be 
capitalized is reduced by (1) any interest income from the 
property (including original issue discount) which is 
includible in gross income for the taxable year, (2) certain 
amounts of acquisition and market discount treated as ordinary 
income with respect to such property for the taxable year, (3) 
the excess of dividends includible in gross income over any 
dividends-received deduction with respect to such property for 
the taxable year, and (4) an amount which is payment with 
respect to a security loan includible in gross income with 
respect to such property for the taxable year.

                        Description of Proposal

     The proposal would clarify that expenses (including 
interest and other periodic payments) associated with 
structured financial transactions that are part of a straddle 
would be capitalized as carrying costs of the straddle under 
section 263(g). Thus, for example, if a taxpayer holds an 
appreciated position in actively traded personal property and 
the taxpayer enters into a prepaid (or collateralized) forward 
contract to sell the property, the taxpayer must capitalize all 
expenses associated with that forward contract.
    In addition, the proposal would repeal the exception for 
stock in the definition of personal property. Thus, under the 
proposal, offsetting positions with respect to actively traded 
stock would generally constitute a straddle.
    No inference would be intended with respect to the tax 
treatment of transactions entered into before the effective 
date.

                             Effective Date

    The proposal would be effective for straddles entered into 
on or after the date of enactment.

                              Prior Action

    A similar proposal was included in the President's tax 
simplification proposals released in April 1997 and, with 
respect to the repeal of the exception for stock in the 
definition of personal property, in the President's fiscal year 
1999 budget proposal.

                                Analysis

    Under present law, when a one of the positions that is part 
of a straddle consists of a debt or a debt-like component, some 
taxpayers have taken the position that interest expense or 
similar periodic payments with respect to that component are 
not costs incurred to purchase or carry personal property that 
is part of the straddle and, therefore, do not have to be 
capitalized. Advocates of the proposal argue that it is 
inappropriate for a taxpayer to deduct expenses associated with 
one position in a straddle to the extent that there is 
unrecognized gain in the offsetting position in the straddle. 
When one position in a straddle has a debt or debt-like 
component, the related interest expense should be viewed as a 
cost of the straddle.
    Opponents of the proposal would argue, on the other hand, 
that interest expense or similar periodic payments should be 
capitalized only when the proceeds from the debt or debt-like 
component of the straddle are used to purchase or carry a 
position in the straddle. To the extent that the proceeds from 
the debt or debt-like component are not used to fund a position 
in personal property that is part of the straddle (e.g., to 
fund a long position that is offset by a forward contract) and 
therefore are available for other purposes, it arguably is 
inappropriate to capitalize the expenses related to the debt or 
debt-like component.
    The repeal of the exception from the straddle rules for 
stock arguably is consistent with the policy of those rules, 
which is to prevent deduction of losses in situations where a 
taxpayer has entered into an offsetting transaction that has 
unrecognized gain, until such time as the gain on the 
offsetting position is recognized. Advocates of the proposal 
also would observe that the offsetting appreciated stock 
positions are subject to the constructive sale rules added by 
the Taxpayer Relief Act of 1997 (sec. 1259) which have more 
onerous results than loss deferral under the straddle rules. 
Additionally, it must be pointed out that proposed Treasury 
regulations would severely limit the stock exception even if 
the proposal is not adopted.\219\ Nonetheless, because stock is 
widely held, the repeal of the stock exception would subject 
many more taxpayers to the complicated straddle rules.
---------------------------------------------------------------------------
    \219\ Prop. Treas. Reg. sec. 1.1092(d)-2.
---------------------------------------------------------------------------

7. Defer interest deduction and original issue discount (OID) on 
        certain convertible debt

                              Present Law

    The issuer of a debt instrument may deduct stated interest 
as it economically accrues. If the debt instrument is issued at 
a discount, the issuer may deduct original issue discount 
(``OID'') as it economically accrues, even though the OID may 
not be paid until the instrument matures. The holder of a debt 
instrument includes in income stated interest under its regular 
method of accounting and OID as it economically accrues.
    In the case of a debt instrument that is convertible into 
the stock of the issuer or a related party, an issuer generally 
may deduct accrued interest and OID up until the time of the 
conversion, even if the accrued interest and OID is never paid 
because the instrument is converted.

                        Description of Proposal

    The proposal would defer interest deductions for accrued 
stated interest and OID on convertible debt until such time as 
the interest is paid. For this purpose, payment would not 
include (1) the conversion of the debt into equity of the 
issuer or a related person (as determined under secs. 267(b) 
and 707(b)) or (2) the payment of cash or other property in an 
amount that is determined by reference to the value of such 
equity. Convertible debt would include debt (1) exchangeable 
for the stock of the issuer or a related party, (2) with cash-
settlement conversion features, or (3) issued with warrants (or 
similar instruments) as part of an investment unit in which the 
debt instrument may be used to satisfy the exercise price of 
the warrant. Convertible debt would not include debt that is 
``convertible'' solely because a fixed payment of principal or 
interest could be converted by the holder into equity of the 
issuer or a related party having a value equal to the amount of 
such principal or interest. Holders of convertible debt would 
continue to include the interest on such instruments in gross 
income as under present law.

                             Effective Date

    The proposal would be effective generally for convertible 
debt issued on or after the date of first committee action.

                              Prior Action

    The proposal was included in the President's fiscal year 
1998 and 1999 budget proposals.

                                Analysis

    The manner in which the proposal would operate may be 
illustrated in one context by examining its effect upon the tax 
treatment of instruments commonly known as liquid yield option 
notes (``LYONs'').\220\ A LYON generally is an instrument that 
is issued at a discount and is convertible into a fixed number 
of shares of the issuer, regardless of the amount of original 
issue discount (``OID'') accrued as of the date of conversion. 
The conversion option usually is in the hands of the holder, 
although a LYON may be structured to allow the issuer to ``cash 
out'' the instrument at certain fixed dates for its issue price 
plus accrued OID. If the LYON is not converted into equity at 
maturity, the holder receives the stated redemption price at 
maturity (i.e., the issue price plus accrued OID). A LYON is 
convertible into a fixed number of shares of issuer stock 
regardless of the amount of accrued OID and does not provide 
interim interest payments to holders. Thus, a LYON could be 
viewed as providing the holder both a discount debt instrument 
and an option to purchase stock at a price equal to the 
maturity value of the debt. If the stock has risen in value 
from the date of issuance to the maturity date to an amount 
that is greater than the stated redemption price at maturity of 
the OID debt, the holder will exercise the option to acquire 
stock by surrendering the debt. If the stock has not 
sufficiently risen in value, the holder will cash in the debt 
and let the option lapse.
---------------------------------------------------------------------------
    \220\ Other convertible debt instruments may have features similar 
to LYONs and may be issued or traded under different names or acronyms. 
The reference to ``LYONs'' in this discussion is intended to be a 
reference to any other similar instruments.
---------------------------------------------------------------------------
    As a simplified example, assume ABC Co. issues a LYON that 
will mature in five years. The LYON provides that, at maturity, 
the holder has the option of receiving $100 cash or one share 
of ABC Co. stock. The LYONs are issued for $70 per instrument 
at time that the ABC Co. stock is trading for less than $70 a 
share. Thus, at the end of five years, the holder of the LYON 
has the following choices: (1) if ABC Co. stock is trading at 
less than $100 a share, the holder will take the $100 cash, but 
(2) if ABC Co. stock is trading at more than $100 a share, the 
holder will take the stock. Because the holder is guaranteed to 
receive at least $100 in value at maturity, present law allows 
the issuer (and requires the holder) to accrue $30 of OID as 
interest over the five-year term of the instrument.
    The structure of LYONs raises several tax issues. The first 
is whether the conversion feature of a LYON is sufficiently 
equity-like to characterize the LYON as equity instead of debt. 
Under present law, issuers of LYONS deduct (and the holders 
include in income) the amount of OID as interest as it accrues. 
A second issue is whether it is appropriate to accrue OID on an 
instrument when it is unclear whether such instrument 
(including the accrued OID) will be paid in cash or property 
other than stock. The proposal provides answers to these two 
issues by applying a ``wait and see'' approach, that is, OID on 
a LYON is not deductible unless and until the amount of OID is 
paid in cash. In this way, the proposal defers the 
determination of whether a LYON is debt or equity until 
maturity. This approach is consistent with present-law section 
163(e)(5) that provides that a portion of the OID of applicable 
high-yield debt instruments is not deductible until paid.
    Opponents of the proposal would argue that the 
determination of whether an instrument is debt or equity should 
be made at its issuance and, at issuance, a LYON has more debt-
like features than equity-like features. They would further 
point out that the holder of a LYON is guaranteed to receive at 
maturity at least the amount of the OID and that present law 
properly allows issuers to accrue such amount over time. They 
would further argue that under present law, taxpayers are 
allowed deductions when stock is issued for deductible expenses 
(or taxpayers can issue stock to the public and use the cash to 
pay deductible expenses) and that the issuance of stock for 
accrued interest is no different. They further claim that 
issuers can achieve results that are similar (or better) than 
the present law treatment of a LYON by issuing callable OID 
indebtedness and options or warrants as separate instruments 
and that the tax law should not discourage the efficient 
combination of the two types of instruments. However, if the 
two instruments truly trade separately, it is not clear that 
they are economically equivalent to a LYON. Finally, opponents 
would argue that it is unfair and contrary to the present-law 
OID rules to require holders of LYONS to accrue OID in income 
while deferring or denying related OID deductions to issuers. 
Again, under present law, holders of applicable high-yield debt 
instruments are required to include OID in income as it 
accrues, while OID deductions of issuers of such instruments 
are deferred or denied.

                        C. Corporate Provisions

1. Conform control test for tax-free incorporations, distributions, and 
        reorganizations

                              Present Law

    The tax consequences of a particular corporate transaction 
(such as an incorporation, distribution, or a reorganization) 
often depend on whether a ``control'' test is satisfied. In 
general, the term ``control'' means the ownership of stock 
possessing at least 80 percent of the total combined voting 
power of all classes of stock entitled to vote and at least 80 
percent of the total number of shares of all other classes of 
stock of the corporation (sec. 368(c)).
    For purposes of determining whether two corporations are 
sufficiently affiliated so that, in essence, they are treated 
as a single corporation for some tax purposes (such as the 
filing of a consolidated return, tax-free liquidations, and 
qualified stock purchases), the ownership test requires at 
least 80 percent of the total voting power of the corporation's 
stock and at least 80 percent of the total value of the 
corporation's stock (sec. 1504(a)(2)). For this purpose, stock 
does not include preferred stock that meets the requirements of 
section 1504(a)(4).

                                Proposal

    The proposal would conform the control test under section 
368(c) with the affiliation test under section 1504(a)(2). 
Thus, ``control'' would be defined as the ownership of at least 
80 percent of the total voting power and at least 80 percent of 
the total value of the corporation's stock. For this purpose, 
stock would not include preferred stock that meets the 
requirements of section 1504(a)(4).

                             Effective Date

    The proposal would be effective for transactions on or 
after the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    Recent publicized corporate transactions have highlighted 
the use of an equity structure where the voting power and the 
value have been separated (e.g., one class of common stock is 
heavy vote-light value stock, and another class is light vote-
heavy value). This separation of vote from value permits a 
party to satisfy the ``control'' test through voting power, 
while disposing of much of the value of the common stock and 
future growth of a subsidiary. Some observers have 
characterized this as the disposition of a subsidiary in a 
transaction that has characteristics of a sale but nonetheless 
is designed to qualify for tax-free treatment.\221\
---------------------------------------------------------------------------
    \221\ See, e.g., Sloan, ``Did Times Mirror Deserve That Tax Break? 
It Depends on Your Definition of a 'Sale,''' The Washington Post, 
October 13, 1998, p. C-3; Sisk, ``Conoco Deal Seen Legitimizing Spinoff 
Tax Technique,'' Corporate Financing Week, Vol. XXIV, No. 46, November 
16, 1998.
---------------------------------------------------------------------------
    The development of this proposal is comparable to the 
history of the affiliation test under section 1504(a). Prior to 
1984, the affiliation test required an ownership of 80 percent 
of the voting power and 80 percent of each class of the 
nonvoting stock of each includible corporation. In the Deficit 
Reduction Act of 1984, Congress amended section 1504(a) to 
include an 80-percent value test, in part because 
``notwithstanding the intent of the provision, corporations 
were filing consolidated returns under circumstances in which a 
parent corporation's interest in the issuing corporation 
accounted for less than 80 percent of the real equity value of 
such corporation.'' \222\ However, Congress did not amend the 
section 368(c) control test.\223\
---------------------------------------------------------------------------
    \222\ Joint Committee on Taxation, General Explanation of the 
Revenue Provisions of the Deficit Reduction Act of 1984 (JCS-41-84), 
December 31, 1984, pp. 170-171.
    \223\ In 1985, the staff of the Senate Finance Committee 
recommended amending the control test to conform with the new 
affiliation test. See, Senate Finance Committee Staff Report, The 
Subchapter C Revision Act of 1985, S. Print 99-47, 99th Cong., 1st 
Sess. (1985), proposed section 366(c).
---------------------------------------------------------------------------
    One type of transaction where the disproportionate equity 
structure has been used is with tax-free spin-offs. A 
corporation must ``control'' a subsidiary at the time of the 
spin-off to qualify for tax-free treatment. However, the 
disposition of significant stock value can occur prior to the 
spin-off through the issuance of ``light vote'' stock. The 
parent corporation may use the proceeds of such stock issuance 
as cash it retains tax-free in connection with the disposition. 
This transaction can be illustrated with the following 
simplified example: P, a corporation, owns 100 percent of S 
(with a value of $100). P plans to dispose of S by combining an 
initial public offering (``IPO'') of S with a tax-free spin-off 
of S. The S equity structure is comprised of two classes of 
voting common stock--60 shares of class A stock, which is 
issued and owned by P (and has five votes per share) and 40 
shares of unissued class B stock (which has one vote per 
share). Prior to the IPO, S declares a $40 dividend to P and 
issues a note to P in that amount. The class B stock is sold in 
the IPO for $40. S uses the proceeds to pay off its note to P. 
Thereafter, P distributes the class A stock to its shareholders 
in a transaction that qualifies as a tax-free spin-off under 
section 355 (because the class A stock represents more than 80 
percent of the voting control of S).
    Light vote-heavy value stock also has been used in 
connection with reorganizations. Voting preferred stock is 
combined with voting common stock in a transaction that 
arguably resembles a disguised sale but is structured to 
qualify as a tax-free reorganization (so the seller can avoid 
capital gains). The putative seller transfers appreciated 
property in exchange for a stock interest that shares in 
little, if any, of the economic growth potential of the 
property it formerly owned--this economic interest now belongs 
to the other party to the transaction (the buyer). Instead, the 
seller's stock interest reflects the economic value of property 
(including cash) contributed by the buyer as part of the 
transaction.\224\
---------------------------------------------------------------------------
    \224\ See, e.g., Sheppard, ``Corporate Sales: Ignore that LLC 
behind the Curtain,'' 82 Tax Notes 32, January 4, 1999.
---------------------------------------------------------------------------
    The Administration proposal is intended to curtail the 
ability to engage in tax-free transactions with ``sales-like'' 
characteristics. At the same time, some commentators might 
argue that the proposal is overly broad because it would affect 
other corporate transactions that lack this element. Some might 
question whether changing this long-standing rule \225\ is 
necessary, and whether it could result in new planning 
opportunities.
---------------------------------------------------------------------------
    \225\ Section 202(c)(3) of the Revenue Act of 1921 provided that 
``for purposes of [the predecessor to section 351], a person is, or two 
or more persons are, 'in control' of a corporation when owning at least 
80 per centum of the voting stock and at least 80 per centum of the 
total number of shares of all other classes of stock of the 
corporation.''
---------------------------------------------------------------------------
    Under present law, if light vote-heavy value stock is 
issued in an IPO that is related to a tax-free spin-off, and 
the stock has a value equal to or greater than 50 percent of 
the issuing corporation, then the IPO would result in a 
corporate level tax under section 355(e). Thus, in section 355 
transactions, the disproportionate equity structure is relevant 
only when the stock being issued has a value of between 20-50 
percent of the issuing corporation. Moreover, a similar result 
might be achieved by having the issuing corporation borrow 
funds and distribute the proceeds to the parent prior to the 
spin-off. It is also arguable that to the extent that the 
parent's basis in the stock of the subsidiary reflects post-
affiliation earnings, the parent corporation should be able to 
receive these amounts regardless of whether the source of the 
funds is from leveraging or from an IPO using light vote-heavy 
value stock.
    One aspect of the proposal is that, in determining whether 
the 80-percent vote and value test is satisfied, so-called 
``pure'' preferred stock would be excluded from the 
calculations.\226\ This raises a question of whether pure 
preferred stock could be used as a substitute for light vote-
heavy value stock.\227\ However, in certain other instances 
where ownership is relevant, the value of pure preferred stock 
is disregarded.\228\
---------------------------------------------------------------------------
    \226\ The term ``pure'' preferred stock refers to preferred stock 
that satisfies the requirements of section 1504(a)(4).
    \227\ The pure preferred stock could not be considered 
``nonqualified preferred stock'' as defined in section 351(g).
    \228\ See, e.g., secs. 332(b)(1) and 338(d)(3). Cf., section 
382(e)(1), where the value of pure preferred stock is included in 
determining the value of a corporation.
---------------------------------------------------------------------------

2. Tax issuance of tracking stock

                              Present Law

    The term ``tracking stock'' refers to a special class of 
stock of the issuing corporation that tracks the performance or 
value of one or more separate assets 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 (a vertical slice of the 
issuer). Subsidiary tracking stock is in form stock of a parent 
corporation that is intended to relate to and track the 
economic performance of a subsidiary of the parent. The 
Internal Revenue Service has indicated it will not rule on 
whether tracking stock is treated as stock of the issuer.\229\ 
Whether tracking stock is stock of the issuer is dependent upon 
the correlation of the rights of the stock to the underlying 
assets.
---------------------------------------------------------------------------
    \229\ Rev. Proc. 99-3, 1999-1 I.R.B. 109, sec. 3.01(44) states that 
the IRS will not issue rulings regarding the classification of an 
interest that has certain voting and liquidation rights in an issuing 
corporation but whose dividend rights are determined by reference to 
the earnings of a segregated portion of the issuing corporation's 
assets, including assets held by a subsidiary.
---------------------------------------------------------------------------

                        Description of Proposal

    The Administration proposes to provide that, upon issuance 
of ``tracking stock'' or a recapitalization of stock or 
securities into tracking stock, gain will be recognized in an 
amount equal to the excess of the fair market value of the 
tracked asset over its adjusted basis. General principles of 
tax law would continue to apply to determine whether tracking 
stock is stock of the issuer or not stock of the issuer. In 
addition, the Secretary would have authority to treat tracking 
stock as nonstock (e.g. debt, a notional principal contract, 
etc.) or as stock of another entity as appropriate to prevent 
tax avoidance, and to provide for increased basis in the 
tracked assets as a result of gain recognized.
    For this purpose, ``tracking stock'' would be defined as 
stock that relates to, and tracks the economic performance of, 
less than all of the assets of the issuing corporation 
(including the stock of a subsidiary), and either 1) the 
dividends are directly or indirectly determined by reference to 
the value or performance of the tracked entity or assets, or 2) 
the stock has liquidation rights directly or indirectly 
determined by reference to the tracked entity or assets. The 
issuance of tracking stock will not result in another class of 
stock of the corporation becoming tracking stock if the 
dividend and liquidation rights of such other class are 
determined by reference to the corporation's general assets, 
even though limited by rights attributable to the tracking 
stock.
    No inference regarding the tax treatment of the above-
described stock under present law is intended by this proposal.

                             Effective Date

    The proposal is effective for tracking stock issued on or 
after the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    Tracking stock has been utilized in a number of acquisition 
transactions as well as in distribution type transactions. The 
Adminstration's concern is that such stock is utilized to 
create a structure that is the economic equivalent of an actual 
division and distribution of the underlying assets. An actual 
distribution of only a portion of the assets of a corporation 
or the stock of a subsidiary would generally result in tax on 
any appreciation. Section 355 provides the ability to 
distribute the stock of a subsidiary tax-free. However, section 
355 contains a number of specific requirements, including a 5-
year active business requirement and various requirements 
limiting spin-offs of recently purchased businesses or spin-
offs involving certain changes in ownership of the parent or 
subsidiary corporation. There is also a requirement that the 
distributing corporation own control (as defined) of the 
distributed subsidiary and that control be distributed. If any 
interest in the subsidiary is retained, there must be a showing 
that the purpose is not the avoidance of tax. It can often be 
difficult to satisfy all the requirements for a tax free 
distribution under section 355.
    Some commentators have suggested that tracking stock can be 
used to obtain some of the benefits of an actual distribution 
that would not qualify under section 355, without the related 
tax burden. However, others contend that the rights associated 
with tracking stock can reflect significant differences from a 
stock ownership that is limited directly to the underlying 
tracked assets. Opponents may also argue that taxpayers should 
be free to issue equity and debt instruments with features that 
satisfy current investor demands.
    Under present law, the IRS has indicated that it will not 
rule on the proper classification of tracking stock. However, 
taxpayers have been permitted to represent that tracking stock 
is stock of the parent corporation issuer (rather than of a 
subsidiary, for example) in obtaining private letter rulings. 
Some observers have suggested that the Treasury Department 
presently has regulatory authority under section 337(d) to 
issue regulations with respect to whether tracking stock should 
be treated as in effect the distribution of underlying assets.
    Analytical questions have been raised regarding the proper 
treatment of tracking stock. Some commentators have suggested 
that if there is a high correlation between the economic 
performance of the tracking stock and the tracked assets, the 
tracking stock could be viewed as if it were an interest in a 
joint venture between the parent corporation and the holders of 
tracking stock. (NYSBA report, 43 Tax Law Review 51 (1987)). If 
a corporation actually distributed or sold to its shareholders 
an interest in a joint venture that was not treated as stock of 
the issuer, then the corporation would generally pay tax on the 
excess of the value of the distributed rights over the basis in 
the hands of the corporation. Alternatively, a primary offering 
by the joint venture might be nontaxable. Disposition or 
offering of a sufficiently large interest in the venture would 
prevent consolidation with the parent.
    Issues may arise regarding the value and nature of the 
interest deemed distributed under the Treasury proposal. For 
example, tracking stock may be structured in any number of ways 
that could result in holders having very different types of 
rights with respect to tracked assets. While it generally is 
anticipated that the issuing corporation will pay dividends 
linked to the tracked assets, in many instances holders of 
tracking stock may not actually be entitled to the dividends, 
even though the tracked assets are profitable, if the parent 
corporation does not declare dividends. The tracked assets may 
be subject to liabilities of the parent corporation that may 
diminish the tracking stock shareholders' interests in the 
values of such assets. Under such circumstances, it might be 
questioned whether the issuance of such stock is economically 
equivalent to a direct ownership of the underlying assets. If 
tracking stock has a value that differs from the value of the 
underlying assets, it could be questioned whether the issuing 
corporation is properly treated as having distributed the 
entire value of the attributable portion of the tracked asset.
    The Administration proposal authorizes the Secretary of the 
Treasury to treat tracking stock as an interest other than 
stock, or as stock of another entity, and to provide for 
increased basis in the tracked assets as the result of gain 
recognized. While it would be anticipated that any unfavorable 
guidance would apply only on a prospective basis, until 
guidance is issued, taxpayers would face uncertainty regarding 
the treatment of any particular transaction.
    Some might argue that basis should be increased in 
underlying assets if gain is recognized. However, present law 
generally does not increase the basis of assets as a result of 
gain recognition on the distribution or sale of stock, unless 
an election is made under section 338 of the Code.\230\
---------------------------------------------------------------------------
    \230\ Section 336(e) grants regulatory authority to permit 
taxpayers to treat the distribution of 80 percent of vote and value (as 
defined) of a subsidiary as an asset sale. However, no regulations have 
been issued.
---------------------------------------------------------------------------
    A question could also be raised whether the issuance of 
subsidiary tracking stock should be taxed under the proposal if 
an actual distribution of the stock of the subsidiary would 
have qualified for tax free treatment under section 355.
    Under the proposal, the issuance of tracking stock would 
not generally cause other classes of stock to be classified as 
tracking stock if the dividend and liquidation rights of such 
other classes are determined by reference to the corporation's 
general assets. Uncertainty may arise regarding whether there 
are cases that would, however, result in such reclassification 
and regarding appropriate transition rules.

3. Require consistent treatment and provide basis allocation rules for 
        transfers of intangibles in certain nonrecognition transactions

                              Present Law

    Generally, no gain or loss is recognized if one or more 
persons transfer property to a corporation solely in exchange 
for stock in the corporation and, immediately after the 
exchange such person or persons are in control of the 
corporation. Similarly, no gain or loss is recognized in the 
case of a contribution of property in exchange for a 
partnership interest. Neither the Internal Revenue Code nor the 
regulations provide the meaning of the requirement that a 
person ``transfer property'' in exchange for stock (or a 
partnership interest). The Internal Revenue Service interprets 
the requirement consistent with the ``sale or other disposition 
of property'' language in the context of a taxable disposition 
of property. See, e.g., Rev. Rul. 69-156, 1969-1 C.B. 101. 
Thus, a transfer of less than ``all substantial rights'' to use 
property will not qualify as a tax-free exchange and stock 
received will be treated as payments for the use of property 
rather than for the property itself. These amounts are 
characterized as ordinary income. However, the Claims Court has 
rejected the Service's position and held that the transfer of a 
nonexclusive license to use a patent (or any transfer of 
``something of value'') could be a ``transfer'' of ``property'' 
for purposes of the nonrecognition provision. See E.I. DuPont 
de Nemours & Co. v. U.S., 471 F.2d 1211 (Ct. Cl. 1973).

                        Description of Proposal

    The transfer of an interest in intangible property 
constituting less than all of the substantial rights of the 
transferor in the property would be treated as a transfer of 
property for purposes of the nonrecognition provisions 
regarding transfers of property to controlled corporation and 
partnerships. Consistent reporting by the transferor and 
transferee would be required. Further, the Administration 
proposes that, in the case of a transfer of less than all of 
the substantial rights, the transferor must allocate the basis 
of the intangible between the retained rights and the 
transferred rights based upon respective fair market values.
    The proposal would not apply to transactions that are 
properly structured as licenses of intangibles. No inference is 
intended as to the treatment of these or similar transactions 
prior to the effective date.

                             Effective Date

    The proposal is effective for transfers on or after the 
date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    The Administration proposal is directed at the potential 
``whipsaw'' that could arise under present law. For example, 
some taxpayers apparently take the position they may rely on 
case law permitting transfer of less than all rights in 
intangible property to be treated as a transfer of property, 
but do not allocate basis between the rights transferred and 
the rights retained (the particular case in question did not 
address that issue). Also, the transferor and transferee might 
take inconsistent positions regarding whether the transfer 
qualified at all as a transfer of property under section 351. 
For example, the transferor might take the position that the 
transfer qualified as a transfer of property (resulting in no 
gain to the transferor) while the transferee might take the 
position that the transfer failed to qualify, resulting in 
``sale'' treatment and a basis step-up to the transferee.
    The proposal would generally remove much of the uncertainty 
regarding whether transfers of less than all intangible rights 
can qualify as a transfer of property. The proposal would also 
require basis allocation, thus clarifying the appropriate 
results when ``contribution'' treatment is provided. The 
requirement of valuation of rights retained and transferred, 
however, arguably may add complexity.
    The proposal would apparently allow some amount of 
electivity, since taxpayers would still be permitted to 
``properly structure'' a transfer of less than all rights as a 
license rather than a contribution or property with basis 
allocation. However, the proposal would require consistent 
treatment by transferor and transferee. It is unclear how the 
proposal would enforce this requirement. Disputes could also 
arise regarding whether a transfer had been ``properly 
structured'' as a license or instead is a transfer of property 
subject to the provision.

4. Modify tax treatment of downstream mergers

                              Present Law

    The combination of a parent and subsidiary corporation may 
qualify for tax-free treatment as either a tax-free liquidation 
pursuant to section 332 or a tax-free reorganization pursuant 
to section 368. The determination of which rule may apply to a 
particular transaction depends on the legal form (e.g., 
upstream v. downstream and statutory merger v. asset transfer) 
of the transaction. In both of these tax-free transactions, any 
difference between the value and basis of any subsidiary 
corporation stock held by the parent corporation disappears, 
without recognition of gain or loss.
    A subsidiary corporation that merges upstream (or 
completely liquidates) into its parent corporation may receive 
tax-free treatment as either a section 332 liquidation or a 
section 368 reorganization. If the parent corporation owns at 
least 80 percent of the subsidiary corporation's voting power 
and value (as defined in section 1504) and certain other 
requirements are satisfied, the transaction generally qualifies 
as a tax-free liquidation pursuant to sections 332 (tax-free to 
the parent corporation) and 337 (tax-free to the subsidiary 
corporation).\231\ If, however, the parent owns less than 
either 80 percent of the stock of the subsidiary corporation, 
by vote or value, sections 332 and 337 are not applicable. In 
cases where the parent corporation does not satisfy the 80 
percent ownership requirement, an upstream merger of a 
subsidiary corporation into its parent corporation may qualify 
as a tax-free reorganization pursuant to section 368, if 
certain other requirements are met.\232\
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    \231\ Section 332(b) (last sentence) and Treas. reg. sec. 1.332-
2(d).
    \232\ Treas. reg. sec. 1.368-1(e)(6), Ex. 7; Rev. Rul. 58-93, 1958-
1 C.B. 188; May B. Kass v. Commissioner, 60 T.C. 218 (1973); GCM 39404; 
PLR 9321025 (2-22-93); and PLR 9011042 (12-20-89).
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    A parent corporation that merges (or transfers its assets) 
downstream into its subsidiary may qualify for tax-free 
treatment pursuant to section 368, irrespective of the amount 
of subsidiary corporation stock held by the parent corporation, 
assuming that certain other requirements are met.\233\
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    \233\ Rev. Rul. 78-47, 1978-1 C.B. 113; Rev. Rul. 70-223, 1970-1 
C.B. 79; Rev. Rul. 57-465, 1957-2 C.B. 250; Rev. Rul. 85-107, 1985-2 
C.B. 121; Commissioner v. Estate of Gilmore, 130 F.2d 791 (3d Cir. 
1942); Edwards Motor Transit Co. v. Commissioner, 23 T.C.M. (CCH) 1968 
(1964); George v. Commissioner, 26 T.C. 396 (1956); PLR 9212018 (12-20-
91); PLR 9506036 (11-15-94); and Bausch & Lomb Optical Co. v. 
Commissioner, 267 F.2d 75 (2d Cir. 1959).
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                        Description of Proposal

    Under the proposal, where a parent corporation does not 
satisfy the stock ownership requirements of section 1504(a)(2) 
(generally, 80 percent or more of vote and value) with respect 
to a subsidiary corporation, and the parent corporation 
combines with the subsidiary corporation in a reorganization in 
which the subsidiary corporation is the survivor, the parent 
corporation must recognize gain, but not loss, as if it 
distributed the subsidiary corporation stock that it held 
immediately prior to the reorganization. As long as the other 
requirements for a reorganization are satisfied, nonrecognition 
treatment will continue to apply to other assets transferred by 
the parent corporation to the subsidiary and to the stock and 
securities received by the parent corporation shareholders. The 
proposal also would apply to the acquisition of parent 
corporation stock by the subsidiary corporation in a 
transaction qualifying for nonrecognition treatment where the 
parent corporation is liquidated pursuant to a plan of 
liquidation adopted not more than two years after the 
acquisition date.

                             Effective Date

    The proposal would be effective for transactions that occur 
on or after the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    The proposal would require gain, but not loss, to be 
recognized with respect to subsidiary corporation stock in what 
would otherwise qualify as tax-free downstream reorganizations, 
but only where the parent corporation owns less than 80 percent 
of the voting power or less than 80 percent of the value of the 
subsidiary corporation stock. The proposal would also require 
similar gain recognition in certain inversion transactions that 
are unwound in otherwise tax-free liquidations within a two 
year period. The proposal would alter long-standing judicial 
and administrative precedents that generally support 
nonrecognition treatment for all parties, and with respect to 
all assets, in otherwise qualifying downstream reorganizations 
(as well as other forms of corporate tiering and un-tiering 
where gain inherent in underlying assets is preserved). 
Furthermore, while the proposal would require gain recognition 
in a downstream merger (where less than 80 percent ownership), 
an upstream merger (and other economically similar 
transactions) could still qualify as fully tax-free and result 
in the same corporate structure.\234\ Imposing taxation on only 
one of several economically similar transactions will place 
increased importance on form and may cause gain recognition 
only to the ill-advised.
---------------------------------------------------------------------------
    \234\ ``NYSBA Offers Recommendations On Treatment of Inversion 
Transactions and Downstream Reorganizations,'' 95 TNT 31-26, February 
15, 1995.
---------------------------------------------------------------------------
    Proposal advocates argue that a downstream reorganization 
is functionally equivalent to a taxable distribution by parent 
corporation of the subsidiary corporation stock, followed by a 
tax-free merger. In the case of a direct distribution of 
subsidiary corporation stock, tax law neutrality principles 
suggest that economically similar transactions should receive 
similar tax treatment.
    The carryover basis rules of tax-free reorganizations 
contemplate that the basis will be relevant to the subsidiary 
corporation. In a downstream reorganization, the parent 
corporation's basis in the subsidiary corporation stock will be 
irrelevant in the hands of the subsidiary corporation. Since 
the carryover basis rationale in tax-free reorganizations 
cannot apply to subsidiary corporation stock in a downstream 
merger, proposal advocates argue that the nonrecognition is not 
warranted.
    Opponents of the proposal argue that downstream mergers 
that appear similar to stock distributions at least do not step 
up the basis of underlying assets, and may even result in an 
additional corporate level of taxation. However, present law 
generally does tax a direct sale or distribution of subsidiary 
stock unless the distribution qualifies under section 355 as a 
tax-free spin-off. Furthermore, after the merger, the former 
parent corporation shareholders may not own separate interests 
in the former parent corporation and subsidiary corporation. 
Thus, the transaction may differ from an actual distribution.
    Some commentators have suggested that the Treasury 
Department presently has authority under section 337(d) to 
issue regulations that would implement the features of this 
proposal. However, the matter of authority is not entirely 
clear and would require further analysis.
    As with any gain recognition provision, increased 
complexity may be caused by valuation issues. Non-publicly 
traded stock valuations are difficult because the underlying 
tangible and intangible business assets must be valued and 
other factors such as minority discounts and control premiums 
must be considered.

5. Deny dividends-received deduction for certain preferred stock

                              Present Law

    A corporate taxpayer is entitled to a deduction of 70 
percent of the dividends it receives from a domestic 
corporation. The percentage deduction is generally increased to 
80 percent if the taxpayer owns at least 20 percent (by vote 
and value) of the stock of the dividend-paying corporation, and 
to 100 percent for ``qualifying dividends,'' which generally 
are from members of the same affiliated group as the taxpayer.
    The dividends-received deduction is disallowed if the 
taxpayer has held the stock for 45 days or less during the 90-
day period beginning on the date that is 45 days before the 
date on which such share becomes ex-dividend with respect to 
such dividend. In the case of certain preferred stock, the 
dividends received deduction is disallowed if the taxpayer has 
held the stock for 90 days or less during the 180-day period 
beginning on the date which is 90 days before the date on which 
such share becomes ex-dividend with respect to such dividend. 
The holding period generally does not include any period during 
which the taxpayer has a right or obligation to sell the stock, 
or is otherwise protected from the risk of loss otherwise 
inherent in the ownership of an equity interest. If an 
instrument was treated as stock for tax purposes, but provided 
for payment of a fixed amount on a specified maturity date and 
afforded holders the rights of creditors to enforce such 
payment, the Internal Revenue Service has ruled that no 
dividends-received deduction would be allowed for distributions 
on the instrument.\235\
---------------------------------------------------------------------------
    \235\ See Rev. Rul. 94-28, 1994-1 C.B. 86.
---------------------------------------------------------------------------
    The Taxpayer Relief Act of 1997 amended sections 351, 354, 
355, 356 and 1036 to treat ``nonqualified preferred stock'' as 
boot in corporate transactions, subject to certain exceptions. 
Nonqualified preferred stock is defined in section 351(g) as 
preferred stock that does not participate (through a conversion 
privilege or otherwise) in corporate growth to any significant 
extent, if (1) the holder has the right to require the issuer 
or a related person to redeem or purchase the stock, (2) the 
issuer or a related person is required to redeem or purchase 
the stock, (3) the issuer or a related person has the right to 
redeem or purchase the stock and, as of the issue date, it is 
more likely than not that such right will be exercised, or (4) 
the dividend rate on the stock varies in whole or in part 
(directly or indirectly) with reference to interest rates, 
commodity prices, or similar indices, regardless of whether 
such varying rate is provided as an express term of the stock 
(as in the case of adjustable rate stock) or as a practical 
result of other aspects of the stock (as in the case of auction 
rate stock). For this purpose, clauses (1), (2), and (3) apply 
if the right or obligation may be exercised within 20 years of 
the issue date and is not subject to a contingency which, as of 
the issue date, makes remote the likelihood of the redemption 
or purchase.

                        Description of Proposal

    Except in the case of ``qualifying dividends,'' the 
dividends-received deduction would be eliminated for dividends 
on nonqualified preferred stock (as defined in section 351(g)).
    No inference regarding the present-law tax treatment of the 
above-described stock is intended by this proposal.

                             Effective Date

    The proposal would apply to stock issued on or after the 
date of enactment.

                              Prior Action

    A substantially similar proposal was included in the 
President's fiscal year 1998 budget proposal.

                                Analysis

    This proposal would deny the dividends-received deduction 
to preferred stock that is treated as taxable consideration (or 
``boot'') in certain otherwise non-taxable corporate 
reorganizations and restructurings.
    It is arguable that stock with the particular 
characteristics identified in the proposal is sufficiently free 
from risk and from participation in corporate growth that it 
should be treated as debt for certain purposes, including 
denial of the dividends received deduction. Many of the types 
of stock described in the proposal are traditionally marketed 
to corporate investors (or can be tailored or designed for 
corporate investors) to take advantage of the dividends 
received deduction.
    As one example, so called ``auction rate'' preferred stock 
has a mechanism to reset the dividend rate on the stock so that 
it tracks changes in interest rates over the term of the 
instrument, thus diminishing any risk that the ``principal'' 
amount of the stock would change if interest rates changed. 
Although it is theoretically possible (and it has sometimes 
occurred) that an auction will ``fail'' (i.e., that a dividend 
rate will not be achieved in the auction that maintains the 
full value of principal of the investment), this has occurred 
extremely rarely in actual practice. Investors may view such 
stock as similar to a floating rate debt instrument.
    In addition to section 351(g) which treats the type of 
stock addressed here as ``boot'' for purposes of certain 
otherwise tax-free transactions, the Code in various places 
treats certain non-participating preferred stock differently 
from other stock. For example, certain preferred stock that 
does not participate to any significant extent in corporate 
growth does not count as stock ownership in determining whether 
two corporations are sufficiently related to file consolidated 
returns; also such stock does not count in determining whether 
there has been a change of ownership that would trigger the 
loss limitation rules of Code section 382.
    On the other hand, some argue that a relatively low level 
of risk and participation in growth, or expectation of 
termination of the instrument at a particular time, should not 
be factors governing the availability of the dividends received 
deduction. Furthermore, it is argued that if this type of 
instrument is viewed as sufficiently debt-like, then it should 
be classified as debt for all tax purposes, rather than merely 
subjected to several detrimental non-stock consequences.

             D. Provisions Affecting Pass-Through Entities

1. Require partnership basis adjustments upon distributions of property 
        and modify basis allocation rules

                              Present Law

In general

    The partnership provisions of present law generally permit 
partners to receive distributions of partnership property 
without recognition of gain or loss (sec. 731).\236\ Rules are 
provided for determining the basis of the distributed property 
in the hands of the distributee, and for allocating basis among 
multiple properties distributed, as well as for determining 
adjustments to the distributee partner's basis in its 
partnership interest. Property distributions are tax-free to a 
partnership. Adjustments to the basis of the partnership's 
remaining undistributed assets are not required unless the 
partnership has made an election that requires basis 
adjustments both upon partnership distributions and upon 
transfers of partnership interests (sec. 754).
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    \236\ Exceptions to this nonrecognition rule apply: (1) when money 
(and the fair market value of marketable securities) received exceeds a 
partner's adjusted basis in the partnership interest (sec. 731(a)(1)); 
(2) when only money, inventory and unrealized receivables are received 
in liquidation of a partner's interest and loss is recognized (sec. 
731(a)(2)); (3) to certain disproportionate distributions involving 
inventory and unrealized receivables (sec. 751(b)); and (4) to certain 
distributions relating to contributed property (secs. 704(c) and 737). 
In addition, if a partner engages in a transaction with a partnership 
other than in its capacity as a member of the partnership, the 
transaction generally is considered as occurring between the 
partnership and one who is not a partner (sec. 707).
---------------------------------------------------------------------------

Partner's basis in distributed properties and partnership interest

    Present law provides two different rules for determining a 
partner's basis in distributed property, depending on whether 
or not the distribution is in liquidation of the partner's 
interest in the partnership. Generally, a substituted basis 
rule applies to property distributed to a partner in 
liquidation. Thus, the basis of property distributed in 
liquidation of a partner's interest is equal to the partner's 
adjusted basis in its partnership interest (reduced by any 
money distributed in the same transaction) (sec. 732(b)).
    By contrast, generally, a carryover basis rule applies to 
property distributed to a partner other than in liquidation of 
its partnership interest, subject to a cap (sec. 732(a)). Thus, 
in a non-liquidating distribution, the distributee partner's 
basis in the property is equal to the partnership's adjusted 
basis in the property immediately before the distribution, but 
not to exceed the partner's adjusted basis in its partnership 
interest (reduced by any money distributed in the same 
transaction). In a non-liquidating distribution, the partner's 
basis in its partnership interest is reduced by the amount of 
the basis to the distributee partner of the property 
distributed and is reduced by the amount of any money 
distributed (sec. 733).
    Present law does not provide for a partial liquidation of a 
partnership interest. A distribution that is not in complete 
liquidation of a partner's interest is treated as a current 
distribution, even if the distribution has the effect of 
reducing the partner's interest in the partnership.

Allocating basis among distributed properties

    In the event that multiple properties are distributed by a 
partnership, present law provides allocation rules for 
determining their bases in the distributee partner's hands. An 
allocation rule is needed when the substituted basis rule for 
liquidating distributions applies, in order to assign a portion 
of the partner's basis in its partnership interest to each 
distributed asset. An allocation rule is also needed in a non-
liquidating distribution of multiple assets when the total 
carryover basis would exceed the partner's basis in its 
partnership interest, so a portion of the partner's basis in 
its partnership interest is assigned to each distributed asset.
    Present law allocates basis first to unrealized receivables 
and inventory items in an amount equal to the partnership's 
adjusted basis (or if the total basis to be allocated is less 
than partnership basis, then by first reducing basis in 
proportion to any unrealized depreciation in the assets and 
then reducing basis in proportion to their adjusted bases), and 
then among other properties. Basis is allocated among the other 
assets first to the extent of each distributed property's 
adjusted basis to the partnership. Any remaining basis 
adjustment, if an increase, is allocated among properties with 
unrealized appreciation in proportion to their respective 
amounts of unrealized appreciation, and then in proportion to 
their respective fair market values. If the remaining basis 
adjustment is a decrease, it is allocated among properties with 
unrealized depreciation in proportion to their respective 
amounts of unrealized depreciation, and then in proportion to 
respective adjusted bases.\237\
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    \237\ A special rule allows a partner that acquired a partnership 
interest by transfer within two years of a distribution to elect to 
allocate the basis of property received in the distribution as if the 
partnership had a section 754 election in effect (sec. 732(d)). The 
special rule also allows the Service to require such an allocation 
where the value at the time of transfer of the property received 
exceeds 110 percent of its adjusted basis to the partnership (sec. 
732(d)). Treas. Reg. sec. 1.732-1(d)(4) generally requires the 
application of section 732(d) where the allocation of basis under 
section 732(c) upon a liquidation of the partner's interest would have 
resulted in a shift of basis from non-depreciable property to 
depreciable property. In the preamble to the proposed regulations under 
section 732, comments were requested as to whether these rules are 
still necessary in light of the changes made to section 732(c) in the 
Taxpayer Relief Act of 1997. See REG 209682-94, 1998-17 I.R.B. 20, 26.
---------------------------------------------------------------------------

Partnership's basis in remaining undistributed assets

    No gain or loss is recognized to a partnership on the 
distribution of property (sec. 731(b)). Nevertheless, no 
adjustment is required to a partnership's basis in its 
remaining undistributed assets, following a distribution of 
property to a partner, unless the partnership has an election 
under section 754 of the Code in effect.
    An electing partnership decreases the basis of its 
remaining property to take account of any increase in the basis 
in the distributee partner's hands, compared to the basis the 
partnership had in the property. This preserves future taxation 
to the other partners to the extent built-in gain was 
eliminated in the hands of the distributee partner, who in a 
liquidating distribution takes a substituted basis in the 
distributed property and will never, therefore, be taxed on 
that built-in gain. The amount of the decrease in the basis of 
remaining partnership property equals (1) the excess of the 
distributee's basis in the distributed property over the 
partnership's adjusted basis in the distributed property 
immediately before the distribution, plus (2) the amount of any 
loss recognized by the distributee partner.\238\
---------------------------------------------------------------------------
    \238\ The general rule is that loss is not recognized by a 
distributee partner on a distribution of partnership property, except 
that a loss may be recognized in a liquidating distribution consisting 
of nothing other than money, unrealized receivables and inventory.
---------------------------------------------------------------------------
    Similarly, an electing partnership increases the basis of 
its remaining property to take account of the extent to which 
the distributee's basis is less than the partnership's basis 
was in the same property. This preserves a future loss (or 
reduces a future gain) for the other partners, and can arise in 
a liquidating or non-liquidating distribution where the 
distributee partner's basis in its partnership interest is less 
than the partnership's total adjusted basis in the distributed 
properties. The amount of the increase in the basis of 
remaining partnership property equals (1) the excess of the 
adjusted basis of the distributed property to the partnership 
immediately before the distribution, over the basis of the 
distributed property to the distributee partner, plus (2) the 
amount of gain recognized by the distributee partner on the 
distribution.\239\
---------------------------------------------------------------------------
    \239\ Generally, gain is not recognized to a distributee partner, 
except to the extent that any money and the fair market value of 
marketable securities distributed exceeds the adjusted basis of its 
partnership interest immediately before the distribution.
---------------------------------------------------------------------------

Allocating basis among partnership's remaining assets

    For purposes of allocating basis to remaining partnership 
assets following a distribution of property by an electing 
partnership, increases and decreases are divided into two 
categories: (1) capital assets and property used in the trade 
or business; and (2) other assets (sec. 755(b)). Adjustments 
are made to partnership property in the same category as that 
of the distributed property giving rise to the adjustment 
(Treas. reg. sec. 1.755-1(b)(1)).
    Within each category of assets, adjustments are made among 
the assets so as to reduce proportionately the difference 
between the fair market value and the adjusted basis of each 
asset in the category. If the adjustment increases basis, 
assets with an adjusted basis in excess of value are not 
adjusted, and if the adjustment decreases basis, assets with a 
value in excess of adjusted basis are not adjusted (Treas. Reg. 
sec. 1.755-1(a)(1)(ii) and (iii)). The basis of an asset cannot 
be reduced below zero. If an adjustment is allocated to a 
category of property in which the partnership has no property, 
or if a negative adjustment cannot be fully absorbed by the 
basis of property in the category, the adjustment is applied to 
subsequently acquired property in the category (sec. 755(b) and 
Treas. Reg. sec. 1.755-1(b)(3)). Under these rules, it is 
possible that a required basis adjustment might never be 
applied to any property held by the partnership.\240\
---------------------------------------------------------------------------
    \240\ In January, 1998, the Treasury Department proposed 
regulations which would modify the basis allocation rules of section 
755 when there is a distribution of partnership property. Prop. Reg. 
sec. 1.755-1(c).
---------------------------------------------------------------------------

Treatment as an exchange

    Under present law, distributions by a partnership in which 
a partner receives substantially appreciated inventory and 
unrealized receivables in exchange for his interest in other 
partnership property (or receives other property in exchange 
for substantially appreciated inventory) are treated as a 
taxable exchange of property, rather than as a nontaxable 
distribution (sec. 751(b)). For this purpose, inventory 
generally is treated as substantially appreciated if the value 
of the partnership's inventory exceeds 120 percent of its 
adjusted basis.

Tax-free liquidation of corporate subsidiary

    Present law generally provides that no gain or loss is 
recognized on the receipt by a corporation of property 
distributed in complete liquidation of another corporation in 
which it holds 80 percent of the stock (by vote and value) 
(sec. 332). The basis of property received by a corporate 
distributee in the distribution in complete liquidation of the 
80-percent-owned subsidiary is a carryover basis, i.e., the 
same as the basis in the hands of the subsidiary (provided no 
gain or loss is recognized by the liquidating corporation with 
respect to the distributed property) (sec. 334(b)).
    If corporate stock is distributed by a partnership to a 
corporate partner with a low basis in its partnership interest, 
the basis of the stock is reduced in the hands of the partner 
so that the stock basis equals the distributee partner's 
adjusted basis in its partnership interest. No comparable 
reduction is made in the basis of the corporation's assets, 
however. The effect of reducing the stock basis can be negated 
by a subsequent liquidation of the corporation under section 
332.\241\
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    \241\ In a similar situation involving the purchase of stock of a 
subsidiary corporation as replacement property following an involuntary 
conversion, the Code generally requires the basis of the assets held by 
the subsidiary to be reduced to the extent that the basis of the stock 
in the replacement corporation itself is reduced (sec. 1033).
---------------------------------------------------------------------------

                        Description of Proposal

In general

    The proposal would make mandatory the currently elective 
adjustments to the basis of partnership properties following a 
liquidating distribution to a partner. Second, the proposal 
would modify the calculation of the adjustments to better 
achieve an appropriate measure of the aggregate amount of 
remaining gain or loss. Third, the proposal would modify the 
manner in which the basis is allocated among both the 
distributed and the retained assets. The proposal also would 
treat partial liquidations as if a portion of a partner's 
interest were liquidated. Further, the proposal would repeal 
the rule of section 751(b) treating certain distributions as 
exchanges. Finally, the proposal would require a reduction in 
the basis of a corporation's assets following certain 
distributions of the corporation's stock.

Basis adjustment to partnership property

    In the case of a distribution of property (including money) 
to a partner in complete or partial liquidation of its 
partnership interest, the partnership would be required to 
adjust the basis of its undistributed partnership property.
    Under the proposal, the partnership would increase the 
basis of its undistributed partnership property by the excess 
(if any) of (1) the amount of money and adjusted basis of 
property distributed over (2) the amount by which the 
distributee partner's share of the partnership's adjusted basis 
in partnership property and money (immediately before the 
distribution) is reduced by reason of the distribution. 
Likewise, the partnership would reduce its basis in its 
undistributed property by the excess (if any) by which the 
amount described in (2) exceeds the amount described in (1). 
Thus, for example, assume a partnership has $11,000 cash, 
property with a basis of $19,000 and a value of $22,000, and no 
liabilities. Assume that A receives the $11,000 cash in 
liquidation of his entire one-third interest in the 
partnership. Under the proposal, the partnership basis in its 
undistributed property would be increased by $1,000 (the excess 
of $11,000 distributed over $10,000 (A's one-third share of the 
partnership's basis in its property)) to $20,000.\242\
---------------------------------------------------------------------------
    \242\ These are the facts in Example (1) in Treas. Reg. sec. 1.734-
1(b)(1). Unlike present law, the $1,000 amount of adjustment is not 
dependent upon A's adjusted basis in the partnership.
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    The allocation of the basis adjustments among properties 
would be made under rules similar to the rules applicable to 
adjustments made to the basis of distributed property. Under 
the proposal, adjustments would be made to nondepreciable 
capital assets. A nondepreciable capital asset would mean 
property other than inventory, unrealized receivables, other 
property that would generate ordinary income on sale (e.g., 
marketable stock in a passive foreign investment company (sec. 
1296(c))), and property of a character subject to an allowance 
for depreciation, amortization, or depletion. If a positive 
adjustment could not be made because the partnership holds no 
nondepreciable capital assets, the partnership would be treated 
as recognizing a long-term capital loss in the amount of the 
required adjustments. If a negative adjustment could not be 
made because the partnership holds no nondepreciable capital 
assets or has insufficient basis in such capital assets, then 
adjustments would be made to the basis of other property in the 
amount of the prevented adjustments. The adjustments would be 
made first to the depreciable assets of the partnership, and if 
there is insufficient basis in those assets, then to the 
remaining assets of the partnership. If a negative adjustment 
could not be made because the partnership has insufficient 
basis in assets (other than money), the partnership would be 
treated as recognizing a long-term capital gain in the amount 
of the prevented adjustments. Within each category of property, 
adjustments would be made first to reduce proportionately the 
difference between fair market value and adjusted basis of each 
asset. Additional positive adjustments would be made in 
proportion to the fair market value of each asset and 
additional negative adjustments would be made in proportion to 
the adjusted basis of each property.
    Special rules would apply to tiered partnerships.

Allocation of basis among distributed properties

    The proposal would modify the present-law rule allocating 
basis adjustments among the distributed properties received by 
a partner (sec. 732(c)).
    First, depreciable property would be treated in the same 
manner that unrealized receivables and inventory are presently 
treated. Thus, allocations would be made first to 
nondepreciable capital assets. Similarly with present law, if 
no nondepreciable capital assets are distributed, loss from the 
sale or exchange of the partnership interest would be 
recognized in the amount of any positive adjustments which 
cannot be made, and if there is insufficient basis in 
nondepreciable capital assets to make required negative 
adjustments, negative adjustments would be made to property 
other than nondepreciable capital assets, being applied first 
to depreciable assets, and then to the remaining assets.

Treatment of partial liquidations

    The proposal would provide that the distribution rules 
applicable to complete liquidations of partnership interests 
also would apply to partial liquidations. A distribution in 
partial liquidation would be defined as a distribution that 
reduces the distributee partner's percentage share in 
partnership capital (resulting from the distribution or a 
series or related distributions). The portion of the 
partnership interest reduced would be treated as a separate 
interest in determining gain or loss and the basis of the 
distributed property to the partner. For example, assume that 
partner A, with a partnership basis of $100, receives a 
distribution of property with an adjusted basis to the 
partnership of $60. A's interest in the partnership is reduced 
by one-half as a result of the distribution. Under the bill, 
the distribution would be treated as a liquidation of an 
interest of A with a basis of $50. A's basis in the distributed 
property would be $50, and A's basis in his remaining 
partnership interest would be $50 (as opposed to $60 basis in 
distributed property and $40 basis in A's partnership interest 
under present law).\243\
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    \243\ Under the proposal described previously, the partnership 
would have a basis adjustment to its undistributed properties to the 
extent that the $60 basis in the distributed property differed from the 
reduction of A's distributive share of the adjusted basis of 
partnership property by reason of the distribution.
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Section 751(b)

    The proposal would repeal the rule of section 751(b) 
treating certain distributions as sales or exchanges.

Acquisition of subsidiary corporation

    The proposal would require that if stock is distributed to 
a corporate partner and after the distribution (and taking into 
account related transactions), the corporation controls the 
distributed corporation, then the distributed corporation must 
reduce the basis of its assets by the same amount by which the 
basis of the stock is reduced, using the same allocation 
method.

                             Effective Date

    The proposal would apply to partnership distributions on or 
after the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    Under present law, the failure to require a partnership to 
make basis adjustments following a distribution of property to 
a partner may result in excessive basis.\244\ This occurs 
because one partner may take out relatively low basis property 
which is properly ``stepped up'' to its basis in its 
partnership interest, while leaving an excessive amount of 
basis in the remaining partnership properties, which may reduce 
the remaining partners' gain or create a loss when the 
properties are sold by the partnership. Similar transactions 
outside the partnership area require appropriate basis 
adjustments to prevent the creation of basis.\245\
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    \244\ These deficiencies have been noted by commentators. See, for 
example, W. Andrews, ``Inside Basis Adjustments and Hot Asset Exchanges 
in Partnership Distributions,'' 47 Tax Law Review, 3 (Fall, 1991); Noel 
Cunningham, ``Needed Reform; Tending the Sick Rose,'' 47 Tax Law 
Review, 77 (Fall, 1991); Freeman and Stephens, ``Using a Partnership 
When a Corporation Won't Do: The Strategic Use and Effects of 
Partnerships to Conduct Joint Ventures and Other Major Business 
Activities,'' 68 Taxes, 962 (Dec. 1990). See also Joint Committee on 
Taxation, Review of Selected Entity Classification and Partnership Tax 
Issues (JCS-6-97), April 8, 1997, pp. 27-40.
    \245\ See, for example, section 1031(d), relating to basis 
adjustments in like-kind exchanges.
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    The present-law formula for measuring the amount of the 
adjustments, if an election under section 754 is in effect, is 
imperfect. If a partner's basis in its partnership interest is 
not the same as its interest in the partnership assets, too 
large or too small an adjustment is made.\246\ In an 
inflationary economy, the imperfection will tend to result in 
too small a basis adjustment. Suggestions to correct this 
defect have been previously made.\247\
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    \246\ This can occur where a partnership interest was transferred 
before the section 754 election was made.
    \247\ In 1974, the Tax Section of the American Bar Association 
recommended that the amount of the adjustment be determined using the 
approach in the Treasury proposal. Recommendation #1974-9.
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    The Administration proposal would prevent the increase in 
the basis of depreciable property in the same way that 
distributed inventory and unrealized receivables may not be 
stepped up under present law. This will tend to cause more 
basis to be allocated to capital assets, such as stock or land. 
This may result in it being easier to create a capital loss, 
which in the case of a corporation may offset capital gain 
which is taxed at the same rate as ordinary income. There is no 
perfect method of allocating basis. The Administration proposal 
would make it more difficult than under present law to create 
depreciation deductions, but easier to create capital losses. 
In lieu of permitting a capital loss, or allocating basis to 
depreciable assets, in the case in which a partnership basis 
adjustment cannot be made to the right category of asset, an 
alternative could be to suspend the amount of the adjustment 
for a period of time, or until the partnership acquires 
property of that type or completely liquidates.
    The Administration proposal would treat the liquidation of 
a portion of a partner's capital account in the same manner as 
if that part of the account were held by a separate partner. 
This would equalize the tax results in cases in which the 
interests were held by one person or by more than one person. 
Thus, advocates argue, providing for partial liquidation of a 
partnership interest permits greater accuracy and fairness than 
does present law. On the other hand, introducing the concept of 
partial liquidation would require the partnership to determine 
the reduction in capital accounts upon the partial liquidation 
of a partner's interest. This part of the proposal could be 
criticized as overly burdensome relative to the gain in 
accuracy, if a partnership is required to treat as a partial 
liquidation every non-pro rata distribution to partners. It 
could be argued that a de minimis rule might address this point 
(for example, the distribution would not be treated as a 
partial liquidation if only a tiny fraction of the partner's 
capital interest, or a small dollar value were distributed), 
but it would still be necessary for the partnership to 
determine whether the de minimis rule applied or not to a 
particular distribution.
    The Administration proposal would repeal the exchange rule 
of section 751(b). This rule has universally been criticized 
for its complexity.\248\ The repeal of the rule would allow the 
distribution of ordinary income assets to some partners and the 
distribution of capital assets to other partners, so that on a 
subsequent sale of the assets, some partners will recognize 
ordinary income and others capital gain. Advocates of repeal 
argue the rule would no longer be needed, because the proposal 
also would prevent the reduction of the total amount of 
ordinary income by preventing the basis of the partnership's 
ordinary income assets from being increased.
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    \248\ For example, the American Law Institute, Federal Income Tax 
Project: Subchapter K: Proposals on the Taxation of Partners (R. Cohen, 
reporter, 1984) recommended the repeal of section 751(b); see also 
Brannan, ``The Subchapter K Reform Act of 1997,'' 75 Tax Notes 121, 136 
(Apr. 7, 1997).
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    Nevertheless, the basis proposal would not address 
instances of conversion of ordinary income to capital gain for 
specific partners that are addressed by section 751(b). In 
addition, it could be said that the repeal of section 751(b) is 
not a necessary corollary to the basis proposal, so need not be 
connected to it.
    Finally, the Administration proposal would require a 
subsidiary corporation to reduce the basis of its assets by the 
amount in which the distributee corporate partner reduced the 
basis in its stock. This would eliminate the tax benefits to a 
transaction in which assets are contributed to a corporation 
and the stock of the corporation is distributed, followed by a 
subsequent liquidation of the corporation. The proposal would 
be consistent with the rules recently enacted requiring basis 
reduction by a subsidiary corporation following the acquisition 
of stock in the subsidiary corporation as replacement property 
following an involuntary conversion.

2. Modify structure of businesses indirectly conducted by REITs

                              Present Law

    Real estate investment trust (``REITs'') are treated, in 
substance, as pass-through entities under present law. Pass-
through status is achieved by allowing the REIT a deduction for 
dividends paid to its shareholders. REITs' are restricted to 
investing in passive investments primarily in real estate and 
securities. Specifically, a REIT is required to receive at 
least 95 percent of its income from real property rents and 
from securities. A REIT is limited in the amount that it can 
own in other corporations. Specifically, a REIT cannot own more 
than 10 percent of the voting securities of any corporate 
issuer nor can more than 5 percent of its assets be stock of a 
single corporation.

                        Description of Proposal

    The proposal would modify the 10-percent requirement of 
present law so a REIT generally would be prohibited from owning 
more than 10 percent of the vote or value of any issuer. The 
proposal would provide, however, an exception to this general 
rule for two newly described subsidiaries to be known as 
``qualified independent contractor subsidiaries'' or 
``qualified business subsidiaries.''
    A ``qualified business subsidiary'' would be permitted to 
undertake activities such as management and development to 
entities that were not tenants of the REIT. A ``qualified 
independent contractor subsidiary'' would be allowed to perform 
non-customary and other currently prohibited services to the 
tenants of the REIT.
    The combined value of all ``qualified independent 
contractor subsidiaries'' or ``qualified business 
subsidiaries'' could not be more than 15 percent of the total 
value of a REIT's assets, nor may more than five percent of the 
value of the REITs assets consist of qualified independent 
contractor subsidiaries. ``Qualified independent contractor 
subsidiaries'' or ``qualified business subsidiaries'' would not 
be entitled to a deduction for any interest paid directly or 
indirectly to the REIT. A 100-percent excise tax would be 
imposed on any payments made by ``qualified independent 
contractor subsidiaries'' or ``qualified business 
subsidiaries'' for services provided to the REIT or its tenants 
in excess of their arm's length value or for any expenses 
shared between the REIT and its subsidiaries. ``Significant 
limits'' would be placed on intercompany rentals between the 
REIT and its taxable subsidiaries and certain additional 
limitations would apply.

                             Effective Date

    The proposal generally would be effective on the date of 
enactment. Transition rules would be provided that would permit 
REITs to combine and convert preferred stock subsidiaries into 
taxable subsidiaries on a tax-free basis prior to a future 
date. The revision of the 10-percent test also would be delayed 
until that date. Non-REIT holders of any stock in a preferred 
stock subsidiary would recognize taxable gain to the extent 
that they receive consideration other than stock in the REIT 
for their interest in the preferred stock subsidiary.

                              Prior Action

    A related provision in the President's fiscal year 1999 
budget proposal would have modified the rules limiting REIT 
ownership of corporate stock, but that proposal did not contain 
the qualified business subsidiary provisions of this proposal.

                                Analysis

    The Administration proposal reflects a concern that REITs 
currently may be deriving significant income from business that 
could not be directly conducted by the REIT, through ownership 
of business corporations (i.e., preferred stock subsidiaries) 
that perform active businesses. The Administration proposal 
also indicates a concern that revenues from such active 
businesses may be extracted by the REIT in the form of interest 
or other payments that are deductible by the C corporation and 
taxed only at a single level through the REIT, thus escaping 
corporate level tax entirely. There also may be difficulty for 
the IRS and REITs in determining the scope of permissible REIT 
services.
    The proposal would permit REITs to use a subsidiary 
structure to perform certain types of business activities. The 
proposal would limit the extent of REIT involvement in such 
activities by permitting no more than a limited amount of the 
value of REIT assets to be in the form of stock of such active 
business entities. Furthermore, the proposal seeks to improve 
corporate level tax collection with respect to revenues of such 
businesses by prohibiting the subsidiary from deducting 
interest on debt directly or indirectly funded by the REIT, 
placing ``significant limits'' on intercompany rentals, and 
imposing an excise tax on ``excess payments'' in an attempt to 
police arm's length payments and sharing of expenses.
    Proponents of the proposal contend that REITs should be 
permitted to perform at least some independent contractor 
services for REIT related property and to engage in limited 
third party management services. At the same time, some may 
contend that corporate level tax collection from such business 
activities might improve under the proposal, due to the denial 
of direct or indirect interest payments and imposition of other 
limitations including the proposed excise tax.
    Others would contend, however, that the proposed interest 
limitations and excise tax may be insufficient to police the 
tendency for related party REIT and C corporation entities to 
allocate income and expenses in a manner that reduces the value 
and taxable income of the C corporation while directly or 
indirectly benefitting the REIT through the C corporation's 
business activities.\249\
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    \249\ For example, Code section 269B addressing stapled entities 
takes the approach that related entities are treated as one. Such an 
approach reflects the perceived difficulty of enforcing allocations. A 
parent subsidiary relationship is effectively similar to a paired share 
structure.
---------------------------------------------------------------------------
    The concept of ``direct or indirect'' interest payments has 
proved difficult to administer in other areas. For example, a 
similar standard in section 265 has been revised in the past in 
certain contexts; and a further proposed revision is contained 
in a different Administration proposal.
    Imposition of the excise tax would not prohibit the 
tendency to move consistently to the highest end of any range 
of potentially ``arm's length'' transactions in cases where 
such range could be identified. In addition, it may be 
difficult to identify such a range. In many situations 
involving real estate, where rental or other payments might be 
based on unique aspects such as particular values or revenues 
of a specific property, arm's length comparisons may be 
difficult to establish or to challenge. The area of shared 
expenses may be particularly difficult to police. Some shared 
expenses may result in the parent and subsidiary collectively 
incurring less cost than would have been incurred if the REIT 
and its subsidiary had separately procured such items from 
unrelated persons who required an arm's length profit element 
to be retained in their hands. Determination of what portion of 
these savings should benefit the parent REIT or its taxable 
subsidiaries is especially problematic since such savings do 
not occur on an independent basis. Further, to the extent 
expenses or certain other items are shifted to the C 
corporation, the ``value'' of the REIT investment in that 
corporation may be technically diminished, raising questions 
regarding the effectiveness of the ``value'' limitations in the 
proposal.
    Imposition of the tax may also result in many controversies 
between the IRS and the REIT subsidiary regarding the exact 
amount of an arm's length transaction.\250\
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    \250\ The Administration proposal does not contain any safe-harbor 
rules in determining whether transactions are at arm's length and, as a 
result, imposition of the proposed excise tax technically requires a 
determination to the closest dollar of the extent to which every 
transaction between the REIT and its subsidiaries is an arm's length 
transaction.
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3. Modify treatment of closely-held REITs

                              Present Law

    In general, a real estate investment trust (``REIT'') is an 
entity that receives most of its income from passive real 
estate related investments and that receives pass-through 
treatment for income that is distributed to shareholders. If an 
electing entity meets the qualifications for REIT status, the 
portion of its income that is distributed to the investors each 
year generally is taxed to the investors without being 
subjected to tax at the REIT level.
    A REIT must satisfy a number of tests on a year-by-year 
basis that relate to the entity's: (1) organizational 
structure; (2) source of income; (3) nature of assets; and (4) 
distribution of income.
    Under the organizational structure test, except for the 
first taxable year for which an entity elects to be a REIT, the 
beneficial ownership of the entity must be held by 100 or more 
persons. Generally, no more than 50 percent of the value of the 
REIT's stock can be owned by five or fewer individuals during 
the last half of the taxable year. Certain attribution rules 
apply in making this determination.

                        Description of Proposal

    The proposal would impose as an additional requirement for 
REIT qualification that no person can own stock of a REIT 
possessing 50 percent or more of the combined voting power of 
all classes of voting stock or 50 percent or more of the total 
value of shares of all classes of stock. For purposes of 
determining a person's stock ownership, rules similar to 
attribution rules for REIT qualification under present law 
would apply (sec. 856(d)(5)). The proposal would not apply to 
ownership by a REIT of 50 percent or more of the stock (vote or 
value) of another REIT.

                             Effective Date

    The proposal would be effective for entities electing REIT 
status for taxable years beginning on or after the date of 
first committee action. Any entity that elects REIT status for 
a taxable year beginning prior to the date of first committee 
action will be subject to this proposal if it does not have 
significant business assets or activities as of such date.

                              Prior Action

    A similar provision was contained in the President's fiscal 
year 1999 budget. That prior provision differed from the 
present proposal in that (1) the limitation on ownership was 
more than 50 percent of vote or value of a REIT (rather than 50 
percent or more of vote or value), and (2) that proposal would 
not have affected any entity that elects REIT status for a 
taxable year beginning prior to the date of committee action. 
That proposal also did not contain an exception for REITs 
owning other REITs.

                                Analysis

    REITs allow individual investors to obtain a single level 
of tax on passive real estate investments, often in publicly-
traded entities. Present law requires that ownership interests 
must be held by at least 100 persons and that 5 or fewer 
individuals cannot own more than 50 percent of the value of the 
REIT. These ownership requirements indicate that Congress 
intended that REIT benefits not be available to closely-held 
entities. A REIT held largely by a single corporation does not 
meet this objective of Congress.
    It is clear that, under present law, it is unnecessary for 
a corporation to establish a separate real estate entity as a 
REIT in order to ensure that there is a single corporate level 
tax. If the separate entity is a corporation, the dividends-
received deduction and the benefits of consolidation can 
eliminate a second corporate tax. If the separate entity is a 
non-publicly-traded partnership or limited liability company, 
only one level of tax is imposed. The REIT rules were enacted 
earlier than most of the rules for other pass-through regimes 
and lack some of the more sophisticated rules of such regimes 
aimed at preventing unwarranted shareholder benefits. For 
example, the REIT rules contain no provisions to prevent REIT 
shareholders from structuring their interests in order to 
divide the income from the REIT's assets among themselves in a 
tax-motivated manner (cf. secs. 704(b) and (c) and 
1361(b)(1)(D)). Consequently, where REIT status is elected by 
an entity with a substantial corporate shareholder, a principal 
reason may be to take advantage of deficiencies in the REIT 
rules that have been the basis for several recently reported 
tax-motivated transactions.
    Congress may have believed that improper use of the REIT 
rules was limited by the restrictions on REIT ownership. The 
100-or-more shareholder requirement, and the rule that no more 
than 50 percent of the value of the REIT's stock can be owned 
by five or fewer individuals, generally require that REIT stock 
be widely held, with the result that it is less likely that 
shareholders will be able to agree on a structure designed to 
yield tax benefits for certain shareholders. However, present 
law does not contain a provision prohibiting ownership of large 
amounts of a REIT's stock by one or a few corporations.
    Several recent transactions have utilized REITs to obtain 
tax benefits for large corporate shareholders. In such 
transactions, the requirement that the REIT have 100 or more 
shareholders often may be met by having related persons (such 
as employees of the majority holder) acquire small amounts of 
stock. The most well-known of these was the so-called ``step-
down preferred'' transaction. In such a transaction, the REIT 
issued a class of preferred stock that paid disproportionately 
high dividends in the REIT's early years and ``stepped down'' 
to disproportionately low dividends in later years. Such stock 
might be sold to a tax-exempt entity. One or more corporate 
shareholders held the REIT's common stock and were in effect 
compensated for the preferred's dividend rights in the early 
years by the right to higher payments on, or liquidation 
proceeds with respect to, the common stock after the preferred 
dividends ``step down.'' These corporate shareholders generally 
funded the high dividends paid to the preferred shareholders by 
making deductible rent payments to the REIT for real property 
it leased to the corporate shareholders.\251\
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    \251\ The Treasury Department issued IRS Notice 97-21, 1997-11 
I.R.B. 9, which denies the benefits of a step-down preferred 
transaction based on a conduit analysis. The Treasury Department 
subsequently issued Proposed Regulations sec. 1.7701(l)-3, addressing 
such transactions.
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    The 50-percent or more rule of the proposal is also 
designed to reduce the ability of REITs and related C 
corporations to continue to engage in ``stapled stock'' 
structures that would otherwise result in single entity 
treatment under section 269B. For example, under present law 
there may be instances in which a C corporation owns more than 
50 percent of REIT stock and the remaining 49 percent of the 
REIT stock is stapled to the C corporation stock. Since no more 
than 49 percent of the C corporation stock would be stapled, 
the arrangement may not fall within the scope of section 269B 
even though no stock of the REIT is unrelated to the C 
corporation. Under the proposal, at least some portion of REIT 
stock would have to be unstapled to the C corporation.
    By preventing a shareholder from owning a 50-percent or 
greater interest in the REIT, the proposal would also 
substantially reduce the ability of a single shareholder or a 
small group of shareholders to utilize a REIT to achieve tax 
benefits based on their individual tax situations. One example 
of such use may be to place various assets in a REIT in order 
to obtain ``dividend'' treatment for income from the REIT where 
desired, even though the assets if held directly might produce 
a different form of income (e.g. interest income). However, the 
proposal may not prevent such structures entirely. For example, 
it still might be possible under the proposal for three 
corporations to acquire nearly all of the REIT's shares (with 
additional small shareholders to meet the 100-shareholder 
test).
    Opponents of the provision would argue that it adds 
complexity and in some cases would prevent legitimate business 
transactions. Because the proposal would prevent one 
shareholder from having a greater-than-50-percent interest by 
vote or value, it would be possible that a shareholder who 
initially did not violate this test subsequently may violate it 
due to a decline in the REIT's value. Under the proposal, the 
REIT apparently would become disqualified at such time. 
Similarly, the proposal could prevent a REIT's organizers from 
having a single large investor for a temporary period, such as 
in preparation for a public offering of the REIT's shares. 
Finally, the proposal may be criticized for adding complexity 
to the already complex REIT rules. For example, individual 
shareholders apparently would be subject to the proposal even 
though they also are subject to the present-law rule preventing 
five or fewer shareholders from owning more than 50 percent of 
a REIT's shares by value.

4. Repeal tax-free conversion of large C corporations to S corporations

                              Present Law

    The income of a corporation described in subchapter C of 
the Internal Revenue Code (a ``C corporation'') is subject to 
corporate-level tax when the income is earned and to 
individual-level tax when the income is distributed. The income 
of a corporation described in subchapter S of the Internal 
Revenue Code (an ``S corporation'') generally is subject to 
individual-level, but not corporate-level, tax when the income 
is earned. The income of an S corporation generally is not 
subject to tax when it is distributed to the shareholders. The 
tax treatment of an S corporation is similar to the treatment 
of a partnership or sole proprietorship.
    The liquidation of a subchapter C corporation generally is 
a taxable event to both the corporation and its shareholders. 
Corporate gain is measured by the difference between the fair 
market values and the adjusted bases of the corporation's 
assets. The shareholder gain is measured by the difference 
between the value of the assets distributed and the 
shareholder's adjusted basis in his or her stock. The 
conversion of a C corporation into a partnership or sole 
proprietorship is treated as the liquidation of the 
corporation.
    The conversion from C to S corporation status (or the 
merger of a C corporation into an S corporation) generally is 
not a taxable event to either the corporation or its 
shareholders.
    Present law provides rules designed to limit the potential 
for C corporations to avoid the recognition of corporate-level 
gain on shifting appreciated assets by converting to S 
corporation status prior to the recognition of such gains. 
Specifically, an S corporation is subject to a tax computed by 
applying the highest marginal corporate tax rate to the lesser 
of (1) the S corporation's recognized built-in gain or (2) the 
amount that would be taxable income if such corporation was not 
an S corporation (sec. 1374). For this purpose, a recognized 
built-in gain generally is any gain the S corporation 
recognizes from the disposition of any asset within a 10-year 
recognition period after the conversion from C corporation 
status, or any income that is properly taken into account 
during the recognition period that is attributable to prior 
periods. However, a gain is not a recognized built-in gain if 
the taxpayer can establish that the asset was not held by the 
corporation on the date of conversion or to the extent the gain 
exceeds the amount of gain that would have been recognized on 
such date. In addition, the cumulative amount of recognized 
built-in gain that an S corporation must take into account may 
not exceed the amount by which the fair market value of the 
corporation's assets exceeds the aggregated adjusted basis of 
such assets on the date of conversion from C corporation 
status. Finally, net operating loss or tax credit carryovers 
from years in which the corporation was a C corporation may 
reduce or eliminate the tax on recognized built-in gain.
    The amount of built-in gain that is subject to corporate-
level tax also flows through to the shareholders of the S 
corporation as an item of income subject to individual-level 
tax. The amount of tax paid by the S corporation on built-in 
gain flows through to the shareholders as an item of loss that 
is deductible against such built-in gain income on the 
individual level.

                        Description of Proposal

    The proposal would repeal section 1374 for large S 
corporations. A C-to-S corporation conversion (whether by a C 
corporation electing S corporation status or by a C corporation 
merging into an S corporation) would be treated as a 
liquidation of the C corporation followed by a contribution of 
the assets to an S corporation by the recipient shareholders. 
Thus, the proposal would require immediate gain recognition by 
both the corporation (with respect to its appreciated assets) 
and its shareholders (with respect to their stock) upon the 
conversion to S corporation status.
    For this purpose, a large S corporation is one with a value 
of more than $5 million at the time of conversion. The value of 
the corporation would be the fair market value of all the stock 
of the corporation on the date of conversion.
    In addition, the Internal Revenue Service would revise 
Notice 88-19 \252\ to conform to the proposed amendment to 
section 1374, with an effective date similar to the statutory 
proposal. As a result, the conversion of a large C corporation 
to a regulated investment company (``RIC'') or a real estate 
investment trust (``REIT'') would result in immediate 
recognition by the C corporation of the net built-in gain in 
its assets.
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    \252\ Notice 88-19, 1988-1 C.B. 486, allows C corporations that 
become RICs or REITs to be subject to rules similar to those of section 
1374, rather than being subject to the rules applicable to complete 
liquidations.
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                             Effective Date

    The proposal generally would be effective for subchapter S 
elections that become effective for taxable years beginning 
after January 1, 2000. Thus, C corporations would continue to 
be permitted to elect S corporation status effective for 
taxable years beginning in 1999 or on January 1, 2000. The 
proposal would apply to acquisitions (e.g., the merger of a C 
corporation into an existing S corporation) after December 31, 
1999.

                              Prior Action

    Similar proposals were included in the President's budget 
proposals for fiscal years 1997, 1998 and 1999.

                                Analysis

    The conversion of a C corporation to an S corporation may 
be viewed as the constructive liquidation of the C corporation 
because the corporation has changed from taxable status to 
pass-through status. The proposal would conform the tax 
treatment of such constructive liquidation to the tax treatment 
of an actual liquidation. Thus, the proposal would conform the 
treatment of the conversion from C corporation status to pass-
through entity status where the pass-through entity is an S 
corporation with the present-law treatment where the pass-
through entity is a partnership or a sole proprietorship.
    The proposal would eliminate some of the complexity of 
subchapter S under present law.\253\ The rules that trace C 
corporation built-in gain and C corporation earnings and 
profits generally would become unnecessary. In addition, the 
rules imposing corporate tax and the possible loss of S 
corporation status after the conversion due to excessive 
passive income also could be eliminated. However, these complex 
rules would continue to apply to small converting C 
corporations and it could be argued that these businesses are 
the least able to handle complexity.
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    \253\ A similar proposal was included in a letter to House Ways and 
Means Chairman Dan Rostenkowski from Ronald A. Pearlman, Chief of Staff 
of the Joint Committee on Taxation, recommending several tax 
simplification proposals. See, Committee on Ways and Means, Written 
Proposals on Tax Simplification (WMCP 101-27), May 25, 1990, p. 24.
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    The proposal would create some complexity, as it would 
require the valuation of C corporation stock to determine if 
the $5 million threshold has been exceeded and C corporation 
assets for purposes of determining the amount of gain on the 
constructive liquidation. However, valuations theoretically are 
required under present law because of the need to determine 
whether corporate tax may be due under the built-in gain 
tracing rules; it is possible that taxpayers may not perform 
the valuations for all assets in all cases, particularly if 
they believe that there is no aggregate net built-in gain, or 
if there is a possibility that built-in gain assets may not be 
disposed of within the present-law tracing period. It should be 
noted that the $5 million threshold creates a ``cliff'' where 
corporations valued at $5 million or less are not subject to 
tax while corporations valued at greater than $5 million would 
be subject to full taxation. It appears that rules would be 
required to address step transactions designed to avoid the 
proposal (e.g., where a series of C corporations, each under 
the $5 million cap, merge into an S corporation; or where a 
large C corporation divides into multiple entities so that some 
or all of the entities are under the $5 million cap). Another 
issue under the proposal is whether the stock of the 
corporation is to be valued immediately before the conversion 
(i.e., as C corporation stock subject to two levels of tax) or 
immediately after the conversion (i.e., as S corporation stock, 
subject to one level of tax).
    The proposal would create significant shareholder and 
corporate liquidity concerns for large C corporations planning 
on converting to S corporation status. Current businesses that 
organized as C corporations may have done so in anticipation of 
converting at a relatively low tax cost in the future. Not 
applying the proposal until taxable years beginning after 
January 1, 2000, addresses some, but not all, of these 
concerns.
    Finally, the proposal raises significant policy issues 
regarding the integrity of the separate corporation tax as 
opposed to integrating the corporate and individual tax 
regimes. More acutely, the proposal raises issues regarding the 
need for the continued existence of subchapter S in light of 
other developments. Recent IRS rulings with respect to the 
various State limited liability companies and the ``check-the-
box'' Treasury regulations \254\ have significantly expanded 
the availability of pass-through tax treatment for entities 
that accord their investors limited legal liability. These 
developments, coupled with the restrictive rules of subchapter 
S,\255\ have decreased the desirability of the subchapter S 
election for newly-formed entities. This proposal would 
decrease the desirability of the subchapter S election for 
existing C corporations. Thus, if the proposal were enacted, 
the primary application of subchapter S would be limited to 
existing S corporations and small converting corporations. At 
that point, one may question whether it is desirable to have a 
whole separate passthrough regime in the Code that pertains to 
a limited number of taxpayers. Any repeal of subchapter S would 
require rules providing for the treatment of existing S 
corporations.\256\
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    \254\ Treas. reg. secs. 301.7701-1,-2, and-3, issued in final form 
on December 17, 1996.
    \255\ For example, only domestic corporations with simple capital 
and limited ownership structures may elect to be S corporations.
    \256\ See, for example, the letter of July 25, 1995, from Leslie B. 
Samuels, Assistant Treasury Secretary (Tax Policy) to Senator Orrin 
Hatch, suggesting possible legislative proposals to allow S 
corporations to elect partnership status or to apply the check-the-box 
regulations to S corporations.
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                      E. Tax Accounting Provisions

1. Require IRS permission to change accounting methods

                              Present Law

Tax-free transactions

    Present law provides a number of ways in which assets or 
entire businesses may be transferred without the immediate 
recognition of gain or loss. Some of the most common of these 
tax-free transactions include contributions to a corporation in 
exchange for stock where the contributors are in control of the 
recipient corporation immediately after the exchange (sec. 
351), contributions to a partnership in exchange for an 
interest in the partnership (sec. 721), distributions in 
complete liquidation of a corporation (sec. 332), and certain 
exchanges of property for stock or securities in corporations 
pursuant to a plan of reorganization (sec. 361). Section 381 
provides rules allowing for the carryover of certain tax 
attributes, including accounting and inventory methods, in the 
case of the tax-free acquisition of assets of a corporation by 
another corporation under section 332, and most acquisitions 
under section 361. However, section 381 does not apply to tax-
free contributions under section 351. Further, no equivalent to 
section 381 exists for the tax-free contributions of assets to 
a partnership.

Methods of accounting

    A taxpayer is allowed to adopt any permissible method of 
accounting. A permissible method of accounting generally must 
(1) be used consistently, (2) clearly reflect the taxpayer's 
income, (3) not be prohibited to the taxpayer by the Code or 
regulations, and (4) be used in keeping the taxpayer's books 
and records.\257\ Once adopted, a method of accounting may not 
be changed without the consent of the Commissioner. While 
automatic consent is provided for certain changes, most 
accounting methods may not be changed without first applying 
for and obtaining the consent of the Commissioner to the 
change.
---------------------------------------------------------------------------
    \257\ A method of accounting generally will be considered used in 
keeping the taxpayer's books and records if the taxpayer can reconcile 
its books and records to the amounts disclosed on the tax return.
---------------------------------------------------------------------------
    Section 381 provides special rules that are applicable to 
certain nonrecognition (tax-free) transactions. In a 
nonrecognition transaction to which section 381 applies, an 
acquiring corporation must use the method of accounting that 
was used by the distributor or transferor corporation, unless 
different methods of accounting were used by the parties to the 
transaction. If different methods of accounting were used by 
the parties to the transaction, Treasury regulations generally 
provide that the acquiring corporation must adopt the principal 
method of accounting of the parties to the transaction. An 
acquiring corporation may use a method of accounting other than 
that required by section 381 and the regulations thereunder 
only if consent of the Commissioner is obtained.
     If the transaction does not involve the integration of 
separate trades or businesses, then each trade or business 
retains its accounting methods. If separate trades or 
businesses are to be integrated, but both parties to the 
transaction use the same method of accounting, that method will 
be the principal method. If, however, separate trades or 
businesses are to be integrated as part of the transaction, and 
the separate trades or businesses use different methods of 
accounting, the regulations provide specific rules for 
determining which method will be the principal method required 
to be used by the integrated business.
    The principal method of accounting is determined by 
comparing the adjusted bases of assets and gross receipts of 
each component trade or business to the transaction. If this 
comparison shows that component trades or businesses that use a 
common method of accounting have both (1) the greatest total of 
the adjusted bases of assets and (2) the greatest total of 
gross receipts, such method of accounting is the principal 
method of accounting. However, if one group using a method of 
accounting has the greatest total of adjusted bases of assets 
and a group using a different method has the greatest total of 
gross receipts, there is no principal method of accounting and 
the taxpayer is required to request that the Commissioner 
determine the appropriate method of accounting.\258\
---------------------------------------------------------------------------
    \258\ Treas. Regs. sec. 1.381(c)(4)-1(c)(2).
---------------------------------------------------------------------------
    Under present law, section 381 generally does not apply to 
the tax-free contribution of assets to a corporation described 
in section 351,\259\ or the tax-free contribution of assets to 
a partnership described in section 721. A corporation or 
partnership that receives assets in a section 351 or section 
721 transaction is required to continue to use its previously 
adopted methods of accounting, unless the consent of the 
Commissioner is obtained to change methods of accounting. If 
the recipient corporation or partnership is a new entity, or 
has not yet adopted a method of accounting, it is free to adopt 
any method of accounting provided the method (1) is used 
consistently, (2) is used in keeping its books and records, (3) 
clearly reflects its income, and (4) is not prohibited by the 
Code or regulations.
---------------------------------------------------------------------------
    \259\ Treas. Regs. sec. 1.1502-17 mandates the application of 
section 381 where the principal purpose of a section 351 transfer 
between members of a consolidated group is to effect a change in method 
of accounting.
---------------------------------------------------------------------------

Inventories

    Taxpayers are required to determine inventories whenever 
the production, purchase or sale of merchandise is a material 
income producing factor. The method the taxpayer uses in 
keeping inventories must conform as closely as possible to the 
best accounting practices in the trade or business and must 
clearly reflect income. Inventories of fungible items are 
generally determined using either the first-in, first-out 
(FIFO) method or the last-in, first-out (LIFO) method. 
Inventories may be priced under both the FIFO or LIFO methods 
in terms of units of goods (the specific goods method) or in 
terms of dollars (the dollar value method).
    If a taxpayer using the LIFO method purchases or produces 
more of a particular type of inventory than it sells in a given 
year, it creates a layer of inventory attributable to that 
year. The inventory in the layer will not be considered sold 
until the taxpayer sells more of that type of inventory than it 
purchases or produces in a later year. Growing businesses may 
establish inventory layers every year. If the cost of 
purchasing or producing an item of inventory consistently 
increases from year to year, the cost of items in older layers 
may be a fraction of the cost of purchasing or producing 
equivalent inventory in the current year. The gross income 
attributable to the sale of any item of inventory is equal to 
its selling price less its cost. Thus, higher taxable income 
will result if the item sold is considered to come from an 
older, lower cost layer than if the item sold is considered to 
come from a later, higher cost layer or from current purchases.
    Inventory that is received in a section 351 transaction 
must be accounted for using the inventory methods of the 
recipient company. If the recipient company is currently using 
LIFO and receives LIFO inventory of the same type, the layers 
established at the contributing company are carried over and 
integrated into the equivalent inventory layers of the 
recipient company.\260\ If, on the other hand, the recipient 
company is not using LIFO or is a new company that must adopt 
an inventory method, the inventory will be considered acquired 
at its average price in the hands of the contributing 
company.\261\
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    \260\ See Joseph E. Seagram & Sons v. Commissioner 394 F. 2d 738 
(2d Cir. 1968), reversing 46 T.C. 698 (1966).
    \261\ If inventory is considered to be acquired at its average 
price in the hands of the contributing company, the identity of the 
LIFO layers is lost. Any sales in the year of acquisition will be 
considered to come from a combination of current purchases and 
production and the LIFO layers. Assuming that costs have increased, 
this will result in an overall lower cost of sales and higher taxable 
income than would have been the case had the original LIFO layers been 
preserved.
---------------------------------------------------------------------------
    Under present law, it is not clear whether the transfer of 
LIFO inventory to a partnership in a section 721 transaction 
can result in the integration of existing layers into the 
recipient partnership's inventory.

Depreciation

    Special rules apply to methods of computing depreciation 
allowances. Section 168(i)(7) requires that a corporation or 
partnership that receives assets in a section 351 or section 
721 transaction be treated as the transferor for purposes of 
computing depreciation deductions with respect to so much of 
the basis of the property as does not exceed the basis of the 
property in the hands of the transferor. This ``step-in-the-
shoes'' approach has the same effect as requiring the 
transferee to use the transferor's method of accounting on that 
portion of the basis that is carried over. Additional basis, as 
may be the case when gain is recognized by the transferor due 
to the receipt of boot, is treated as a new asset that is 
placed in service on the date of acquisition. Depreciation on 
this portion of the asset may be accomplished by the use of 
different methods.

                        Description of Proposal

    The proposal would extend the application of the rules of 
section 381(c)(4) (regarding methods of accounting) to section 
351 and section 721 transactions. If the transferee is a new 
corporation or partnership (one that has not yet adopted its 
methods of accounting), it would be required to use the methods 
of accounting that were used by the transferring entity. An 
existing corporation or partnership could be required to change 
its methods of accounting to those of the transferring entity 
if the transferring entity's method of accounting were 
considered the integrated business' principal method of 
accounting.
    The proposal would also extend the application of the rules 
of section 381(c)(5) (regarding inventories) to section 351 and 
section 721 transactions. Similar to the extension of section 
381(c)(4), this could require an existing corporation or 
partnership to change its methods of keeping inventory to those 
of the transferring entity if the transferring entity's methods 
of keeping inventory were considered the integrated business' 
principal method. However, the proposal would also preserve 
LIFO inventory layers and allow them to be integrated into the 
inventory of the recipient entity, rather than treating them as 
acquired at average cost, assuming the recipient entity will be 
using LIFO. This could reduce the taxable income of the 
recipient company, compared to present-law treatment.
    The proposal would not modify the present-law rules 
regarding the methods that must be used to determine 
depreciation on property that is contributed in a section 351 
or 721 transaction.

                             Effective Date

    The proposal would be effective for transfers after the 
date of enactment.

                              Prior Action

    No prior action.

                                Analysis

Methods of accounting

    A taxpayer that is otherwise unable to obtain the consent 
of the Secretary to a change in its method of accounting may 
seek to circumvent the consent requirement by contributing the 
assets to a new or inactive corporation or partnership in a 
tax-free transaction under section 351 or section 721. Many 
commentators feel that it is not appropriate to allow taxpayers 
to circumvent the requirement that they obtain the consent of 
the Commissioner to changes in methods of accounting in this 
manner. They note that the consent requirement will support 
sound tax administration by permitting the Commissioner to 
review the proposed change in method of accounting to make 
certain that the change will be to a correct method, that no 
tax abuse will result from the change, and that the change will 
be made with the appropriate section 481(a) adjustment so that 
no items of income escape taxation and no items of expense are 
deducted twice. They also note that the consent requirement 
enables the Commissioner to insure taxpayer compliance with the 
clear reflection of income requirement.
    On the other hand, other commentators have expressed 
concern that the Commissioner sometimes may withhold consent to 
changes from one permissible method of accounting to a 
different permissible method, particularly where such change is 
beneficial to the taxpayer. They note that the Commissioner 
currently can disallow the use of the new method if the method 
does not clearly reflect the acquiring entity's income. They 
suggest that an opportunity to restructure in order to adopt 
new permissible methods of accounting is a necessary check on 
the Commissioner's authority in the accounting method area.
    The proposal also may create additional complexities in 
more complex section 351 or section 721 transactions. If a 
single company contributes assets to a new or inactive 
corporation in a section 351 transaction, it is not difficult 
to determine which methods of accounting would be required 
under the proposal. If multiple companies contribute several 
trades or businesses to a joint venture (whether operated as a 
partnership or a separate corporation), determining which 
method of accounting is the principal method of accounting 
under the section 381 regulations may be very complex. The 
application of the section 381 regulations may result in 
determining that there is no principal method of accounting, 
thus necessitating a determination by the Commissioner of which 
accounting methods will be used. This would introduce an 
additional level of uncertainty into the transaction.
    It should be noted that the present section 381 regulations 
are primarily designed to address the treatment of tax 
attributes in the tax-free combination of two or more active 
trades or businesses. It is not clear how or if the section 381 
regulations would be modified if they were to be expanded to 
include the transactions under section 351 and 721. In 
particular, it is not clear how the section 381 regulations 
would be intended to apply if one party to the transaction 
contributes assets that do not, in and of themselves, 
constitute a trade or business. If such assets are considered, 
their contribution to an active trade or business may force 
that acquiring company to change its methods of accounting to 
those of the contributing company. This may be appropriate in 
certain circumstances, such as when the contributing entity 
acquires most of the ownership of the receiving entity in the 
transaction. However, in other circumstances, it may not be 
appropriate for the receiving entity's accounting methods to be 
called into question.

Inventories

    Proponents of the proposal will argue that it facilitates 
the transfer of inventory by LIFO taxpayers in section 351 and 
section 721 transactions. Allowing LIFO inventory layers to be 
preserved and integrated into the recipient entity's inventory 
will preserve one of the essential benefits of the use of the 
LIFO method. Thus, the proposal will contribute to an accurate 
reflection of income in the same manner as the contributing 
entity's use of the LIFO method did.
    Opponents of the proposal will argue that requiring the 
acquiring taxpayer to maintain the LIFO layers created by the 
contributor will create additional record keeping burdens since 
a record of the layers and the underlying information 
supporting their valuation must be maintained. This may be 
particularly troublesome if the contributing company does not 
fully share its records relating to the inventory or the 
contributing and recipient entities use different systems of 
record retention. It may be appropriate to consider a taxpayer 
to elect to use an averaging convention where record keeping is 
considered too burdensome.

2. Repeal installment method for most accrual basis taxpayers

                              Present Law

    An accrual method taxpayer is generally required to 
recognize income when all events have occurred that fix the 
right to its receipt and its amount can be determined with 
reasonable accuracy. The installment method of accounting 
provides an exception to this general recognition principle by 
allowing a taxpayer to defer the recognition of income from the 
disposition of certain property until payment is received. 
Taxpayers (other than farmers and dealers in timeshares and 
residential lots) are not allowed to use the installment method 
for sales to customers in the ordinary course of business. 
Dealers in timeshares and residential lots must pay interest on 
any taxes deferred by use of the installment method.
    For sales in excess of $150,000, several rules limit the 
benefits of the installment method. If the amount of 
installment obligations that arose in, and remain outstanding 
at the end of, any year exceed $5 million, interest must be 
paid on the deferred tax attributable to the excess. Also, a 
pledge rule provides that if an installment obligation is 
pledged as security for any indebtedness, the net proceeds 
\262\ of such indebtedness are treated as a payment on the 
obligation, triggering the recognition of income. Actual 
payments received on the installment obligation subsequent to 
the receipt of the loan proceeds are not taken into account 
until such subsequent payments exceed the loan proceeds that 
were treated as payments.
---------------------------------------------------------------------------
    \262\ The net proceeds equal the gross loan proceeds less the 
direct expenses of obtaining the loan.
---------------------------------------------------------------------------
    For example, in 1999 a taxpayer (who is not in the trade or 
business of selling real estate) sells non-farm real property 
with a basis of $100 for $1,000, a gain of $900. At closing, 
the taxpayer receives $200 in cash and an $800 note bearing 
adequate interest that is due in 2002. In 2000, the taxpayer 
borrows $300, pledging the note as collateral. In 2001, the 
taxpayer receives a $300 prepayment on the note. The remainder 
of the note is paid when due in 2002.
    The accrual method would require the taxpayer to report the 
entire $900 gain in the year of sale, 1999. Under the 
installment method, the taxpayer only reports the portion of 
the gain equal to the percentage of the total sales price it 
has received. In this case, since the taxpayer has received 20 
percent of the sale price, it reports 20 percent of the gain 
(.2 X $900 = $180) in 1999.
    In 2000, this taxpayer is required to report an additional 
30 percent of the gain (.3 X $900 = $270), since the pledging 
of the note for the $300 loan is treated as a payment of $300 
on the installment obligation. Subsequent payments on the loan 
would not be taken into account until they exceed the amount 
($300) that was considered paid as a result of the pledge. 
Thus, this taxpayer would not report any gain as a result of 
the $300 prepayment in 2001. The final payment of the note in 
2002 causes the remaining portion of the deferred gain, $450, 
to be taken into income.
    A taxpayer who borrows money and pledges its installment 
obligation as security triggers the recognition of such 
installment obligation as if payment was received. However, it 
is not clear whether a taxpayer who borrows money and gives a 
put or similar right against its installment obligation as 
security for the loan also triggers recognition of the 
installment obligation.

                        Description of Proposal

    The proposal would repeal the installment method of 
accounting for accrual method taxpayers (other than those 
taxpayers that are eligible to use the dealer disposition 
exceptions under present law).
    The proposal would also provide that the granting of put 
rights in connection with a loan, or any similar arrangement, 
would receive the same treatment as pledges and require the 
amount of the loan to be treated as a payment on the 
installment obligation.
    Further, the proposal would modify the subsequent payment 
rule to take into account both loan proceeds and subsequent 
payments to the extent of the full amount of the installment 
obligation.\263\
---------------------------------------------------------------------------
    \263\ In the example discussed as part of present law, the $300 
prepayment in 2001 would result in an additional taxable gain of $270 
in 2001, rather than offsetting the earlier pledge as is the case under 
present law. The final payment of $500 in 2002 would result in the 
recognition of the remaining taxable gain on the sale, or $180.
---------------------------------------------------------------------------

                             Effective Date

    The proposal generally would be effective for installment 
sales entered into on or after the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

Repeal of installment method for accrual basis taxpayers

    The installment method is inconsistent with the accrual 
method of accounting in that it allows an accrual method 
taxpayer to defer the recognition of gain on the sale of 
certain property until the funds from the sale are received. 
The installment method arguably fails to reflect the economic 
results of a taxpayer's business during the taxable year, since 
it does not recognize the gain from the sale of property in the 
period in which the sale is completed. Opponents of the 
installment method contend that it makes the U.S. Treasury an 
obligatory lender, requiring it to loan an amount equal to the 
deferred taxes to the taxpayer.
    On the other hand, the installment method insures that a 
taxpayer will not be required to pay tax attributable to 
extraordinary sales, those that are not in connection with its 
ordinary trade or business, prior to the time the taxpayer 
receives the funds from the sale. Although this deferral of tax 
creates a benefit that would not otherwise be available under 
the accrual method of accounting, the pledging rule and the 
requirement that interest be paid on larger deferrals limits 
the potential for abusing this benefit.

Clarifications to the pledge rule

    The pledge rule, requiring that the net proceeds of any 
indebtedness that is secured by the installment obligation be 
considered the same as a payment on the obligation, is designed 
to require the recognition of income when the taxpayer receives 
cash related to an installment obligation. This recognition of 
income could be avoided if transactions that are equivalent, 
but not identical to, the pledging of the installment 
obligation do not result in income recognition. The purpose for 
permitting the reporting of gain using the installment method 
is to tax the income from a deferred payment sale at the time 
that the taxpayer receives the cash from which the taxes are to 
be paid. A taxpayer who uses the unpaid balance of an 
installment obligation to obtain a loan has received cash equal 
to the net proceeds of the loan. This is true whether the 
installment obligation has been formally pledged, or utilized 
in some other fashion to obtain cash currently. In either case, 
arguably there is no need to defer recognition of gain until 
the cash is received.

Modifications to the subsequent receipt rule

    The subsequent receipt rule provides that, where loan 
proceeds are treated as a payment on the installment obligation 
under the pledging rule, subsequent payments received on the 
pledged installment obligation are not taken into account until 
they exceed the loan proceeds that were treated as payments. 
This may result in the deferral of gain beyond the time cash is 
received with respect to the installment obligation if the net 
proceeds of the secured loan are less than the unpaid amount of 
the installment obligation. For example, a taxpayer sells an 
asset with no basis in 1999 for a $1,000 installment 
obligation, payable $500 in 2000 and $500 in 2001. In 1999, the 
taxpayer pledges the installment obligation as collateral for a 
$500 loan. Under present law, the taxpayer recognizes a $500 
gain in 1999, but no gain in 2000, despite the fact that it has 
collected all $1,000 it expects to receive as a result of the 
sale.\264\
---------------------------------------------------------------------------
    \264\ The taxpayer will recognize the remaining $500 of gain in 
2001. However, that event does not affect the taxpayer's cash flow 
because it is offset by the repayment of the $500 loan.
---------------------------------------------------------------------------
    On the other hand, to the extent the amount of the secured 
loan decreases as the installment obligation is repaid, the 
subsequent receipt rule may be necessary to prevent gain 
recognition in advance of the receipt of cash. If the terms of 
the loan in the above example had required repayment of half of 
its balance ($250) when half of the balance of the installment 
obligation was received in 2000, the taxpayer will have 
received only $750 of cash flow (the $250 loan that remains 
outstanding plus the $500 payment) from the installment 
obligation at the end of 2000, while the proposal would require 
all $1,000 of the gain to be recognized. Thus, it may be 
appropriate to retain the subsequent receipt rule to the extent 
that net proceeds from a loan secured by an installment 
obligation are no longer outstanding at the time of the payment 
on the installment obligation is received.

3. Deny deduction for punitive damages

                              Present Law

    A deduction is allowed for all ordinary and necessary 
expenses pair or incurred by the taxpayer during the taxable 
year in carrying on any trade or business (Code sec. 162(a)). A 
deduction is not allowed, however, for any payment made to an 
official of any government or governmental agency if the 
payment constitutes an illegal bribe or kickback or if the 
payment is to an official or employee of a foreign government 
that illegal under Federal law (sec. 162(c)). In addition, no 
deduction is allowed for any fine or similar payment made to a 
government for violation of any law (sec. 162(f)). Finally, no 
deduction is allowed for two-thirds of the damage payments made 
by the taxpayer who is convicted of a violation of the Clayton 
antitrust law or any related antitrust law (sec. 162(g)).
    In general, gross income does not include amounts received 
on account of personal injuries and physical sickness (sec. 
104(a)). This exclusion generally does not apply, however, to 
punitive damages (P.L. 104-188; K. M. O'Gilvie v. U.S, 519 U.S. 
79 (1996)).

                        Description of Proposal

    No deduction would be allowed for punitive damages paid or 
incurred by the taxpayer as a judgment or in settlement of a 
claim. Where the liability for punitive damages is covered by 
insurance, any such damages paid by the insurer would be 
included in the gross income of the insured person and the 
insurer would be required to report such amounts to both the 
insured person and the Internal Revenue Service.

                             Effective Date

    The proposal would apply to damages paid or incurred on or 
after the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    Proponents of the Administration proposal argue that 
allowance of a tax deduction for punitive damages undermines 
the role of punitive damages in discouraging and penalizing the 
activities or actions for which the punitive damages were 
imposed. Further, proponents note that the determination of the 
amount of punitive damages generally can be determined by 
reference to pleadings filed with a court and such a 
determination already is made by plaintiffs in determining the 
portion of any payment that is taxable.
    Opponents of the proposal argue that a deduction should be 
allowed for all ordinary and necessary expenses paid or 
incurred by the taxpayer in carrying on a trade or business in 
order to properly measure the income of the taxpayer. 
Disallowance of punitive damages would result in the taxpayer 
paying taxes on amounts in excess of his income. Opponents also 
note that determining the amount of any punitive damages will 
be difficult in many cases, especially where the payment arises 
from a settlement of a claim.

4. Apply uniform capitalization rules to certain contract manufacturers

                              Present Law

    Section 263A provides uniform rules for capitalization of 
certain costs. Section 263A requires the capitalization of the 
direct costs and an allocable portion of the indirect costs of 
real or tangible personal property produced by a taxpayer or 
real or personal property described in section 1221(1) that is 
acquired by a taxpayer for resale. Costs attributable to 
producing or acquiring property generally must be capitalized 
by charging such costs to basis or, in the case of property 
which is inventory in the hands of the taxpayer, by including 
such costs in inventory.
    A taxpayer is generally not considered to be producing 
property, and thus subject to the uniform capitalization rules, 
unless it is considered the owner of the property produced 
under Federal income tax principles. Such ownership is 
determined by consideration of the facts and circumstances, 
including who bears the benefits and burdens of ownership. A 
taxpayer may be considered the owner of property for Federal 
income tax purposes even though it does not hold legal title.
    Property produced for a taxpayer pursuant to a contract 
with another party is considered to be produced by the taxpayer 
to the extent the taxpayer makes payments or otherwise incurs 
costs with regard to the property. There is an exception to 
this rule for routine purchase orders.
    Certain contract manufacturers, known as ``tollers'', 
perform manufacturing or processing operations on property 
owned by their customers either for a fee (known as a toll) or 
for a share of the production. The toller may not consider 
itself the owner of the property, and thus subject to the 
uniform capitalization rules.

                        Description of Proposal

    The proposal would apply section 263A to tollers and other 
contract manufacturers in the same manner and to the extent as 
would be required if the contract manufacturer owned the 
property. Such manufacturers would be required to capitalize 
the direct costs, and an allocable portion of the indirect 
costs, allocable to property manufactured or processed under 
such a contract manufacturing arrangement. For this purpose, a 
contract manufacturing arrangement is one in which the taxpayer 
performs manufacturing or processing operations (including 
manufacturing, processing, finishing, assembling, or packaging) 
on property owned by its customers for a fee without the 
passage of title. Tollers would be required to capitalize 
direct and indirect costs (such as labor and overhead) 
allocable to property tolled. The proposal would not apply to a 
toller or other contract manufacturer whose average annual 
gross receipts for the prior three taxable years are less than 
$1 million. Appropriate aggregation rules would be provided.

                             Effective Date

    The proposal would be effective for taxable years beginning 
after the date of enactment. If a taxpayer is required to 
change its method of accounting to comply with the proposal, 
such change would be treated as initiated by the taxpayer with 
the consent of the Secretary of Treasury and any section 481 
adjustment generally would be included in income ratably over a 
four-year period.

                              Prior Action

    No prior action.

                                Analysis

    The uniform capitalization rules generally require the 
costs of producing property to be recovered at the time the 
property is sold or used by the taxpayer, rather than as period 
costs. In choosing to enact a uniform set of rules, Congress 
was concerned that differences in capitalization rules could 
distort the allocation of economic resources and the manner in 
which certain economic activity is organized.\265\
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    \265\ See Joint Committee on Taxation, General Explanation of the 
Tax Reform Act of 1986, (JCS-10-87), May 4, 1987, p. 508.
---------------------------------------------------------------------------
    The manufacturing and processing operations performed by a 
toller may be identical to the manufacturing and processing 
operations performed by a producer subject to section 263A. If 
a toller is able to currently deduct the direct and indirect 
costs attributable to its manufacturing activities, while a 
producer must capitalize the same costs when it manufacturers 
its own items, a disparate treatment based on ownership of the 
property results.
    The requirement that a contract manufacturer's customer 
must capitalize its costs under section 263A is not by itself 
sufficient to prevent the disparate treatment. The customer may 
take the position that it is not the owner of the property, 
with the result that the uniform capitalization rules are not 
applied to the manufacturing activity at all. Even if the 
customer recognizes ownership of the property, and applies the 
uniform capitalization rules, that capitalization need not 
occur at the same time as would be the case if the manufacturer 
were subject to the uniform capitalization rules. In 
particular, where the customer is not obligated to pay for the 
manufacturing activities until delivery, capitalization of the 
customer's costs at the time of delivery does not fully offset 
the benefit of allowing the toller an earlier deduction of its 
direct and indirect costs.

5. Repeal the lower of cost or market inventory accounting method

                              Present Law

    A taxpayer that sells goods in the active conduct of its 
trade or business generally must maintain inventory records in 
order to determine the cost of goods it sold during the taxable 
period. Cost of goods sold generally is determined by adding 
the taxpayer's inventory at the beginning of the period to 
purchases made during the period and subtracting from that sum 
the taxpayer's inventory at the end of the period.
    Because of the difficulty of accounting for inventory on an 
item-by-item basis, taxpayers often use conventions that assume 
certain item or cost flows. Among these conventions are the 
``first-in-first-out'' (``FIFO'') method which assumes that the 
items in ending inventory are those most recently acquired by 
the taxpayer, and the ``last-in-first-out'' (``LIFO'') method 
which assumes that the items in ending inventory are those 
earliest acquired by the taxpayer.
    Treasury regulations provide that taxpayers that maintain 
inventories under the FIFO method may determine the value of 
ending inventory under a (1) cost method or (2) ``lower of cost 
or market'' (``LCM'') method (Treas. reg. sec. 1.471-2(c)). 
Under the LCM method, the value of ending inventory is written 
down if its market value is less than its cost. Similarly, 
under the subnormal goods method, any goods that are unsalable 
at normal prices or unusable in the normal way because of 
damage, imperfections, shop wear, changes of style, odd or 
broken lots, or other similar causes, may be written down to 
net selling price. The subnormal goods method may be used in 
conjunction with either the cost method or LCM.
    Retail merchants may use the ``retail method'' in pricing 
ending inventory. Under the retail method, the total of the 
retail selling prices of goods on hand at year-end is reduced 
to approximate cost by deducting an amount that represents the 
gross profit embedded in the retail prices. The amount of the 
reduction generally is determined by multiplying the retail 
price of goods available at year-end by a fraction, the 
numerator of which is the cost of goods available for sale 
during the year and the denominator of which is the total 
retail selling prices of the goods available for sale during 
the year, with adjustments for mark-ups and mark-downs (Treas. 
reg. sec. 1.471-(8)(a)). Under certain conditions, a taxpayer 
using the FIFO method may determine the approximate cost or 
market of inventory by not taking into account retail price 
mark-downs for the goods available for sale during the year, 
even though such mark-downs are reflected in the retail selling 
prices of the goods on hand at year end (Treas. reg. sec. 
1.471-8(d)). As a result, such taxpayer may write down the 
value of inventory below both its cost and its market value.

                        Description of Proposal

    The proposal would repeal the LCM method and the subnormal 
goods method. Appropriate wash-sale rules would be provided. 
The proposal would not apply to taxpayers with average annual 
gross receipts over a three-year period of $5 million or less.

                             Effective Date

    The proposal would be effective for taxable years beginning 
after the date of enactment. Generally, any section 481(a) 
adjustment required to be taken into account pursuant to the 
change of method of accounting under the proposal would be 
taken into account ratably over a four taxable year period 
beginning with the first taxable year the taxpayer is required 
to change its method of accounting.

                              Prior Action

    The proposal is substantially similar to a provision that 
was reported favorably by the Senate Committee on Finance in 
conjunction with the passage of the General Agreement on 
Tariffs and Trade, but was not included in the final 
legislation as passed by the Congress in 1994. The proposal is 
identical to a provision contained in the President's budget 
proposals for fiscal years 1997, 1998 and 1999.

                                Analysis

    Under present law, income or loss generally is not 
recognized until it is realized. In the case of a taxpayer that 
sells goods, income or loss generally is realized and 
recognized when the goods are sold or exchanged. The LCM and 
subnormal goods inventory methods of present law represent 
exceptions to the realization principle by allowing the 
recognition of losses without a sale or exchange. These methods 
have been described as one-sided in that they allow the 
recognition of losses, but do not require the recognition of 
gains.
    In general, the LCM and subnormal goods inventory methods 
have been long-accepted as generally accepted accounting 
principles (``GAAP'') applicable to the preparation of 
financial statements and have been allowed by Treasury 
regulations for tax purposes since 1918. However, the mechanics 
of the tax rules differ from the mechanics of the financial 
accounting rules. Moreover, the conservatism principle of GAAP 
requires the application of the LCM and subnormal goods methods 
so that the balance sheets of dealers in goods are not 
overstated relative to realizable values. There is no analog to 
the conservatism principle under the Federal income tax.
    The repeal of the LCM method may cause some taxpayers to 
change their methods of accounting for inventory to the LIFO 
method. The LIFO method generally is considered to be a more 
complicated method of accounting than is the FIFO method and 
often results in less taxable income. Despite this potential 
tax saving, many taxpayers are deterred from using the LIFO 
method because of the present-law requirement that the LIFO 
method must also be used for financial statement purposes, thus 
reducing financial accounting income.

6. Repeal the non-accrual experience method of accounting

                              Present Law

    An accrual method taxpayer generally must recognize income 
when all events have occurred that fix the right to its receipt 
and its amount can be determined with reasonable accuracy. An 
accrual method taxpayer may deduct the amount of any receivable 
that was previously included in income if the receivable 
becomes worthless during the year.
    Accrual method service providers are provided an exception 
to these general rules. Under the exception, a taxpayer using 
an accrual method with respect to amounts to be received for 
the performance of services is not required to accrue any 
portion of such amounts which (on the basis of experience) will 
not be collected (``non-accrual experience method''). This 
exception applies as long as the taxpayer does not charge 
interest or a penalty for failure to timely pay on such 
amounts.

                        Description of Proposal

    Under the proposal, the non-accrual experience method would 
be repealed.

                             Effective Date

    The proposal generally would be effective for taxable years 
ending after the date of enactment. Any required section 481(a) 
adjustment generally would be taken into account ratably over a 
four-year period.

                              Prior Action

    The proposal is identical to a provision contained in the 
President's budget proposals for fiscal year 1999.
    A related provision, that would have limited the use of the 
non-accrual experience method of accounting to amounts to be 
received for the performance of qualified professional 
services, was included in H.R. 4250 (105th Cong.), ``The 
Patient Protection Act of 1998,'' as passed by the House of 
Representatives on July 24, 1998.

                                Analysis

    The principal argument made for repeal of the non-accrual 
experience method is that it allows accrual method service 
providers the equivalent of a bad debt reserve, which is not 
available to other accrual method taxpayers. Opponents of the 
use of bad debt reserves argue that such reserves allow 
deductions for bad debts to be taken prior to the time they 
actually occur. The more favorable regime for service debts 
under the non-accrual experience method has also given rise to 
controversies over what constitutes a service (as opposed, for 
example, to selling property).
    On the other hand, the non-accrual experience method allows 
an accrual method service provider to avoid the recognition of 
income that, on the basis of experience, it expects it will 
never collect. This moderates the disparity in treatment 
between accrual method service providers and service providers 
using the cash method of accounting, who generally are not 
required to recognize income from the performance of services 
prior to receipt of payment. Most large entities are required 
to use the accrual method of accounting, either because their 
inventories are a material income producing factor or they are 
corporations with gross receipts in excess of $5,000,000. 
Service providers, however, are frequently organized as 
partnerships of individuals or as qualified personal service 
corporations, eligible to use the cash method of accounting. 
Where accrual basis service providers compete on a relatively 
even footing with entities using the cash method, it may be 
appropriate to continue to allow the use of the non-accrual 
experience method to avoid the disparity of treatment between 
accrual and cash method competitors that could otherwise 
result.

7. Disallow interest on debt allocable to tax-exempt obligations

                              Present Law

In general

    Present law disallows a deduction for interest on 
indebtedness incurred or continued to purchase or carry 
obligations the interest on which is not subject to tax (tax-
exempt obligations) (sec. 265). This rule applies to tax-exempt 
obligations held by individual and corporate taxpayers. The 
rule also applies to certain cases in which a taxpayer incurs 
or continues indebtedness and a related person acquires or 
holds tax-exempt obligations.\266\
---------------------------------------------------------------------------
    \266\ Code section 7701(f) (as enacted in the Deficit Reduction Act 
of 1984 (sec. 53(c) of P.L. 98-369)) provides that the Treasury 
Secretary shall prescribe such regulations as may be necessary or 
appropriate to prevent the avoidance of any income tax rules which deal 
with linking of borrowing to investment or diminish risk through the 
use of related persons, pass-through entities, or other intermediaries.
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Application to non-financial corporations

    General guidelines.--In Rev. Proc. 72-18, 1972-1 C.B. 740, 
the IRS provided guidelines for application of the disallowance 
provision to individuals, dealers in tax-exempt obligations, 
other business enterprises, and banks in certain situations. 
Under Rev. Proc. 72-18, a deduction is disallowed only when 
indebtedness is incurred or continued for the purpose of 
purchasing or carrying tax-exempt obligations.
    This purpose may be established either by direct or 
circumstantial evidence. Direct evidence of a purpose to 
purchase tax-exempt obligations exists when the proceeds of 
indebtedness are directly traceable to the purchase of tax-
exempt obligations or when such obligations are used as 
collateral for indebtedness. In the absence of direct evidence, 
a deduction is disallowed only if the totality of facts and 
circumstances establishes a sufficiently direct relationship 
between the borrowing and the investment in tax-exempt 
obligations.
    Two-percent de minimis exception.--In the case of an 
individual, interest on indebtedness generally is not 
disallowed if during the taxable year the average adjusted 
basis of the tax-exempt obligations does not exceed 2 percent 
of the average adjusted basis of the individual's portfolio 
investments and trade or business assets. In the case of a 
corporation other than a financial institution or a dealer in 
tax-exempt obligations, interest on indebtedness generally is 
not disallowed if during the taxable year the average adjusted 
basis of the tax-exempt obligations does not exceed 2 percent 
of the average adjusted basis of all assets held in the active 
conduct of the trade or business. These safe harbors are 
inapplicable to financial institutions and dealers in tax-
exempt obligations.
    Interest on installment sales to State and local 
governments.--If a taxpayer sells property to a State or local 
government in exchange for an installment obligation, interest 
on the obligation may be exempt from tax. Present law has been 
interpreted to not disallow interest on a taxpayer's 
indebtedness if the taxpayer acquires nonsalable tax-exempt 
obligations in the ordinary course of business in payment for 
services performed for, or goods supplied to, State or local 
governments.\267\
---------------------------------------------------------------------------
    \267\ R.B. George Machinery Co., 26 B.T.A. 594 (1932) acq. C.B. XI-
2, 4; Rev. Proc. 72-18, as modified by Rev. Proc. 87-53, 1987-2 C.B. 
669.
---------------------------------------------------------------------------

Application to financial corporations and dealers in tax-exempt 
        obligations

    In the case of a financial institution, the allocation of 
the interest expense of the financial institution (which is not 
otherwise allocable to tax-exempt obligations) is based on the 
ratio of the average adjusted basis of the tax-exempt 
obligations acquired after August 7, 1987, to the average 
adjusted basis of all assets of the taxpayer (sec. 265). In the 
case of an obligation of an issuer which reasonably anticipates 
to issue not more than $10 million of tax-exempt obligations 
(other than certain private activity bonds) within a calendar 
year (the ``small issuer exception''), only 20 percent of the 
interest allocable to such tax-exempt obligations is disallowed 
(sec. 291(a)(3)). A similar pro rata rule applies to security 
dealers in tax-exempt obligations, but there is no small issuer 
exception, and the 20-percent disallowance rule does not apply, 
and the proportional disallowance rule does not apply to 
interest of debt whose proceeds the dealer can trace to uses 
other than the acquisition of tax-exempt obligations (Rev. 
Proc. 72-18).

Treatment of insurance companies

    Present law provides that a life insurance company's 
deduction for additions to reserves is reduced by a portion of 
the company's income that is not subject to tax (generally, 
tax-exempt interest and deductible intercorporate dividends) 
(secs. 807 and 812). The portion by which the life insurance 
company's reserve deduction is reduced is related to its 
earnings rate. Similarly, in the case of property and casualty 
insurance companies, the deduction for losses incurred is 
reduced by a percentage (15 percent) of (1) the insurer's tax-
exempt interest and (2) the deductible portion of dividends 
received (with special rules for dividends from affiliates) 
(sec. 832(b)(5)(B)). If the amount of this reduction exceeds 
the amount otherwise deductible as losses incurred, the excess 
is includible in the property and casualty insurer's income.

                        Description of Proposal

    The proposal would amend the definition of financial 
institution to which the proportionate disallowance rule 
applies also to include any person engaged in the active 
conduct of a banking, financing, or similar business, such as 
securities dealers and other financial intermediaries. Thus, 
the rule that applies to financial institutions that disallows 
interest deductions of a taxpayer (that are not otherwise 
disallowed as allocable under present law to tax-exempt 
obligations) in the same proportion as the average basis of its 
tax-exempt obligations bears to the average basis of all of the 
taxpayer's assets would be applied to all financial 
intermediaries. This proposal would not apply to insurance 
companies (although a separate proposal included in the 
President's fiscal 2000 budget proposals would increase the 
proration percentage for property and casualty insurance 
companies).

                             Effective Date

    The proposal would be effective for taxable years beginning 
after the date of enactment with respect to obligations 
acquired on or after the date of first committee action.

                              Prior Action

    The proposal is substantially similar to a proposal made in 
the President's fiscal year 1999 budget proposal. In addition, 
the proposal is narrower than a similar proposal made by the 
President's fiscal year 1998 budget proposal. In general, the 
fiscal year 1998 budget proposal would have applied the 
proportional disallowance rule to all corporations and would 
have applied the proportionate disallowance rule to all assets 
and borrowings of all related corporations. No legislative 
action was taken on either proposal.

                                Analysis

In general

    The present-law rules which disallow interest deductions on 
indebtedness whose proceeds are used to finance tax-exempt 
obligations are intended to limit what is perceived as double 
tax benefit of (1) exclusion of interest received on tax-exempt 
obligations from income and (2) deduction of interest paid on 
obligations that finance the tax-exempt obligations. Present 
law provides different rules for different types of taxpayers. 
The Administration proposal is based on acceptance of the 
premise that money is fungible for all financial intermediaries 
that operate similarly and, accordingly, all debt of any 
financial intermediary finances its proportionate share of all 
of that intermediary's assets, including tax-exempt 
obligations.

Limitations to 2-percent de minimis exception

    The Administration proposal would extend the pro rata rule 
that presently only applies to banks to all financial 
intermediaries. Extension of the pro rata rule would repeal the 
2-percent de minimis exception for non-bank financial 
intermediaries. In addition, extension of the statutory pro 
rata rule to securities dealers would remove their ability to 
avoid an administrative pro rata rule where the taxpayer can 
establish through tracing of funds that borrowings were not 
used to acquire tax-exempt obligations.

Proponent's arguments

    Some proponents of the Administration proposal accept the 
premise that money of all financial intermediaries is fungible 
and, accordingly, would disallow interest deductions on a pro 
rata basis (e.g., in the same proportion as the taxpayer's 
average basis in its tax-exempt obligations bears to the 
average basis of its total assets). These proponents argue that 
permitting the holding of tax-exempt obligations without 
limiting the deductibility of interest expense under the 2-
percent de minimis exception for some financial intermediaries, 
but not others, may be viewed as a tax subsidy which may create 
a competitive advantage for some financial intermediaries over 
other financial intermediaries with whom they compete. These 
proponents argue that the proposed pro rata allocation of 
indebtedness among assets (in the manner prescribed for 
financial institutions) has the additional administrative 
benefit, for taxpayer's that own more tax-exempt obligations 
than the 2-percent de minimis amount, of avoiding the difficult 
and often subjective inquiry of when indebtedness is incurred 
or continued to purchase or carry tax-exempt obligations.

Opponent's arguments

    Opponents of the Administration proposal argue that the 
proposal would have the effect of raising the financing costs 
for a State or local government. Opponents also argue that the 
scope of the Administration proposal is unclear since it is 
unclear what taxpayers will be treated as financial 
intermediaries for this purpose. Finally, opponents note that 
the 2-percent de minimis exception of present law avoids the 
complexity of complying with the proposed pro rata rule.

                      F. Cost Recovery Provisions

1. Modify treatment of start-up and organizational expenditures

                              Present Law

    At the election of the taxpayer, start-up expenditures 
(sec. 195) and organizational expenditures (sec. 248) may be 
amortized over a period of not less than 60 months, beginning 
with the month in which the trade or business begins. Start-up 
expenditures are amounts that would have been deductible as 
trade or business expenses, had they been paid or incurred 
after business began. Organizational expenditures are 
expenditures that are incident to the creation of a 
corporation, are chargeable to capital, and that would be 
eligible for amortization had they been paid or incurred in 
connection with the organization of a corporation with a 
limited life.
    The regulations \268\ require that a taxpayer file an 
election to amortize start-up expenditures no later than the 
due date for the taxable year in which the trade or business 
begins. The election must describe the trade or business, 
indicate the period of amortization (not less than 60 months), 
describe each start-up expenditure incurred, and indicate the 
month in which the trade or business began. Similar 
requirements apply to the election to amortize organizational 
expenditures. A revised statement may be filed to include 
start-up expenditures that were not included on the original 
statement, but a taxpayer may not include as a start-up 
expenditure any amount that was previously claimed as a 
deduction.
---------------------------------------------------------------------------
    \268\ Treas. Regs. sec. 1.195-1.
---------------------------------------------------------------------------
    Section 197 requires most acquired intangible assets 
(goodwill, trademarks, franchises, patents, etc.) that are held 
in connection with the conduct of a trade or business or an 
activity for the production of income to be amortized over 15 
years beginning with the month in which the intangible was 
acquired.

                        Description of Proposal

    The proposal would modify the treatment of start-up and 
organizational expeditures. A taxpayer would be allowed to 
elect to deduct up to $5,000 each of start-up or organizational 
expenditures in the taxable year in which the trade or business 
begins. However, each $5,000 amount is reduced (but not below 
zero) by the amount by which the cumulative cost of start-up or 
organizational expenditures exceeds $50,000, respectively. 
Start-up and organizational expenditures that are not 
deductible in the year in which the trade or business begins 
would be amortized over a 15-year period consistent with the 
amortization period for section 197 intangibles.

                             Effective Date

    The proposal would be effective for start-up and 
organizational expenditures incurred after the date of 
enactment. Start-up and organizational expenditures that are 
incurred on or before the date of enactment would continue to 
be eligible to be amortized over a period not to exceed 60 
months. However, all start-up and organizational expenditures 
related to a particular trade or business, whether incurred 
before or after the date of enactment, would be considered in 
determining whether the cumulative cost of start-up or 
organizational expenditures exceeds $50,000.

                              Prior Action

    No prior action.

                                Analysis

    Allowing a fixed amount of start-up and organizational 
expenditures to be deductible, rather than requiring their 
amortization, may help encourage the formation of new 
businesses that do not require significant start-up or 
organizational costs to be incurred. However, requiring all 
start-up or organizational costs to be amortized over 15 years 
(rather than 5 years as under present law) if such category of 
costs exceeds $55,000 may discourage the formation of 
businesses that incur greater costs prior to the commencement 
of business.

2. Establish specific class lives for utility grading costs

                              Present Law

    A taxpayer is allowed a depreciation deduction for the 
exhaustion, wear and tear, and obsolescence of property that is 
used in a trade or business or held for the production of 
income. For most tangible property placed in service after 
1986, the amount of the depreciation deduction is determined 
under the modified accelerated cost recovery system (MACRS) 
using a statutorily prescribed depreciation method, recovery 
period, and placed in service convention. For some assets, the 
recovery period for the asset is provided in section 168. In 
other cases, the recovery period of an asset is determined by 
reference to its class life. Section 168 provides specific 
class lives for certain assets. The class life of other assets 
is determined by reference to the list of class lives provided 
by the Treasury Department that was in effect on January 1, 
1986.\269\ If no class life is provided, the asset is allowed a 
7-year recovery period under MACRS.
---------------------------------------------------------------------------
    \269\ Rev. Proc. 87-56, 1987-2 C.B. 674.
---------------------------------------------------------------------------
    Assets that are used in the transmission and distribution 
of electricity for sale are included in asset class 49.14, with 
a class life of 30 years and a MACRS life of 20 years. The cost 
of initially clearing and grading land improvements are 
specifically excluded from asset class 49.14. Prior to adoption 
of the accelerated cost recovery system (ACRS), the IRS ruled 
that an average useful life of 84 years for the initial 
clearing and grading relating to electric transmission lines 
and 46 years for the initial clearing and grading relating to 
electric distribution lines, would be accepted.\270\ However, 
the result in this ruling was not incorporated in the asset 
classes included in Rev. Proc. 87-56 or its predecessors. 
Accordingly such costs are depreciated over a 7-year life under 
MACRS as assets for which no class life is provided.
---------------------------------------------------------------------------
    \270\ Rev. Rul. 72-403, 1972-2 C.B. 102.
---------------------------------------------------------------------------
    A similar situation exists with regard to gas utility trunk 
pipelines and related storage facilities. Such assets are 
included in asset class 49.24, with a class life of 22 years 
and a MACRS life of 15 years. Initial clearing and grade 
improvements are specifically excluded from the asset class, 
and no separate asset class is provided for such costs. 
Accordingly, such costs are depreciated over a 7-year life 
under MACRS as assets for which no class life is provided.

                        Description of Proposal

    The proposal would assign a class life to depreciable 
electric and gas utility clearing and grading costs incurred to 
locate transmission and distribution lines and pipelines. The 
proposal would include these assets in the asset classes of the 
property to which the clearing and grading costs relate 
(generally, asset class 49.14 for electric utilities and asset 
class 49.24 for gas utilities, giving these assets a recovery 
period of 20 years and 15 years, respectively).

                             Effective Date

    The proposal would be effective for electric and gas 
utility clearing and grading costs incurred after the date of 
enactment.

                              Prior Action

    No prior action.

                                Analysis

    The clearing and grading costs in question are incurred for 
the purpose of installing the transmission lines or pipelines. 
They are properly seen as part of the cost of installing such 
lines or pipelines and their cost should be recovered in the 
same manner. There is no indication that the clearing and 
grading costs have a useful other than the useful life of the 
transmission line or pipeline to which they relate.

                        G. Insurance Provisions

1. Require recapture of policyholder surplus accounts

                         Prior and Present Law

    Under the law in effect from 1959 through 1983, a life 
insurance company was subject to a three-phase taxable income 
computation under Federal tax law. Under the three-phase 
system, a company was taxed on the lesser of its gain from 
operations or its taxable investment income (Phase I) and, if 
its gain from operations exceeded its taxable investment 
income, 50 percent of such excess (Phase II). Federal income 
tax on the other 50 percent of the gain from operations \271\ 
was accounted for as part of a policyholder's surplus account 
and, subject to certain limitations, taxed only when 
distributed to stockholders or upon corporate dissolution 
(Phase III). Under these rules, the deferred income (i.e., 50 
percent of gain from operations in excess of taxable investment 
income) was added to a policyholders surplus account. Amounts 
in the policyholders surplus account were taxed only when 
distributed by the company to its shareholders. To determine 
whether amounts had been distributed, a company maintained a 
shareholders surplus account, which generally included the 
company's previously taxed income that would be available for 
distribution to shareholders.\272\ Distributions to 
shareholders were treated as being first out of the 
shareholders surplus account, then out of the policyholders 
surplus account, and finally out of other accounts.
---------------------------------------------------------------------------
    \271\ The legislative history to the Life Insurance Company Tax Act 
of 1959 states that ``[t]his 50 percent reduction in underwriting gains 
is made because of the claim that it is difficult to establish with 
certainty the actual annual income of life insurance companies. It has 
been pointed out that because of the long-term nature of their 
contracts, amounts, which may appear as income in the current year and 
as proper additions to surplus, may, as a result of subsequent events, 
be needed to fulfill life insurance contracts. Because of this 
difficulty in arriving at true underwriting gains on an annual basis, 
the bill provides for the taxation of only 50 percent of this gain on a 
current basis.'' Report of the Committee on Ways and Means to accompany 
H.R. 4245, H. Rep. No. 34, 86th Cong., 1st Sess. at 13 (1959). 
Similarly, the Senate report provides, ``Although it is believed 
desirable to subject this underwriting income to tax, it is stated that 
because of the long-term nature of insurance contracts it is difficult, 
if not impossible, to determine the true income of life insurance 
companies otherwise than by ascertaining over a long period of time the 
income derived from a contract or block of contracts. Because of this, 
the bill as amended by your committee, like the bill as passed by the 
House, does not attempt to tax on an annual basis all of what might 
appear to be income. In both the House and your committee's bill, half 
of the underwriting income is taxed as it accrues each year. The other 
half of the underwriting income is taxed when it is paid out in a 
distribution to shareholders after the taxed income has been 
distributed, or when it is voluntarily segregated and held for the 
benefit of the shareholders. This other half of the underwriting income 
also is taxed if the cumulative amount exceeds certain prescribed 
limits or if for a specified period of time the company ceases to be a 
life insurance company.'' Report of the Committee on Finance to 
accompany H.R. 4245, S. Rep. No. 291, 86th Cong., 1st Sess. at 7 
(1959).
    \272\ Other events are treated as a subtraction from the 
policyholders surplus account. If for any taxable year the taxpayer is 
not an insurance company, or for any 2 taxable years the company is not 
a life insurance company, then the balance in the policyholder surplus 
account at the close of the preceding taxable year is taken into income 
(former sec. 815(d)(2) as in effect prior to the 1984 Act, which is 
referred to in present-law sec. 815(f)). Further, the policyholder 
surplus account is reduced by the excess of the account over the 
greatest of 3 amounts related to reserves: (1) 15 percent of life 
insurance reserves at the end of the taxable year; (2) 25 percent of 
the amount by which the life insurance reserves at the end of the 
taxable year exceed the life insurance reserve at the end of 1958; or 
(3) 50 percent of the net amount of the premiums and other 
consideration taken into account for the taxable year (former sec. 
815(d)(4)(A)-(C), as in effect prior to the 1984 Act, which is referred 
to in present-law sec. 815(f)).
---------------------------------------------------------------------------
    The Deficit Reduction Act of 1984 included provisions that, 
for 1984 and later years, eliminated further deferral of tax on 
amounts (described above) that previously would have been 
deferred under the three-phase system. Although for taxable 
years after 1983, life insurance companies may not enlarge 
their policyholders surplus account, the companies are not 
taxed on previously deferred amounts unless the amounts are 
treated as distributed to shareholders or subtracted from the 
policyholders surplus account.
    Under present law, any direct or indirect distribution to 
shareholders from an existing policyholders surplus account of 
a stock life insurance company is subject to tax at the 
corporate rate in the taxable year of the distribution (sec. 
815). Present law provides that any distribution to 
shareholders is treated as made (1) first out of the 
shareholders surplus account, to the extent thereof, (2) then 
out of the policyholders surplus account, to the extent 
thereof, and (3) finally, out of other accounts (sec. 815(b)).

                        Description of Proposal

    The proposal would require a stock life insurance company 
with a policyholders surplus account to include in income the 
amount in the account as of the beginning of the first taxable 
year beginning after the date of enactment. The inclusion 
generally would be ratable over the 10-year period beginning 
with the first taxable year after the date of enactment. Thus, 
one-tenth of the total includable amount would be included in 
each year of the 10-year period. In the event of a direct or 
indirect distribution to shareholders or other event that 
requires inclusion in income of any amount in a policyholders 
surplus account, then the company would include a pro rata 
portion of the remaining amount in the policyholders surplus 
account in income over the remainder of the 10-year period.

                             Effective Date

    The proposal would be effective for taxable years beginning 
after the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    Proponents of the proposal argue that continued deferral of 
income that was tax-deferred in years before 1984 is no longer 
justified. Proponents argue that the original rationale for 
permitting the deferral--that ascertaining the underwriting 
underwriting of a life insurance company on an annual basis is 
too difficult and could result in an overestimate of the 
company's income--no longer applies. Present law taxing life 
insurance companies provides for inclusion of underwriting 
income without a 50 percent exclusion as under the prior three-
phase system. Further, virtually all the contracts that 
generated the deferred income have either terminated (whether 
through surrender of the contract, non-payment of premiums, or 
because the insured person has died), or have been reinsured 
with other companies. Thus, the risks are no longer with the 
companies that maintain the policyholders surplus accounts and 
continue to defer pre-1984 income with respect to those 
contracts.
    Opponents might argue that both the 1959-1983 rules that 
permitted deferral, and the 1984 (present-law) rules that 
generally continue the deferral of tax on that income, were 
structured so favorably to taxpayers that events triggering tax 
on the deferred amounts are extremely unlikely to occur. It is 
argued that this structure reflects an implicit Congressional 
intent never to impose tax on the deferred amounts except in 
the extraordinary circumstances which would arise only if a 
company were liquidating and going out of business. Therefore, 
it is argued, it would be inconsistent with Congressional 
intent, and with taxpayers' understanding of the 1959 and 1984 
legislation, to impose tax now on amounts in stock life 
insurance companies' policyholders surplus accounts.
    On the other hand, it could be said that there is no reason 
to assume that Congress believed no amount would ever be 
included in a taxpayer's income, but rather, that such amounts 
were simply deferred and could be taxed later. The rules would 
not have listed events triggering tax on amounts in the policy 
holder's surplus account, if Congress had intended permanent 
deferral, it is argued.\273\ Also, it could be argued that 
other favorable tax rules, some explicitly providing for 
permanent deferral or exclusion, have been repealed by Congress 
as it became clear that the rationale for them no longer 
applied. Thus, it is argued, the fact that Congress enacted a 
deferral provision in the past is not a sufficient reason to 
retain the deferral rule permanently.
---------------------------------------------------------------------------
    \273\ In addition, the prior law has been interpreted in a recent 
case as requiring taxpayers to include amounts from the policyholders 
surplus account in income. See Bankers Life and Casualty Co. v. U.S., 
142 F.3rd 973 (7th Cir. 1998), cert. denied (Nov. 2, 1998), 119 S. Ct. 
403.
---------------------------------------------------------------------------
    Generally, the rules relating to amounts in policyholder 
surplus accounts affect stock but not mutual life insurance 
companies, because direct and indirect distributions to 
shareholders trigger tax on amounts in the policyholder surplus 
account under present law. Some might argue that the proposal 
would have a disparate impact on stock life insurance companies 
that is based only on their form of doing business and not 
related to any real economic distinction among the companies. 
As a practical matter, it is understood that mutual companies 
under the prior three-phase system rarely came within Phase II, 
but rather, were ordinarily taxed under Phase I on their 
taxable investment income (because their gain from operations 
generally did not exceed their taxable investment income). 
Thus, only the companies that had the benefit of deferral would 
be affected by the proposal.

2. Modify rules for capitalizing policy acquisition costs of insurance 
        companies

                              Present Law

    Insurance companies are required to capitalize policy 
acquisition expenses and amortize them on a straight-line 
basis, generally over a period of 120 months \274\ beginning 
with the first month in the second half of the taxable year. 
Policy acquisition expenses required to be capitalized and 
amortized are determined, for any taxable year, for each 
category of specified insurance contracts, as a percentage of 
the net premiums for the taxable year on specified insurance 
contracts in that category. The percentages for each of the 
categories are as follows:
---------------------------------------------------------------------------
    \274\ A special rule permits a 60-month amortization period for 
certain small companies.

 
                                                                 Percent
 
Annuities......................................................     1.75
Group life.....................................................     2.05
Other life (including noncancellable or guaranteed renewable        7.70
 accident and health)..........................................
 


    Specified insurance contracts that are subject to the 
capitalization and amortization rule do not include any pension 
plan contract, any flight insurance or similar contract, 
contracts of certain noncontiguous foreign branches, or any 
contract that is a medical savings account (``MSA'').
    Regulatory authority is provided to the Treasury Department 
to provide a separate category for a type of insurance 
contract, with a separate percentage applicable to the 
category, under certain circumstances. The authority may be 
exercised if the Treasury Department determines that the 
deferral of policy acquisition expenses for the type of 
contract which would otherwise result under the provision is 
substantially greater than the deferral of acquisition expenses 
that would have resulted if actual acquisition expenses 
(including indirect expenses) and the actual useful life of the 
contract had been used. In making this determination, Congress 
intended that the amount of a reserve for a contract not be 
taken into account.\275\ If the authority is exercised, the 
Treasury Department is required to adjust the percentage that 
would otherwise have applied to the category that included the 
type of contract, so that the exercise of the authority does 
not result in a decrease in the amount of revenue received by 
reason of the amortization provision for any fiscal year.
---------------------------------------------------------------------------
    \275\ See H. Rept. 101-964, Conference Report to accompany H.R. 
5835, Omnibus Budget Reconciliation Act of 1990 (101st Cong., 2d 
Sess.), 1066, 1070.
---------------------------------------------------------------------------

                        Description of Proposal

    The proposal would modify the categories of specified 
insurance contracts under the rules requiring capitalization 
and amortization of policy acquisition expenses. The proposal 
would also provide for a different amortization percentage for 
the first five years and the second five years of the 
amortization period, for some categories of specified insurance 
contracts. The proposal would provide for the following 
categories:

 
                                                                 Percent
 
Term life insurance (group or individual)......................     2.05
Non-pension annuity contracts:
    1st through 5th year.......................................     4.25
    6th and later years........................................     5.15
Group or individual noncancellable health insurance............     7.70
Cash value life insurance, credit life insurance, credit health
 insurance, and any other specified insurance contracts:
    1st through 5th year.......................................    10.50
    6th and later years........................................    12.85
 


The category of group or individual noncancellable health 
insurance at 7.70 percent is the same as under present law. In 
addition, the percentage of net premiums capitalized for group 
or individual non-cancellable health insurance remains at 7.70 
percent, as under present law.
    The proposal retains the present-law exceptions from the 
definition of specified insurance contracts for any pension 
plan contract, any flight insurance or similar contract, 
certain contracts of noncontiguous foreign branches, or any 
contract that is an MSA.
    The proposal would also provide that an insurance company 
would be able to elect to capitalize the amount of its actual 
policy acquisition expenses, in lieu of applying the above 
percentages to its net premiums. This election would be made on 
a one-time basis for all lines of business of all members of 
the controlled group (within the meaning of sec. 848(b)(3)), 
and would be treated as a method of accounting.

                             Effective Date

    The proposal would be effective for taxable years beginning 
after the date of enactment.

                              Prior Action

    The proposal is similar to a narrower proposal contained in 
the President's budget proposals for fiscal year 1999, that 
applied only to credit life insurance (whether or not group 
credit life insurance). That proposal would have required 
insurance companies to capitalize and amortize 7.70 percent of 
net premiums for the taxable year with respect to credit life 
insurance, not 2.05 percent as under present law.

                                Analysis

    The provision requiring insurance companies to capitalize 
and amortize policy acquisition expenses was enacted in 1990 to 
correct prior-law mismeasurement of the income of insurance 
companies. Policy acquisition expenses arise in connection with 
acquiring a stream of premium and investment income that is 
earned over a period well beyond the year the expenses are 
incurred. It is a well-established principle of the tax law 
that costs of acquiring an asset with a useful life beyond the 
taxable year are amortized over the life of the asset. Congress 
adopted a ``proxy'' approach designed to approximate the 
expenses for each year that are attributable to new and renewed 
insurance contracts in each of several broad categories of 
business. While this approach does not measure actual 
acquisition expenses, Congress believed that the advantage of 
adopting a theoretically correct approach was outweighed by the 
administrative simplicity of the proxy approach.\276\
---------------------------------------------------------------------------
    \276\ Finance Committee Report, supra, at S 15961 (see footnote 
271, supra).
---------------------------------------------------------------------------
    It could be argued that Congress was aware that a proxy 
approach could not be accurate with respect to the actual 
percentage of net premiums representing commissions and other 
policy acquisition costs, and therefore, that all of the 
percentages were calculated deliberately to err on the low side 
rather than on the high side. On the other hand, it could be 
said that there is no evidence that Congress intended the 
percentages to be low, or it is possible that accurate 
information was not available at the time the percentages were 
set, so that the percentages represented the best approximation 
that could be made at the time. Now that specific, current 
information about commission rates for particular lines of 
insurance business is available, it arguably is appropriate to 
revise the percentages applicable under present law. It could 
further be argued that, even if Congress did have specific, 
current information at the time the percentages were set, that 
commissions and other policy acquisition costs may have 
changed, and updating the percentages, modifying the 
amortization periods, and increasing the number of categories 
would be appropriate to achieve greater accuracy in measuring 
income.
    For some lines of business, it could be argued that even 
though that line of business has relatively high actual 
acquisition expenses, the contracts tend to have a relatively 
short duration and therefore the present value of the 
amortization deduction (plus any currently deductible amounts) 
is lower under present law than if the contracts had a shorter 
amortization period for tax purposes (even if the entire actual 
amount of such expenses were capitalized). Therefore, it is 
argued, the percentages for these lines of business should not 
be increased, so as to take account indirectly of the short 
duration of such contracts. On the other hand, proponents point 
to the high ratio of commissions (which do not necessarily 
include all policy acquisition expenses) to net premiums. These 
ratios are higher than the percentages under the proposal. 
Also, they argue that the actual duration of most contracts is 
longer than ten years, and the duration is shorter than ten 
years generally for lines of business with particularly high 
ratios of policy acquisition expenses to net premiums. Further, 
they argue, some lines of insurance business may be reinsured 
with small companies eligible for the more favorable 60-month 
amortization period, and consequently the present value of the 
deductions for acquisition expenses in such a case is greater.
    Proponents of the proposal argue that the revision of the 
categories and percentages for capitalization and amortization 
is similar to the methodology that insurance companies use for 
financial reporting purposes under generally accepted 
accounting principles (``GAAP''). While a GAAP approach may 
have been rejected at the time the present-law rules were 
enacted, at least in part because some mutual insurance 
companies did not file GAAP statements, some observers point to 
a change in financial reporting practices under which insurance 
companies now generally report on a GAAP basis. They argue that 
GAAP more accurately measures income than the present-law tax 
rules do.
    Opponents of increasing the percentages may argue that 
efficient companies with relatively low acquisition costs would 
be unfairly penalized by the increases under the proposal. 
Proponents point to the election under the proposal to 
capitalize and amortize actual acquisition expenses, and argue 
that efficient companies could make this election. They argue 
that the election could be based on the amount of policy 
acquisition expenses the company reports for GAAP purposes, so 
that the election could be relatively simple to administer.
    The Treasury Department has regulatory authority to create 
an additional category of contract (provided it adjusts the 
category from which the contract was drawn so that there is no 
decrease in revenue from the provision), as noted above. Some 
may argue that this may suggest that legislation might not be 
required to change the capitalization percentages. On the other 
hand, it could be said that determining the proper percentage 
for any new category of contract and making the correct 
adjustment to its former category might be viewed as a judgment 
that is best left to Congress. Further, it could be said that 
the regulatory authority may not encompass changing the 
amortization period for a particular percentage, nor increasing 
the percentages in all the categories without offsetting 
reductions. Some might argue that the requirement that 
adjustments to the categories be balanced by an offsetting 
adjustment indicates that Congress viewed unfavorably any 
administrative change to the categories, making legislation the 
preferred means for any change to the categories.
    Some argue that the proposal would apply with respect to 
existing contracts, and would change the percentages for them. 
It is argued that this type of effective date is unfair, and 
that it would be preferable to apply the proposal to premiums 
paid on newly issued contracts. On the other hand, it could be 
argued that if the percentages had been based on the ratio of 
commissions to first-year premiums, then the percentages would 
have been considerably higher, to reflect current commission 
payment practices for the first year of premiums. Proponents 
argue that because the percentages in the proposal are not 
based on the ratio of commissions to first-year premiums, it 
would be theoretically incorrect to apply the percentages in 
the proposal only to premiums on newly issued contracts.

3. Increase the proration percentage for property and casualty 
        insurance companies

                              Present Law

    The taxable income of a property and casualty insurance 
company is determined as the sum of its underwriting income and 
investment income (as well as gains and other income items), 
reduced by allowable deductions. Underwriting income means 
premiums earned during the taxable year less losses incurred 
and expenses incurred. In calculating its reserve for losses 
incurred, a property and casualty insurance company must reduce 
the amount of losses incurred by 15 percent of (1) the 
insurer's tax-exempt interest, (2) the deductible portion of 
dividends received (with special rules for dividends from 
affiliates), and (3) the increase for the taxable year in the 
cash value of life insurance, endowment or annuity contracts.
    This 15-percent proration requirement was enacted in 1986. 
The reason the provision was adopted was Congress' belief that 
``it is not appropriate to fund loss reserves on a fully 
deductible basis out of income which may be, in whole or in 
part, exempt from tax. The amount of the reserves that is 
deductible should be reduced by a portion of such tax-exempt 
income to reflect the fact that reserves are generally funded 
in part from tax-exempt interest or from wholly or partially 
deductible dividends.'' \277\ In 1997, the provision was 
modified to take into account the increase for a taxable year 
in the cash value of certain insurance contracts.\278\
---------------------------------------------------------------------------
    \277\ H. Rept. 99-426, Report of the Committee on Ways and Means on 
H.R. 3838, The Tax Reform Act of 1985 (99th Cong., 1st Sess.,), 670.
    \278\ P.L. 105-34, The Taxpayer Relief Act of 1997, section 1084.
---------------------------------------------------------------------------

                        Description of Proposal

    The proposal would increase the proration percentage 
applicable to a property and casualty insurance company from 15 
percent to 25 percent.

                             Effective Date

    The proposal would be effective for taxable years beginning 
after the date of enactment with respect to investments 
acquired on or after the date of first committee action.

                              Prior Action

    The proposal is similar to a provision contained in the 
President's budget proposal for fiscal year 1999, except that 
in the prior proposal the percentage was 30 percent, not 25 
percent.

                                Analysis

    The proposal relates to the effect of the 15-percent 
proration percentage of present law on the funding of 
deductible loss reserves by means of income that may be, in 
whole or in part, exempt from tax. In 1996, property and 
casualty insurers held between 13 and 14 percent of all tax-
exempt debt outstanding,\279\ and about 21 percent of these 
companies' financial assets were invested in tax-exempt 
debt.\280\ Proponents of the proposal interpret this as 
evidence that property and casualty insurers continue to find 
tax-exempt debt more profitable than otherwise comparable 
taxable debt.
---------------------------------------------------------------------------
    \279\ Federal Reserve Board, Flow of Funds Accounts, Flows and 
Outstanding, second quarter 1997.
    \280\ Ibid.
---------------------------------------------------------------------------
    Critics of the proposal note that by reducing the effective 
yield received by property and casualty insurers on their 
holdings of tax-exempt debt, the proposal can reduce the demand 
for tax-exempt bonds by this industry. As noted above, property 
and casualty insurers are large holders of tax-exempt bonds. A 
reduction in demand for these securities by the property and 
casualty 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.
    On the other hand, it could be said that the proration rate 
under the proposal is low enough so that there would be no such 
reduction in demand. Depending on yield spreads between tax-
exempt and taxable securities, a modest increase in the 
proration percentage may only reduce the profit of the property 
and casualty insurers without changing the underlying advantage 
those taxpayers find in holding tax-exempt rather than taxable 
debt.
    A taxpayer generally is likely to buy a tax-exempt security 
rather than an otherwise equivalent taxable security if the 
interest rate paid on the tax-exempt security is greater than 
the after-tax yield from the taxable security.\281\ The 15-
percent proration requirement of present law has the effect of 
imposing tax on interest paid by a tax-exempt bond at an 
effective marginal tax rate equal to 15 percent of the 
taxpayer's statutory marginal tax rate. Proponents of the 
proposal argue that the 15-percent rate could be increased to a 
rate that reduces but does not eliminate the use of tax-
preferred income to fund deductible reserves.\282\
---------------------------------------------------------------------------
    \281\ Mathematically, it is more profitable to hold a tax-exempt 
security paying an interest rate, rte, than a taxable 
security of comparable risk and maturity paying an interest rate, r, if 
rte > r.(1 - t), where t is the taxpayer's 
marginal tax rate.
    \282\ By reducing the deduction for increases in reserves by 15 
percent of the taxpayer's tax-exempt interest earnings, the taxpayer's 
taxable income is increased by 15 percent of the taxpayer's tax-exempt 
interest earnings. Thus, the 15-percent proration requirement has the 
effect of imposing tax on the interest paid by a tax-exempt bond at an 
effective marginal tax rate equal to (.15).t, where t is the 
taxpayer's marginal tax rate. One effect of creating an effective tax 
on the interest earned from a tax-exempt bond is that a property and 
casualty insurer would only find holding the tax-exempt bond more 
profitable than holding an otherwise comparable taxable bond when 
rte.(1 - (.15)t) > r.(1 - t). This is 
equivalent to: rte > r.((1 - t)/(1 - (.15)t)).
    If the statutory marginal tax rate of the property and casualty 
insurer were 35 percent, then it would be profitable to purchase tax-
exempt debt in lieu of taxable debt when rte > (.686)r. 
Under the proposal, it would be profitable to purchase tax-exempt debt 
in lieu of taxable debt when rte > (.726)r
    Because the tax-exempt debt offers yields less than that of 
otherwise comparable taxable debt, some analysts maintain that a holder 
of tax-exempt debt already pays an ``implicit tax'' by accepting a 
lower, albeit tax free, yield. This implicit tax can be measured as the 
yield spread between the tax-exempt debt and the otherwise comparable 
taxable security. In this sense the taxpayer's true effective marginal 
tax rate to holding tax-exempt debt would be the implicit tax rate plus 
(.15).t. However, in considering the ``implicit'' tax one 
must recognize that this implicit tax is not paid to the Federal 
Government, but rather is received by the issuer of the tax-exempt debt 
in the form of a lower borrowing cost.
---------------------------------------------------------------------------
    It is also argued that banks and life insurance companies 
(which also maintain reserves, increases in which are 
deductible for Federal income tax purposes) are subject to more 
effective proration rules that generally prevent them from 
funding reserve deductions with tax-preferred income. Present 
law may promote unequal treatment of competitors in the 
financial service sectors and the proposal would reduce any 
such unequal treatment, it is argued.
    Critics of the proposal could respond that property and 
casualty insurance may be a sufficiently different business 
from that of other financial service providers that the 
disparate treatment of tax-exempt securities across the 
financial services industry does not create any unfair 
competitive advantage for one sector over another. Some 
observers point out that health, disability and long-term care 
insurance are sold by both life insurance companies and 
property and casualty companies, so in some respects property 
and casualty insurers cannot be distinguished from life 
companies, even though life insurers have more rigorous 
proration rules. The proposal alternatively could be criticized 
because it would still provide property and casualty insurers 
with more favorable proration rules than currently apply to 
banks and life insurance companies.
    More broadly, it is said that the present tax rules provide 
an inefficient subsidy for borrowing by State and local 
governments. The interest rate subsidy provided to State and 
local governments by the ability to issue tax-exempt bonds 
cannot efficiently pass the full value of the revenue lost to 
the Federal Government to the issuer. The Federal income tax 
has graduated marginal tax rates. Thus, $100 of interest income 
forgone by a taxpayer in the 31-percent bracket costs the 
Federal Government $31, while the same amount of interest 
income forgone by a taxpayer in the 28-percent bracket costs 
the Federal Government $28. Consequently, if a taxpayer in the 
28-percent bracket finds it profitable to hold a tax-exempt 
security, a taxpayer in the 31-percent bracket will find it 
even more profitable.\283\ This conclusion implies that the 
Federal Government loses more in revenue than an issuer of tax-
exempt debt gains in reduced interest payments, illustrating 
the inefficiency of this subsidy.
---------------------------------------------------------------------------
    \283\ As explained above, a taxpayer generally finds it more 
profitable to buy a tax-exempt security rather than an otherwise 
equivalent taxable security if the interest rate paid by the tax-exempt 
security, rte, is greater than the after-tax yield from the 
taxable security, r(1-t), where t is the taxpayer's marginal tax rate 
and r is the yield on the taxable security.
---------------------------------------------------------------------------

                        H. Exempt Organizations

1. Subject investment income of trade associations to tax

                              Present Law

    Under present law, nonprofit business leagues, chambers of 
commerce, trade associations, and professional sports leagues 
described in section 501(c)(6) generally are exempt from 
Federal income taxes. Such organizations generally are not 
subject to tax on membership dues and contributions they 
receive, and generally are not subject to tax on their 
investment income. However, section 501(c)(6) organizations are 
subject to tax on their unrelated business taxable income. The 
unrelated business income tax (``UBIT'') applies with respect 
to income derived from a trade or business regularly carried on 
by the organization unless the conduct of the trade or business 
is related substantially (aside from the organization's need 
for or use of the revenues) to performance of its tax-exempt 
functions. Under special rules, dividends, interest, royalties, 
certain rental income, certain gains or losses from 
dispositions of property, and certain other specified types of 
income (and directly connected deductions) of a tax-exempt 
organization generally are excluded from unrelated business 
taxable income subject to UBIT, except where derived from debt-
financed property or certain controlled entities (sec. 512(b)).
    In the case of tax-exempt social clubs, voluntary 
employees' beneficiary associations (VEBAs), and certain other 
mutual benefit organizations, the UBIT generally applies under 
present law to all gross income--including investment income--
other than certain ``exempt function income.'' Exempt function 
income includes items such as membership receipts, income set 
aside to be used for charitable purposes specified in section 
170(c)(4), and ``rollover'' gain on certain dispositions of 
property directly used by the organization in carrying out its 
exempt functions (sec. 512(a)(3)).
    Dues paid by members of a section 501(c)(6) organization 
generally are deductible as ordinary and necessary business 
expenses under section 162(a). However, section 162(e), as 
amended by the Omnibus Budget Reconciliation Act of 1993, 
provides that no deduction shall be allowed for any amount paid 
or incurred in connection with certain lobbying and political 
activities. For section 501(c)(6) organizations, the primary 
consequence of this provision is to deny members a deduction 
for dues or similar amounts allocable to lobbying and political 
activities. An organization must notify its members of a 
reasonably estimated disallowance percentage for the year at 
the time of assessment or payment of the dues for that year. 
Under section 6033(e)(1)(C), any lobbying and political 
expenditures made by an organization described in section 
501(c)(6) are deemed to be made first out of the dues payments 
made by the members during the tax year. As an alternative to 
the notice requirement and the disallowance of otherwise 
deductible dues, an organization may choose to pay a proxy tax 
on the actual amount of its expenditures for lobbying and 
political expenditures for the year (sec. 6033(e)(2)).
    Under section 527(f), a tax-exempt organization, including 
an organization described in section 501(c)(6), that makes 
expenditures in an attempt to influence the selection of an 
individual to any Federal, State, or local public office (which 
generally are referred to as ``electioneering'' expenditures) 
is subject to a tax at the highest corporate rates.\284\ This 
tax is determined by computing an amount equal to the lesser of 
the organization's net investment income for the year involved 
or the amount expended on electioneering activities (sec. 
527(f)(1)). In computing net investment income for purposes of 
this tax, items of the organization's income already subject to 
UBIT are excluded from the computation (sec. 527(f)(2)).
---------------------------------------------------------------------------
    \284\ The electioneering activities covered by section 527 are 
somewhat different than the lobbying and political activities covered 
by section 162(e).
---------------------------------------------------------------------------

                        Description of Proposal

    Under the proposal, trade associations and other 
organizations described in section 501(c)(6) generally would be 
subject to tax (at applicable corporate income tax rates) on 
their net investment income in excess of $10,000. For this 
purpose, ``net investment income'' would include dividends, 
interest, royalties, rent, and certain gains and losses from 
dispositions of property, minus all expenses directly connected 
with such items of income.
    As under present-law section 512(a)(3), tax would not be 
imposed under the proposal to the extent that income is set 
aside to be used exclusively for a charitable purpose specified 
in section 170(c)(4). In addition, if an organization described 
in section 501(c)(6) sells property that is used directly in 
the performance of its exempt function, any gain from such sale 
is subject to tax under the proposal only to the extent that 
the association's sales price of the old property exceeds the 
association's cost of purchasing certain replacement property 
(see sec. 512(a)(3)(D)).

                             Effective Date

    The proposal would be effective for taxable years beginning 
on or after the date of enactment.

                              Prior Action

    A similar proposal was included in the House version of the 
Omnibus Budget Reconciliation Act of 1987; however, that 
proposal did not include the exemption for the first $10,000 of 
investment income. The provision was not included in the 
conference report.

                                Analysis

In general

    Under present law, dues payments by members of an 
organization described in section 501(c)(6) generally are 
deductible. In addition, the organization generally is not 
subject to tax on its investment income. Thus, members of such 
an organization are able to fund future operations of the 
organization through deductible dues payments, even though the 
members would have been subject to tax on the earnings 
attributable to such dues payments if they had been retained 
and invested by the members and paid at the time the 
organization had expenses. Supporters of the Administration 
proposal argue that the tax-exempt treatment accorded to 
organizations described in section 501(c)(6) should not extend 
to the accumulation of assets on a tax-free basis. Thus, it can 
be argued that such organizations should be subject to tax on 
earnings attributable to amounts collected in excess of the 
amounts needed to fund current operations of the organization.
    Opponents of the proposal will argue that the proposal does 
not permit organizations described in section 501(c)(6) to plan 
for anticipated expenditures, such as the purchase of a 
headquarters building. Thus, it could be argued that the 
proposal has the effect of forcing such an organization to 
collect substantial dues from members in the year in which an 
extraordinary expense arises and that this will have the effect 
of penalizing those individuals who are members at the time of 
an extraordinary expense. On the other hand, the Administration 
proposal does not subject the first $10,000 of investment 
earnings to tax, and thus allows an organization described in 
501(c)(6) to accumulate some assets to meet future expenses.
    Opponents of the proposal also may contend that it is not 
appropriate to extend the tax treatment of social clubs (and 
other mutual benefit organizations) to other organizations 
described in section 501(c)(6), because the purposes and 
activities of these types of entities are not analogous. The 
purpose of a social club is to provide to its members benefits 
of a recreational or social nature, which generally would not 
be deductible if directly paid for by the members. Accordingly, 
it is considered appropriate to prevent such benefits from 
being provided through tax-free investment income. In contrast, 
expenditures for many of the activities of a trade association 
(e.g., although not expenditures for lobbying or political 
activities (sec. 162(e)(2)) would be deductible by the 
association's members if carried on by the members directly, 
because the expenditures would constitute ordinary and 
necessary business expenses under section 162(a).
    Alternatively, opponents might argue the proposal is too 
narrow because it would not impose tax on the investment income 
of organizations exempt under other provisions of section 501 
(for example, labor, agricultural or horticultural 
organizations under sec. 501(c)(5)). On the other hand, it 
could be argued that such organizations are not analogous to 
the ones taxed under the proposal, or to organizations subject 
to UBIT under present law on all gross income other than exempt 
function income.
    The proposal does not explicitly address what effect it 
would have on the section 527(f) tax imposed on an organization 
because of its involvement in electioneering activities. 
Because the proposal would subject the net investment income 
(above the $10,000 threshold) of section 501(c)(6) 
organizations to UBIT under all circumstances, section 
527(f)(2) would prevent that investment income from being taken 
into account for purposes of computing the tax under section 
527(f)(1). Consequently, it is unclear whether the tax imposed 
under section 527(f) would have continuing applicability to 
section 501(c)(6) organizations.

Economic analysis of proposal

    In general, the dues collected by a trade association are 
established at levels that are intended to provide sufficient 
funds to carry out the exempt purposes of the trade 
association. That is, the trade association ultimately spends 
all dues collected on the exempt purposes of the trade 
association. The effect of the present-law exclusion from UBIT 
for certain investment income of trade associations is that if 
the trade association collects $1.00 in dues today, but does 
not incur expenses until some point in the future, the 
association will have an amount with a present value of $1.00 
available to meet those expenses. For example, if interest 
rates are 10 percent and the trade association collects $1.00 
in January 1999, but incurs no expenses until January 2000, at 
that time it will have $1.10 available to meet expenses.
    The deductibility of dues paid by the trade association 
member to the trade association effectively reduces the cost of 
paying such dues.\285\ Depending upon whether investment 
earnings of trade associations predominately are earned and 
used to fund current year operations or whether substantial 
balances of assets are carried forward for a number of years, 
the present-law exclusion from UBIT for investment income of 
trade associations may permit the trade association and its 
members to effectively lower the cost of the trade 
association's dues below the cost reduction created solely by 
deductibility of dues.
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    \285\ In general, permitting a taxpayer to deduct certain expenses 
from gross income for the purpose of computing taxable income means 
that the taxpayer makes those expenditures out of pre-tax income. The 
taxpayer must make most other purchases out of after-tax income. As a 
result, the ``cost,'' in terms of the forgone other (non-deductible) 
spending, of the deductible expenditures is $1.00(1 - t), where t is 
the taxpayer's marginal tax rate. Thus, to give $1.00 to the trade 
association, the trade association member must sacrifice less than 
$1.00 of other spending.
---------------------------------------------------------------------------
    Assume that a trade association does not anticipate any 
expenses during the first half of 1999, but anticipates $1.05 
in expenses in the second half of 1999. The trade association 
could collect $1.00 in dues in January 1999 and by investing 
the $1.00 at 10-percent (as in the example above) for half of 
the year have sufficient funds to meet the future expense. 
Alternatively, the trade association could collect $1.05 in 
dues from its members in July 1999. In that case, the 
association member could invest the $1.00 in dues that was not 
collected in January and, at a 10-percent rate of return, could 
realize a gross return of $1.05 in July 1999. The association 
member could use the $1.05 to pay the association dues at that 
time. By investing, the association member would have earned an 
additional $0.05 in income, but by paying dues of $1.05 which 
are deductible against income, the association member's after-
tax (and after dues) income is the same as when he or she paid 
$1.00 in dues in January 1999. Because the trade association 
receives $1.05 in July 1999, the trade association is in the 
same position as if it had received $1.00 in January 1999. 
Thus, within a single tax year, present law leaves a trade 
association member indifferent between paying deductible dues 
now and letting the trade association earn pre-tax rates of 
return to meet exempt purpose expenses or earning the income 
itself and paying the income over to the trade association as 
part of its deductible dues.
    If the trade association carries over assets on which it 
earns income from the current year to future years, the trade 
association member may not be indifferent between paying $1.00 
in dues in 1999 or $1.21 in dues in 2001. Under present law, 
the trade association could invest $1.00 in 1999 at 10 percent 
and have $1.21 available in 2001. However, the trade 
association member that invests $1.00 in 1999 may not have 
$1.21 to contribute as dues to the trade association in 2001, 
because the member would have to pay taxes on the annual 
interest earnings if the $1.00 were invested in a bank account. 
As a result, the trade association member would have somewhat 
less than $1.21 available in its bank account in 2001 and would 
have to sacrifice some other consumption to pay $1.21 in dues 
in 2001. By transferring $1.00 in dues in 1999, the trade 
association member can both obtain a current deduction and 
avoid income tax liability on the investment earnings 
attributable to the dues payment because the trade 
association's investment earnings are not taxed. Thus, the 
trade association member would prefer to pay $1.00 in dues in 
1999 and let the trade association earn pre-tax rates of return 
to meet exempt purpose expenses. In this way, the present-law 
exclusion from UBIT for investment income of trade associations 
effectively lowers the amount of spending on other goods that 
the trade association members must give up to fund the 
activities of the trade association.
    The proposal would subject the investment income of the 
trade association to income tax. In the example above, if the 
trade association collected $1.00 in dues in 1999 and invested 
the proceeds, it would have something less than $1.21 in funds 
available in 2001 to meet expenses, the same result as if the 
trade association member had retained the $1.00 and invested it 
itself. Compared to present law, the proposal would have the 
effect of raising the amount of spending on other goods that 
the trade association members must give up to fund the exempt 
purposes of the trade association. If the rate of tax 
applicable to the trade association and the rate of tax 
applicable to the trade association member were equal, the 
trade association member will be indifferent between paying 
deductible dues now and letting the trade association earn 
after-tax rates of return to meet exempt purpose expenses or 
earning the income itself, paying tax on the annual income, and 
paying the after-tax proceeds over to the trade association as 
part of its deductible dues.\286\
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    \286\ In general, if the trade association were subject to a higher 
marginal tax rate than the trade association member, the trade 
association member would prefer not to pre-fund future expenses of the 
trade association.
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                   I. Estate and Gift Tax Provisions

1. Restore phase-out of unified credit for large estates

                              Present Law

    Prior to enactment of the Taxpayer Relief Act of 1997, a 5-
percent surtax was imposed upon cumulative taxable transfers 
between $10 million and $21,040,000 in order to phase out the 
benefits of the graduated rates and the unified credit. The 
Taxpayer Relief Act of 1997 increased the unified credit, 
beginning in 1998, from an effective exemption of $600,000 to 
an effective exemption of $1 million in 2006. A conforming 
amendment made to the 5-percent surtax phased out the benefits 
of the graduated rates but not of the unified credit, such that 
the 5-percent surtax applies to taxable estates between $10 
million and $17,184,000.

                        Description of Proposal

    The proposal would extend the phaseout in section 
2001(c)(2), which currently applies only to the graduated 
rates, to the unified credit. The phase-out range would 
increase as the unified credit continues to rise until 2006. In 
order to phase out the benefit of both the graduated rates and 
unified credit, the 5-percent surtax would apply to taxable 
estates between $10 million and $21,410,000 for 1999; between 
$10 million and $21,595,000 for 2000 and 2001; between $10 
million and $21,780,000 for 2002 and 2003; between $10 million 
and $22,930,000 for 2004; between $10 million and $23,710,000 
for 2005; and between $10 million and $24,100,000 for 2006 and 
thereafter.

                             Effective Date

    The proposal would be effective for decedents dying after 
the date of enactment.

                              Prior Action

    A similar provision was included as a technical correction 
in the Senate version of the Internal Revenue Service 
Restructuring and Reform Act of 1998. The provision was deleted 
in conference.

                                Analysis

    The phaseout of the unified credit and the benefits of the 
graduated rates was originally adopted in the Omnibus Budget 
Reconciliation Act of 1987 to restrict the full benefits of the 
unified credit and graduated rates to small estates, which the 
Congress had determined had the greatest need for tax relief. 
Under the proposal, in 2006 for example, the phase out would 
have the effect of increasing the marginal tax rate to 60 
percent with respect to taxable estates between $17,184,000 and 
$24,100,000. Taxable estates above $24,100,000 would continue 
to be taxed at a marginal tax rate of 55 percent. This would 
have the effect of creating a tax liability equal to 55 percent 
of the taxable estate on all estates valued at $24,100,000 or 
greater. That is, the average tax rate on estates of 
$24,100,000 or greater would be 55 percent. Under present law, 
the average tax rate, in 2006, on an estate of $24,100,000 
would be 50.9 percent, and the average tax rate would increase 
for estates above $24,100,000, although the average tax rate 
would never reach 55 percent.

2. Require consistent valuation for estate and income tax purposes

                              Present Law

    Under present law, property included in the gross estate of 
a decedent generally is valued at its fair market value on the 
date of death (or on an alternate valuation date). Likewise, 
the basis of property acquired from a decedent is its fair 
market value on the date of death. However, there is no 
statutory requirement that the determination of fair market 
value for estate tax purposes and the determination of fair 
market value for income tax purposes be consistent. The only 
current statutory duty of consistency for estates concerns the 
duty of the beneficiary of a trust or estate to report for 
income tax purposes consistent with the Form K-1 information 
received from the trust or estate.287 The K-1, 
however, does not include basis information.
---------------------------------------------------------------------------
    \287\ Code section 6034A.
---------------------------------------------------------------------------
    When a lifetime gift of property is made, the donee 
generally takes a carryover basis in the property. (Adjustments 
are made if gift tax is paid on the transfer, and the dual 
basis rules apply if the property is later sold at a loss.) The 
donor has no duty to notify the donee of the basis of the 
transferred property.

                        Description of Proposal

    The proposal would require that a person receiving property 
from a decedent use, as basis, the fair market value of the 
property as reported on the decedent's estate tax return (if 
one is filed).
    The proposal further would require that an estate, by its 
representative, notify each heir, as well as the Internal 
Revenue Service, of the fair market value on the date of the 
decedent's death of any property distributed to such heir. 
Moreover, donors of lifetime gifts (other than annual exclusion 
gifts) would be required to notify donees, as well as the IRS, 
of the donor's basis in the property at the time of the 
transfer as well as any payment of gift tax that would increase 
the basis of the property.

                             Effective Date

    The proposal would be effective for estates of decedents 
dying after the date of enactment in the case of transfers at 
death, and transfers after the date of enactment in the case of 
lifetime gifts.

                              Prior Action

    No prior action.

                                Analysis

    The proposal would impose both a duty of consistency and a 
reporting requirement. To ensure consistency, the proposal 
would require that an individual taking a basis under section 
1014 (property acquired from a decedent) use the fair market 
value as reported on the decedent's estate tax return, provided 
one was filed, as the basis of the property for income tax 
purposes.
    Courts have recognized that taxpayers have a duty to 
maintain consistent positions with the IRS.\288\ In fact, a 
duty of consistency has been held to apply when an estate 
determines the fair market value of property at the date of 
death, and a recipient/heir (who was the estate's executor) 
later argues, after the period of limitations on the estate tax 
assessment had expired, that the property had a basis different 
from that reported (or stipulated to) by the estate.\289\ The 
proposal would codify a duty of consistency with respect to the 
reporting of the basis of property received from a decedent's 
estate.
---------------------------------------------------------------------------
    \288\ See, e.g., LeFever v. Commissioner, 103 T.C. 525 (1994) 
(applying a duty of consistency where taxpayers agreed to special-use 
valuation, then, after the period of limitations on the estate tax 
return expired, tried to argue that the special-use valuation election 
was invalid).
    \289\ See Cluck v. Commissioner, 105 T.C. 324 (1995) (estopping the 
taxpayer from arguing, after the period of limitations on the estate 
tax expired, that the basis in land inherited by her spouse should be 
higher because it was undervalued for estate tax purposes; the 
taxpayer's spouse in this case was the executor of the decedent's 
estate, and he was one of the individuals who entered into a prior 
agreement with the IRS as to the value of the property for estate tax 
purposes).
---------------------------------------------------------------------------
    It may be appropriate to codify a duty of consistency for 
those heirs who participated in valuing property for estate tax 
purposes initially or by agreement with the IRS. In such a 
case, an heir would be estopped from claiming a value different 
than the one claimed on the estate tax return or agreed to with 
the IRS.
    Estoppel, however, may not be appropriate for those 
transferees who had not participated in the valuation process 
for an estate. In this instance, the proposal would require 
these individuals to report, for income tax purposes, the value 
as reported on the estate tax return or agreed to with the IRS, 
without an opportunity to challenge such value. The proposal 
may preclude an heir, who had no role in determining the value 
of property for estate tax purposes, from challenging the 
property's value for personal income tax purposes.
    It is unclear, under the proposal, what would result when 
an estate tax return need not be filed, or when the IRS later 
asserts that an estate tax return should have been filed. It 
may be that, when an estate is not required to file a return, 
there would be no duty of consistency under the proposal. In 
such case, an heir would not be bound to use any value 
determined by the estate. If an adjustment has been made to an 
estate, then the estate may have a duty under the proposal to 
notify heirs of such changes to the valuation of property. When 
an estate tax return is filed but an item of property is 
omitted, the proposal may require that the heir takes such 
property at a zero basis if the period of limitations on 
assessment of the estate tax has lapsed. In such case, another 
possible result would be that the heir would take the property 
at a carryover basis.
    The proposal also would impose reporting requirements on 
estates and donors of lifetime gifts. The representative of an 
estate would be required to notify heirs, and the IRS, of the 
fair market value on the date of death of property distributed 
to such heir. This requirement extends to both property passing 
under a will and property not passing under a will, so long as 
the property is included in the decedent's gross estate. Donors 
of lifetime gifts (other than annual exclusion gifts) also 
would be required to notify donees, and the IRS, of the donor's 
basis in the property at the time of transfer, as well as any 
payment of gift tax which would increase the basis.

3. Require basis allocation for part-sale, part-gift transactions

                              Present Law

    Under present law, where there is a transaction that is a 
part-sale, part-gift, the donee takes a basis equal to the 
greater of the amount paid by the donee or the donor's adjusted 
basis at the time of transfer, plus any gift tax paid by the 
donor. If the property is later sold by the donee at a loss, 
then the basis is limited to the fair market value at the time 
of the gift.
    Under the rules for bargain sales to charities, the basis 
of property sold must be allocated between the portion of the 
property which is ``sold'' to the charity and the portion of 
the property which is ``donated'' to the charity. Thus, the 
adjusted basis for determining the gain from a bargain sale is 
that portion of the adjusted basis which bears the same ratio 
to the property's adjusted basis as the amount realized on the 
sale bears to the property's fair market value.
    The dual basis rule that applies both to gifts and 
charitable bargain sales requires that, if property is later 
sold by a donee at a loss, the basis is limited to its fair 
market value. There is neither gain nor loss on the property's 
disposition when the amount realized is less than the basis for 
gain and greater than the basis for loss.

                        Description of Proposal

    The proposal would require that the basis of property 
transferred in a part-gift, part-sale transaction be allocated 
ratably between the gift portion and the sale portion based on 
the fair market value of the property and the consideration 
paid.

                             Effective Date

    The proposal would be effective for transactions entered 
into after the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    Under the proposal, the charitable bargain sale rule would 
be adopted for all part-sale, part-gift transactions, including 
those in which a charity is not involved. Under section 1011, 
the adjusted basis for determining the gain from a charitable 
bargain sale is that portion of the adjusted basis which bears 
the same ratio to the property's adjusted basis as the amount 
realized on the sale bears to the property's fair market value. 
The proposal would allocate the basis of part-sale, part-gift 
property ratably between the gift portion and the sale portion 
based on the fair market value of the property on the date of 
transfer and the consideration paid. For example, a donor sells 
to a child for $50,000 property with a basis to the donor of 
$40,000 and a fair market value of $100,000. Thus, the donor 
makes a gift to the child of $50,000 ($100,000 fair market 
value less $50,000 amount realized), which is 50 percent of the 
value of the property. The amount realized on the part-sale, 
part gift is 50 percent ($50,000/$100,000) of the value of the 
property. Under the proposal, the adjusted basis of the nongift 
(i.e., sold) portion of the property is $20,000 ($40,000 
adjusted basis times 50 percent), and the donor/seller 
recognizes $30,000 of gain ($50,000 amount realized -$20,000 
adjusted basis of portion sold). The child would take a basis 
of $70,000 ($50,000 paid plus $20,000 which is the gift portion 
of donor's basis).
    The proposal would establish consistency among the rules 
for calculating basis in a charitable bargain sale and a part-
sale, part-gift transaction. Moreover, under the proposed rule, 
the basis of property received in a part-sale, part-gift would 
accurately reflect the portion of the basis which is deemed 
sold and the portion of the basis which is deemed transferred 
by gift.
    The dual basis rule would continue to apply if there is a 
loss transaction and the fair market value of the gift on the 
date of transfer was less than the donor's basis. For example, 
if the donor's basis in the above example just prior to the 
transfer was $140,000, then the donor would have a loss of 
$20,000 ($50,000 consideration less allocated basis of $70,000 
(50 percent of $140,000)). The child's unadjusted basis would 
be $120,000 ($50,000 paid plus $70,000 which is the gift 
portion of the donor's basis); however, if the child sold the 
property at a loss, then the basis would be limited to $100,000 
(i.e., fair market value). As under current law, there would be 
neither gain nor loss on the sale of the property by the child 
if the amount realized is less than the basis for gain and 
greater than the basis for loss.

4. Eliminate the stepped-up basis in community property owned by 
        surviving spouse

                              Present Law

    Property acquired from a decedent generally is assigned a 
new basis equal to the property's fair market value on the date 
of the decedent's death. In common-law (non-community-property) 
States, property jointly owned by both husband and wife at the 
time one spouse dies is treated as owned one-half by the 
deceased spouse and one-half by the surviving spouse. 
Therefore, the surviving spouse receives a step up in basis 
only as to the deceased spouse's half of property which passes 
to the surviving spouse. The half treated as owned by the 
surviving spouse is not eligible for a step up in basis at the 
death of the first spouse to die.
    In community property States, each spouse is treated as 
owning one-half of the community property. However, under 
section 1014(b)(6), the surviving spouse is entitled to a step 
up in basis of property for the portion treated as owned by the 
surviving spouse as well as the portion owned by the decedent 
spouse. There are nine community property States and one State 
with an elective community property regime.\290\
---------------------------------------------------------------------------
    \290\ Community-property States include Arizona, California, Idaho, 
Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. Alaska 
has an elective regime.
---------------------------------------------------------------------------

                        Description of Proposal

    The proposal would eliminate the step up in basis in the 
portion of community property which is owned by the surviving 
spouse prior to the deceased spouse's death. The portion of 
community property which passes from the deceased spouse, 
however, would continue to receive a stepped-up basis.

                             Effective Date

    The proposal would be effective for decedent dying after 
the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    The proposal identifies that, under the Federal estate tax 
law, surviving spouse's property which did not pass from a 
decedent spouse is treated differently in community-property 
States than in common-law States. Under present law, assets 
passing from a decedent spouse to a surviving spouse qualify 
for a step up in basis. Moreover, under section 1014(b)(6), the 
step up in basis also applies to a surviving spouse's one-half 
interest in community property if the other half interest was 
includible in the decedent spouse's gross estate. This 
provision grants a step up in basis in a surviving spouse's 
property which did not pass from a decedent spouse. In common-
law (non-community-property) jurisdictions, a surviving 
spouse's property which did not pass from a decedent spouse is 
not eligible for a step up in basis.
    The step up in basis for community property provision was 
enacted in 1948. As stated in S. Rept. No. 1013, 80th Cong., 2d 
Sess., p. 26 (1948), ``the usual case was that practically all 
the wealth of the married couple was the property of the 
husband.'' For example, if a husband died first, having owned 
``practically all the wealth,'' the surviving spouse would have 
had a stepped-up basis in most of the property because most of 
it would have, in fact, passed from the decedent spouse to the 
surviving spouse by bequest or inheritance. In a community-
property State, however, a surviving spouse is deemed to own 
one-half of the community property, and, consequently, the 
surviving spouse's one-half interest in community property 
could not pass to the surviving spouse by bequest or 
inheritance. Only the decedent spouse's one-half interest would 
have passed to the surviving spouse from the decedent spouse; 
therefore, only one-half of the property was eligible for a 
step up in basis. Section 1014(b)(6), which provides a step up 
in basis for the surviving spouse's one-half of property, was 
intended to equalize the two State regimes and ``give persons 
receiving community property the same basis for determining 
gain or loss on a sale of property after death as is given 
recipients of property passing under the common law'' in that 
``the surviving spouse's interest in community property shall 
be deemed to have been acquired by bequest, devise, or 
inheritance' from the decedent.'' S. Rept. No. 1013, 80th 
Cong., 2d Sess., p. 29 (1948).
    The Administration's position is that changes to the 
Federal estate tax treatment of jointly-held property in 1981 
have undermined the premises upon which section 1014(b)(6) is 
based. For example, under section 2040(b), one-half of the 
value of any property held by the decedent and the decedent's 
spouse as tenants by the entirety or as joint tenants with 
right of survivorship (when the decedent and decedent's spouse 
are the only joint tenants) is included in the gross estate of 
the first spouse to die, regardless of the source of the 
consideration for the property. As a result, the basis in the 
part of the jointly held property included in the decedent 
spouse's estate will be stepped up to fair market value. The 
one-half interest which is not included in the decedent 
spouse's estate, however, is not eligible for a step up in 
basis. In community property States, however, the one-half 
interest in community property which is not included in a 
decedent spouse's estate may be eligible for a step up in 
basis. To the extent that surviving spouses in community-
property States may receive a step up in basis for property 
which, in a common-law State, would not be eligible for a step 
up in basis, there is inconsistent treatment under present law.
    The proposal would eliminate the inconsistent treatment 
among decedents in community-property and common-law States by 
eliminating the step up in basis for property which never 
passed from a decedent spouse to a surviving spouse. Surviving 
spouses' interests in property which would not have been 
eligible for a step up in basis in a common-law State would 
also not be eligible for a step up in basis in a community-
property State. In this regard, the proposal establishes 
consistency in the application of the basis rules by ensuring 
that a step up in basis applies only to property which passes 
from the decedent spouse to a surviving spouse. Thus, in a 
community-property State, only the one-half share of the 
property which is deemed to have passed from a decedent spouse 
to a surviving spouse would be eligible for a step up in basis.
    Under present law, separate property of one spouse receives 
similar treatment whether in a common-law State or community-
property State. Property which was owned 100 percent by a 
decedent spouse which passes to a surviving spouse would be 
eligible for a step up in basis as to the entire property 
because it was included in the decedent spouse's estate, even 
if no tax is due. Similarly, if property was owned 100 percent 
by the surviving spouse, there would be no step up in basis 
because the property would not have passed from the decedent 
spouse. It should be noted, however, that the procedures for 
converting community-property to separate property may be 
difficult in some States. Under the proposal, community 
property would be treated less generously than non-jointly-held 
property in common law States where the property was owned by 
the first spouse to die.

5. Require that qualified terminable interest property for which a 
        marital deduction is allowed be included in the surviving 
        spouse's estate

                              Present Law

    For estate and gift tax purposes, a marital deduction is 
allowed for qualified terminable interest property (``QTIP''). 
Such property generally is included in the surviving spouse's 
gross estate. The surviving spouse's estate is entitled to 
recover the portion of the estate tax attributable to such 
inclusion from the person receiving the property, unless the 
spouse directs otherwise by will (sec. 2207A). A marital 
deduction is allowed for QTIP passing to a qualifying trust for 
a spouse either by gift or by bequest. Under section 2044, the 
value of the recipient spouse's estate includes the value of 
property in which the decedent had a qualifying income interest 
for life and for which a marital deduction was allowed under 
the gift or estate tax.

                        Description of Proposal

    The proposal would provide that if a marital deduction is 
allowed with respect to qualified terminable interest property 
(QTIP), inclusion is required in the beneficiary spouse's 
estate.

                             Effective Date

    The proposal would be effective for decedents (i.e., 
surviving spouses) dying after the date of enactment.

                              Prior Action

    The proposal is identical to a provision contained in the 
President's budget proposal for fiscal year 1999.

                                Analysis

    Both the gift tax and the estate tax allow an unlimited 
deduction for certain amounts transferred from one spouse to 
another spouse who is a citizen of the United States.\291\ 
Under both the gift and estate marital deduction, deductions 
are not allowed for so-called ``terminable interests.'' 
Terminable interests generally are created where an interest in 
property passes to the spouse and another interest in the same 
property passes from the donor or decedent to some other person 
for less than full and adequate consideration. For example, an 
income interest to the spouse generally would not qualify for 
the marital deduction where the remainder interest is 
transferred to a third party. Special rules permit a marital 
deduction where the surviving spouse has an income interest if 
that spouse has a testamentary power of appointment or the 
remainder passes to the estate of the surviving spouse.
---------------------------------------------------------------------------
    \291\ In addition, a marital deduction is allowed for both gift and 
estate tax purposes for transfers to spouses who are not citizens of 
the United States if the transfer is to a qualified domestic trust 
(``QDOT''). A QDOT is a trust which has at least one trustee that is a 
United States citizen or a domestic corporation and no distributions 
from corpus can be made without withholding from those distributions.
---------------------------------------------------------------------------
    An exception to the terminable interest rule was added when 
the unlimited marital deduction was provided in 1981. Under 
this exception, a marital deduction is allowed for a transfer 
to a trust of ``qualified terminable interest property,'' 
called ``QTIP,'' in which the spouse has a qualifying income 
interest, so long as the transferor spouse's executor elects to 
include the trust in the spouse's gross estate for Federal 
estate tax purposes and subjects the QTIP to gift tax if the 
spouse disposes of the income interest.
    The purpose and effect of the terminable interest and 
qualified terminable interest rules is to permit deferral of 
taxation on amounts transferred to spouses that are not 
consumed before the death of the second spouse, not to provide 
an exemption from estate and gift tax. In some cases, the 
estate of the first spouse to die has claimed a marital 
deduction as a QTIP and then, after the period of limitations 
for assessing tax on the first estate has lapsed, the estate of 
the second spouse to die argues against inclusion in the second 
estate due to a technical flaw in the QTIP eligibility or 
election in the first estate. If it is determined, after the 
limitations period on the first spouse's estate lapsed, that a 
prior QTIP election was in fact defective, the estate of the 
second spouse would assert that it is not required to include 
the QTIP in the second spouse's estate, thus excluding the QTIP 
from both spouses' estates.
    Under the proposal, the estate of the second spouse to die 
would be required to include property with respect to which the 
estate of the first spouse to die claimed a marital deduction 
even if there was a technical flaw in the QTIP eligibility or 
election in the first estate. This would effectively estop a 
second spouse from claiming, after the limitations period on 
the first spouse's estate lapsed, that the QTIP election on 
behalf of the first spouse's estate was defective.

6. Eliminate non-business valuation discounts

                              Present Law

    Generally, for Federal transfer tax purposes, the value of 
property is its fair market value, i.e., the price at which the 
property would change hands between a willing buyer and a 
willing seller, neither being under any compulsion to buy or 
sell and both having reasonable knowledge of relevant facts. In 
valuing a fractional interest in an non-publicly traded entity, 
taxpayers routinely claim discounts for factors such as 
minority ownership or lack of marketability. The concept of 
such valuation discounts is based upon the principle that a 
willing buyer would not pay a willing seller a proportionate 
share of the value of the entire business when purchasing a 
minority interest in a non-publicly traded business, because 
the buyer may not have the power to manage or control the 
operations of the business, and may not be able to readily sell 
his or her interest.
    In the family estate planning area, a common planning 
technique is for an individual to contribute marketable assets 
to a family limited partnership or limited liability company 
and make gifts of minority interests in the entity to other 
family members. In valuing such gifts for transfer tax 
purposes, taxpayers often claim large discounts on the 
valuation of these gifts.

                        Description of Proposal

    The proposal would eliminate valuation discounts except as 
they apply to active businesses. Interests in entities would be 
required to be valued for transfer tax purposes at a 
proportional share of the net asset value of the entity to the 
extent that the entity holds non-business assets (including 
cash, cash equivalents, foreign currency, publicly traded 
securities, real property, annuities, royalty-producing assets, 
non-income producing property such as art or collectibles, 
commodities, options, and swaps) at the time of the gift or 
death. To the extent the entity conducts an active business, 
the reasonable working capital needs of the business would be 
treated as part of the active business (i.e., not subject to 
the limits on valuation discounts). No inference is intended as 
to the propriety of these discounts under present law.

                             Effective Date

    The proposal would be effective for transfers made after 
the date of enactment.

                              Prior Action

    The proposal is substantially similar to a provision 
contained in the President's budget proposal for fiscal year 
1999.

                                Analysis

    It is well established that discounts may be appropriate in 
valuing minority interests in business entities. See, e.g., 
Estate of Andrews v. Commissioner, 79 T.C. 938 (1982). 
Generally, these discounts take the form of minority discounts 
and lack of marketability discounts. A minority discount 
reflects a decreased value due to the fact that a minority 
shareholder (or partner) may have little ability to control or 
participate in the management of the business, or to compel 
liquidation of the business or payment of distributions. The 
IRS has stated that minority discounts even may be appropriate 
in cases where the transferred interest, when aggregated with 
interests held by family members, is part of a controlling 
interest. See Rev. Rul. 93-12, 1993-1 C.B. 202. In addition to 
minority discounts, an additional valuation discount due to 
lack of marketability also may be available to reflect the fact 
that there is no ready market for interests in a closely-held 
entity. It is not unusual for taxpayers to claim combined 
discounts of 30 to 50 percent, although taxpayers have claimed 
discounts of as much as 60 to 70 percent in some cases. See, 
e.g., Estate of Barudin v. Commissioner, T.C. Memo. 1996-395 
(taxpayer claimed a combined discount of 67.5 percent; the Tax 
Court allowed 45 percent). The appropriate level of discount 
for any particular business interest often is the subject of 
litigation.
    The proposal raises two separate issues relevant to the 
valuation of assets and the administration of the estate tax: 
the appropriateness of minority discounts and the liquidity of 
assets. The issue of minority discounts relates to 
circumstances where the value of a fractional holding of an 
asset may not equal the proportionate market value of the 
entire holding. Analysts generally believe that minority 
discounts result from the ability of the controlling owner to 
dictate the course of future investment, business strategy, or 
timing of liquidation of the asset. Not being able to make such 
decisions generally makes a minority claim on the asset less 
valuable.\292\ The extent of any minority discount depends upon 
the facts and circumstances related to the asset.
---------------------------------------------------------------------------
    \292\ Using the same reasoning, it can be argued that individuals 
may be willing to pay more than the proportionate market value of the 
entire holding in order to have control (i.e., ``control premiums'').
---------------------------------------------------------------------------
    An asset's liquidity is its ability to be readily converted 
to cash. The issue of liquidity of assets relates to 
identifying those assets which are readily tradeable and, 
therefore, for which market values are readily ascertainable 
without great expense to the assets's owner. While people 
generally view passive assets such as stocks and bonds as 
liquid assets, not all passive assets are equally liquid, and 
some passive assets may be less liquid than active assets. For 
example, specialty brokers may be able to more readily generate 
offers to purchase a radio station in a major metropolitan 
area, than would a financial broker who attempts to generate 
offers for the purchase of a bond issued by a small rural 
school district.
    Although the practice of claiming valuation discounts has 
been accepted in valuing active businesses, proponents of the 
proposal maintain that it is less clear whether such discounts 
are appropriate for entities holding non-business assets. For 
example, if an individual contributes his or her stock 
portfolio to an entity and transfers interests in the entity to 
his or her children, it has been questioned whether the stock 
portfolio is somehow worth less to the family, simply because 
its ownership is dispersed among several individuals. In such 
circumstances, where the underlying assets remain non-business 
assets, proponents may argue that issues of control are much 
less important than in the context of making decisions to 
manage the operations of an ongoing active business. That is, 
the proposal would deem there to be no minority or other 
discount in the case of a family enterprise that holds non-
business assets.
    Opponents of this approach note that it is inconsistent 
with observed market outcomes to claim that a minority discount 
cannot exist when the non-business assets in question are 
liquid. For example, assume that a taxpayer holds a one-third 
share in a portfolio of New York Stock Exchange stocks and that 
her brother holds the two-thirds share. In this circumstance, 
the brother might be able to dictate the course of future 
investment, investment strategy, and timing of liquidation of 
the portfolio. Some may argue that such a circumstance could 
reasonably give rise to a minority discount on the value of the 
taxpayer's one-third holding even though the underlying assets 
are liquid.
    In determining how much of a minority discount might be 
appropriate with respect to entities holding liquid assets, it 
may be helpful to consider the value placed on closed-end 
mutual funds. Closed-end mutual funds are traded regularly on 
the open market and, among funds that invest in domestic 
assets, are almost always traded at a discount from the net 
asset value of the underlying assets. The discounts observed in 
the marketplace generally are smaller than those often claimed 
as minority discounts in valuing transfers of business 
interests for estate and gift tax purposes. For example, during 
the last half of 1997, the discount from net asset value of the 
Herzfeld Closed-End Average has ranged from between 12 and four 
percent of net asset value.\293\ On the other hand, closed-end 
mutual funds also may be valued at a premium. While this is 
observed infrequently with closed-end mutual funds that invest 
in domestic equities, it may make it difficult to arrive at any 
generalized conclusions as to the proper valuation of interests 
in such entities.
---------------------------------------------------------------------------
    \293\ The Herzfeld Closed-End Average measures 16 equally-weighted 
closed-end funds that invest principally in equities of U.S. 
corporations. Barron's Market Week, February 9, 1998, p. 89. As an 
average, the Herzfeld Closed-End Average does not reflect the range of 
discounts or premiums that may be observed on individual funds.
---------------------------------------------------------------------------
    To the extent that the proposal would cover assets such as 
real estate and art, the arguments that valuation discounts are 
inappropriate may not be as applicable.\294\ For example, if 
individuals are transferred a portion of art collectibles, it 
may be appropriate for the value transferred to each individual 
to reflect a discount under certain circumstances.
---------------------------------------------------------------------------
    \294\ For example, the Tax Court recently accepted a taxpayer's 
expert's valuation allowing a 44-percent combined discount with respect 
to the transfer of an undivided one-half interest in timberland, based 
on the taxpayer's lack of control and the marketing time and real 
estate commission cost involved in selling real property in that 
particular market, where the Commissioner's expert admitted that an 
undivided one-half interest in real property has a limited market and 
that a fractional interest may be discounted, but introduced no 
testimony or other evidence to rebut the taxpayer's expert's testimony 
as to the appropriate level of discount. Estate of Williams v. 
Commissioner, T.C. Memo. 1998-59.
---------------------------------------------------------------------------

7. Eliminate gift tax exemption for personal residence trusts

                              Present Law

    Section 2702 sets forth special valuation rules for 
circumstances in which an individual sets up a trust, retaining 
a partial interest in the trust and transferring other 
interests in the trust to family members. In general, if an 
interest in a trust is retained by a grantor when other 
interests are transferred to family members, the retained 
interest is valued at zero for gift tax purposes unless it is a 
qualified annuity interest (a ``GRAT''), unitrust interest (a 
``GRUT''), or a remainder interest after a GRAT or a GRUT. A 
special exception under section 2702(a)(3)(A)(ii) provides that 
the special valuation rules do not apply in the case of 
personal residence trusts. In general, a personal residence 
trust is a trust ``all of the property of which consists of a 
residence to be used as a personal residence by persons holding 
term interests in such trust.''

                        Description of Proposal

    The 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, then the trust would be required to pay out the 
required annuity or unitrust amount; otherwise, the grantor's 
retained interest would be valued at zero for gift tax 
purposes.

                             Effective Date

    The proposal would be effective for transfers in trust 
after the date of enactment.

                              Prior Action

    The proposal is identical to a provision contained in the 
President's budget proposal for fiscal year 1999.

                                Analysis

    The present-law rules pertaining to personal residence 
trusts were enacted by Congress in 1990 as a specific statutory 
exception to the general rules of section 2702. Personal 
residence trusts are commonly used as a tax planning device to 
reduce transfer taxes by allowing an individual's home (or 
vacation home) to be transferred to his or her heirs at 
significant tax savings. For example, an individual may 
transfer his primary residence to a trust which provides that 
the grantor may continue to live in the house for fifteen 
years, at which time the trust assets (i.e., the home) will be 
transferred to his children. The grantor may retain a 
reversionary interest in the property (i.e., provide that, if 
the grantor does not survive the trust term, then the property 
would revert to his estate).\295\ The trust agreement may 
further provide that the grantor may continue to live in the 
home after the fifteen-year period as long as he makes rental 
payments to his children at fair market value. If the 
requirements for a personal residence trust are satisfied, then 
the transfer is treated as a gift of the contingent remainder 
interest, which generally has a relatively small value as 
compared to the full fair market value of the residence.
---------------------------------------------------------------------------
    \295\ Reversionary interests commonly are retained so that, if the 
grantor dies before the end of the trust term, then the property may be 
left to the grantor's spouse, thus qualifying for the marital 
deduction. Retention of a reversionary interest also has the effect of 
reducing the amount of the taxable gift.
---------------------------------------------------------------------------
    The gift tax is imposed on the fair market value of the 
property transferred. In the case of a transfer such as the one 
described above, the value of the gift would be determined by 
taking the fair market value of the entire property, and 
subtracting from it the actuarially determined value of the 
grantor's retained income interest and the actuarially 
determined value of any contingent reversionary interest 
retained by the grantor. The actuarially determined value of 
any annuity, interest for life or a term of years, or any 
remainder or reversionary interest is based upon tables set 
forth by the IRS under section 7520. These tables set forth 
valuation rates for each type of interest (e.g., annuity, life 
interest, remainder interest) based upon applicable interest 
rates and the length of the term.
    There are several advantages and disadvantages to the use 
of personal residence trusts. First, such trusts allow an 
individual to transfer his home to his heirs at a significantly 
reduced value for gift tax purposes. In addition, any future 
appreciation in the house is not subject to transfer taxes if 
the grantor survives the trust's term.\296\ Lastly, if the 
grantor continues to live in the home after the trust term has 
expired, then the required rental payments to his heirs will 
reduce the size of his estate (and thus his estate taxes) even 
further. On the other hand, when a personal residence trust is 
utilized, the heirs receive a carryover basis in the residence 
rather than having the basis stepped up to its full fair market 
value on the date of death, as would be the case if the grantor 
held the property until death and transferred it outright to 
the heirs at that time. This disadvantage may be alleviated 
somewhat, however, by the provision in the Taxpayer Relief Act 
of 1997 that potentially exempts up to $500,000 of capital gain 
from tax when the home is sold, if the heirs meet the ownership 
and residence requirements of that provision.
---------------------------------------------------------------------------
    \296\ If the grantor dies during the trust term, then the full fair 
market value of the house at the date of death will be brought back 
into his estate under section 2036, regardless of whether the grantor 
has retained a reversionary interest in the property. However, the 
estate will receive credit for any gift taxes paid (or use of the 
unified credit) with respect to the initial transfer to the personal 
residence trust.
---------------------------------------------------------------------------
    The valuation rules of section 2702 are patterned after the 
rules set forth in section 2055 for determining whether a 
charitable deduction is allowed for split interests in property 
where an interest is given to a charity. When Congress enacted 
section 2055 in 1969, there were concerns that it would be 
inappropriate to give a charitable deduction except in cases 
where there was some assurance that the interest given to 
charity could be properly valued. Types of interests for which 
a deduction was allowed included annuities and unitrusts. 
Generally, an annuity pays a fixed amount each year while a 
unitrust pays out a certain fraction of the value of the trust 
annually. Thus, a charitable deduction is allowed in cases 
where, for example, an annuity is paid to charity with the 
remainder going to an individual, or an annuity is paid to an 
individual with the remainder going to charity, or a unitrust 
pays out to charity annually with the remainder going to an 
individual, or a unitrust pays out to an individual annually 
with the remainder going to charity. In addition, a charitable 
deduction is allowed for the contribution of a remainder 
interest in a personal residence or farm under an exception 
provided in section 170(f)(3)(B)(i). These same basic rules 
were adopted in valuing non-charitable gifts for purposes of 
section 2702.
    Proponents of the proposal argue that the use value of the 
residence retained by the grantor is a poor substitute for an 
annuity or unitrust interest, and that the actuarial tables 
overstate the value of the grantor's retained interest in the 
house. These conclusions are based in part on the fact that in 
a personal residence trust situation, the grantor ordinarily 
remains responsible for the insurance, maintenance, and 
property taxes on the residence, and, thus, the true rental 
value of the house should be less than the fair market rent. 
Such proponents also argue that, by completely exempting 
personal residence trusts from the requirements of section 
2702, personal residence trusts are accorded even more 
beneficial treatment than are GRATs, GRUTs, or remainder 
interests after a GRAT or a GRUT, because, under those 
arrangements, it is not possible to reduce the value of the 
gift by retaining a contingent reversionary interest.
    The proposal does not question whether a remainder interest 
in a personal residence can be appropriately valued for 
purposes of determining the amount of a charitable 
contribution, in that no modification of section 2055 is 
proposed. It is unclear how the same basic valuation rules 
could produce an acceptable result where a remainder interest 
is going to charity, yet an unacceptable result where the 
remainder interest is being transferred to private parties.

                      J. International Provisions

1. Treat certain foreign-source interest and dividend equivalents as 
        U.S.-effectively connected income

                              Present Law

    Nonresident alien individuals or foreign corporations 
(collectively, foreign persons) are subject to U.S. tax on 
income that is effectively connected with the conduct of a U.S. 
trade or business; the U.S. tax on such income is calculated in 
the same manner and at the same graduated rates as the tax on 
U.S. persons (secs. 871(b) and 882). Foreign persons also are 
subject to a 30-percent gross basis tax, collected by 
withholding, on certain U.S.-source income, such as interest, 
dividends and other fixed or determinable annual or periodical 
(``FDAP'') income, that is not effectively connected with a 
U.S. trade or business. This 30-percent withholding tax may be 
reduced or eliminated pursuant to an applicable tax treaty. 
Foreign persons generally are not subject to U.S. tax on 
foreign-source income that is not effectively connected with a 
U.S. trade or business.
    Detailed rules apply for purposes of determining whether 
income is treated as effectively connected with a U.S. trade or 
business (so-called ``U.S.-effectively connected income'') 
(sec. 864(c)). The rules differ depending on whether the income 
at issue is U.S-source or foreign-source income. Under these 
rules, U.S.-source FDAP income, such as U.S.-source interest 
and dividends, and U.S.-source capital gains are treated as 
U.S.-effectively connected income if such income is derived 
from assets used in or held for use in the active conduct of a 
trade or business, or from business activities conducted in the 
United States. All other types of U.S.-source income are 
treated as U.S.-effectively connected income.
    In general, foreign-source income is not treated as U.S.-
effectively connected income (sec. 864(c)(4)). However, certain 
foreign-source rents, royalties, dividends, interest, and 
income on sales of goods in the ordinary course of business are 
treated as U.S.-effectively connected income. In the case of 
foreign-source dividends and interest, such income generally is 
treated as U.S.-effectively connected income if the income is 
attributable to an office or other fixed place of business of 
the foreign person in the United States, and the foreign person 
derives the income in the active conduct of a banking, 
financing or similar business within the United States, or the 
foreign person is a corporation whose principal business is 
trading in stocks or securities for its own account. Income 
generally is not considered attributable to an office or other 
fixed place of business within the United States unless such 
office or fixed place of business is a material factor in the 
production of the income, and such office or fixed place of 
business regularly carries on activities of the type that 
generate such income. In addition, foreign-source dividend or 
interest income generally is not treated as U.S.-effectively 
connected income if the items are paid by a foreign corporation 
in which the recipient owns, directly, indirectly or 
constructively, more than 50 percent of the total combined 
voting power of the stock.
    The Code provides sourcing rules for enumerated types of 
income, including interest, dividends, rents, royalties and 
personal services income (secs. 861 through 865). For example, 
interest income generally is sourced based on the residence of 
the obligor. Dividend income generally is sourced based on the 
residence of the corporation paying the dividend. Thus, 
interest paid on obligations of foreign persons and dividends 
paid by foreign corporations generally are treated as foreign-
source income.
    Other types of income are not specifically covered by the 
Code's sourcing rules. For example, fees for accepting or 
confirming letters of credit have been sourced under principles 
analogous to the interest sourcing rules (See Bank of America 
v. United States, 680 F.2d 142 (Ct. Cl. 1982)). In addition, 
under regulations, payments in lieu of dividends and interest 
derived from securities lending transactions are sourced in the 
same manner as interest and dividends, including for purposes 
of determining whether such income is effectively connected to 
a U.S. trade or business (Treas. Reg. sec. 1.864-5(b)(2)(ii)). 
Moreover, income from notional principal contracts (such as 
interest rate swaps) generally is sourced based on the 
residence of the recipient of the income (Treas. Reg. sec. 
1.863-7).

                        Description of Proposal

    The proposal would expand the categories of foreign-source 
income that are treated as effectively connected with a U.S. 
trade or business to include interest equivalents and dividend 
equivalents. Such income would be treated as U.S.-effectively 
connected income in the same circumstances as foreign-source 
dividends and interest. Thus, foreign-source interest and 
dividend equivalents would be treated as U.S.-effectively 
connected income if the income is attributable to a U.S. office 
of the foreign person, and such income is derived by such 
foreign person in the active conduct of a banking, financing or 
similar business within the United States, or the foreign 
person is a corporation whose principal business is trading in 
stocks or securities for its own account.
    For these purposes, the term ``interest equivalent'' would 
include letter of credit fees, guarantee fees and loan 
commitment fees (whether or not the loan is actually made). 
Dividend equivalents generally would mean payments in lieu of 
dividends derived from equity securities lending transactions. 
The proposal would not affect the determination of whether such 
interest or dividend equivalents are treated as U.S.-source or 
foreign-source income.

                             Effective Date

    The proposal would be effective for taxable years beginning 
after the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    The Administration's proposal analogizes two transactions 
that currently are treated differently for purposes of 
determining whether income is U.S.-effectively connected 
income; guarantees of foreign risk by a U.S. trade or business, 
and an extension of credit through the material activities of a 
U.S. trade or business. Under present law, interest received on 
a short-term loan to a foreign customer by the U.S. branch of a 
foreign corporation generally would be treated as U.S.-
effectively connected income. However, fees received by such a 
U.S. branch with respect to its guarantee of an obligation of a 
foreign person may not be treated as U.S.-effectively connected 
income, even if the U.S. branch materially participated in the 
transaction.
    Some argue that present law creates arbitrary distinctions 
between economically similar transactions that are equally 
related to a U.S. trade or business. The proposal reflects the 
view that the United States should be permitted to tax certain 
income generated from material business activities that take 
place in the United States through a U.S. office, regardless of 
the source of such income. It is argued that the rules for 
determining whether income that is sourced by analogy to 
interest and dividends is U.S.-effectively connected income 
should be the same as the rules for determining whether 
interest and dividends are U.S.-effectively connected income.
    Some, however, might argue that guarantee fees, letter of 
credit fees, as well as loan commitment fees (for loans not 
actually made) are not items that are equivalent to 
interest.\297\ On the other hand, it could be argued that such 
items may be viewed as sufficiently analogous to interest to 
warrant taxation under similar circumstances.
---------------------------------------------------------------------------
    \297\ See, e.g., section 954(c)(1)(E), which treats loan commitment 
fees and similar amounts as interest equivalents and, thus, as subpart 
F foreign personal holding company income, only for loans actually 
made.
---------------------------------------------------------------------------

2. Recapture overall foreign losses when controlled foreign corporation 
        stock is disposed

                              Present Law

    U.S. persons may credit foreign taxes against U.S. tax on 
foreign-source income. The amount of foreign tax credits that 
may be claimed in a year is subject to a limitation that 
prevents taxpayers from using foreign tax credits to offset 
U.S. tax on U.S.-source income. The amount of foreign tax 
credits generally is limited to the portion of the taxpayer's 
U.S. tax which the taxpayer's foreign-source taxable income 
(i.e., foreign-source gross income less allocable expenses or 
deductions) bears to the taxpayer's worldwide taxable income 
for the year (sec. 904(a)). Separate limitations are applied to 
specific categories of income.
    Special recapture rules apply in the case of foreign losses 
for purposes of applying the foreign tax credit limitation 
(sec. 904(f)). Under these rules, losses for any taxable year 
in a limitation category which exceed the aggregate amount of 
foreign income earned in other limitation categories (a so-
called ``overall foreign loss'') are recaptured by resourcing 
foreign-source income earned in a subsequent year as U.S.-
source income (sec. 904(f)(1)). The amount resourced as U.S.-
source income generally is limited to the lesser of the amount 
of the overall foreign losses not previously recaptured, or 50 
percent of the taxpayer's foreign-source income in a given year 
(the ``50-percent limit''). Taxpayers may elect to recapture a 
larger percentage of such losses.
    A special recapture rule applies to ensure the recapture of 
an overall foreign loss where property which was used in a 
trade or business predominantly outside the United States is 
disposed of prior to the time the loss has been recaptured 
(sec. 904(f)(3)). In this regard, dispositions of trade or 
business property used predominantly outside the United States 
are treated as having been recognized as foreign-source income 
(regardless of whether gain would otherwise be recognized upon 
disposition of the assets), in an amount equal to the lesser of 
the excess of the fair market value of such property over its 
adjusted basis, or the amount of unrecaptured overall foreign 
losses. Such foreign-source income is resourced as U.S.-source 
income without regard to the 50-percent limit. For example, if 
a U.S. corporation transfers its foreign branch business assets 
to a foreign corporation in a nontaxable section 351 
transaction, the taxpayer would be treated for purposes of the 
recapture rules as having recognized foreign-source income in 
the year of the transfer in an amount equal to the excess of 
the fair market value of the property disposed over its 
adjusted basis (or the amount of unrecaptured foreign losses, 
if smaller). Such income would be recaptured as U.S.-source 
income to the extent of any prior unrecaptured overall foreign 
losses.\298\
---------------------------------------------------------------------------
    \298\ Coordination rules apply in the case of losses recaptured 
under the branch loss recapture rules (sec. 367(a)(3)(C)).
---------------------------------------------------------------------------
    Detailed rules apply in allocating and apportioning 
deductions and losses for foreign tax credit limitation 
purposes. In the case of interest expense, such amounts 
generally are apportioned to all gross income under an asset 
method, under which the taxpayer's assets are characterized as 
producing income in statutory or residual groupings (i.e., 
foreign-source income in the various limitation categories or 
U.S.-source income) (sec. 864(e) and Temp. Treas. Reg. sec. 
1.861-9T). Interest expense is apportioned among these 
groupings based on the relative asset values in each. Taxpayers 
may elect to value assets based on either tax book value or 
fair market value.
    Each corporation that is a member of an affiliated group is 
required to apportion its interest expense using apportionment 
fractions determined by reference to all assets of the 
affiliated group. For this purpose, an affiliated group 
generally is defined to include only domestic corporations. 
Stock in a foreign subsidiary, however, is treated as a foreign 
asset that may attract the allocation of U.S. interest expense 
for these purposes. If tax basis is used to value assets, the 
adjusted basis of the stock of certain 10-percent or greater 
owned foreign corporations or other non-affiliated corporations 
must be increased by the amount of earnings and profits of such 
corporation accumulated during the period the U.S. shareholder 
held the stock.

                        Description of Proposal

    The proposal would apply the special recapture rule for 
overall foreign losses that currently applies to dispositions 
of foreign trade or business assets to the disposition of 
controlled foreign corporation stock. Thus, dispositions of 
controlled foreign corporation stock would be recognized as 
foreign-source income in an amount equal to the lesser of the 
fair market value of the stock over its adjusted basis, or the 
amount of prior unrecaptured overall foreign losses. Such 
income would be resourced as U.S.-source income for foreign tax 
credit limitation purposes without regard to the 50-percent 
limit.

                             Effective Date

    The proposal would be effective as of the date of 
enactment.

                              Prior Action

    No prior action.

                                Analysis

    Dispositions of stock of a corporation generally are not 
subject to the special recapture rules for overall foreign 
losses under section 904(f)(3). Ownership of stock in a foreign 
subsidiary can lead to, or increase, an overall foreign loss as 
a result of interest expenses allocated against foreign-source 
income under the interest expense allocation rules. The 
recapture of overall foreign losses created by such interest 
expense allocations may be avoided if, for example, the stock 
of the foreign subsidiary subsequently were transferred to 
unaffiliated parties in non-taxable transactions. The proposal 
would recapture such overall foreign losses where stock of a 
controlled foreign corporation is disposed, regardless of 
whether such stock is disposed in a non-taxable transaction.
    Some have observed that the interest expense allocation 
rules can operate to restrict a taxpayer's ability to claim 
foreign tax credits. Expanding the special recapture rules to 
include dispositions of controlled foreign stock could be 
viewed as further limiting the ability of taxpayers to claim 
relief from potential double taxation.

3. Amend 80/20 company rules

                              Present Law

    In general, U.S.-source interest and dividends paid to 
nonresident alien individuals and foreign corporations 
(``foreign persons'') that are not effectively connected with a 
U.S. trade or business are subject to a U.S. withholding tax on 
the gross amount of such income at a rate of 30 percent (secs. 
871(a) and 881(a)). The 30-percent withholding tax may be 
reduced or eliminated pursuant to an income tax treaty between 
the United States and the foreign country where the foreign 
person is resident. Furthermore, an exemption from this 
withholding tax is provided for certain items of U.S.-source 
interest income (e.g., portfolio interest). The United States 
generally does not impose withholding tax on foreign-source 
interest and dividend payments.
    Interest and dividend income generally is sourced in the 
country of incorporation of the payor. Thus, interest or 
dividends paid by a U.S. corporation to foreign persons 
generally are subject to U.S. withholding tax. However, if a 
U.S. corporation meets an 80-percent active foreign business 
income test (the ``80/20 test''), all or a portion of any 
interest or dividends paid by that corporation (a so-called 
``80/20 company'') effectively is exempt from U.S. withholding 
tax. In general, a U.S. corporation meets the 80/20 test if at 
least 80 percent of the gross income of the corporation during 
a specified testing period is derived from foreign sources and 
is attributable to the active conduct of a trade or business in 
a foreign country (or a U.S. possession) by the corporation or 
a 50-percent owned subsidiary of the corporation. The testing 
period generally is the three-year period preceding the year in 
which the interest or dividend is paid.
    Interest paid by an 80/20 company is treated as foreign-
source income (and, therefore, exempt from the 30-percent 
withholding tax) if paid to unrelated parties. Interest paid by 
an 80/20 company to related parties is treated as having a 
prorated source based on the source of the income of such 
company during the three-year testing period (a so-called 
``look-through'' approach). Dividends paid by an 80/20 company 
are treated as wholly or partially exempt from U.S. withholding 
tax under a similar look-through approach based on the source 
of the income of such company during the three-year testing 
period.

                        Description of Proposal

    The proposal would apply the 80/20 test on a group-wide 
basis. Therefore, members of a group would be required to 
aggregate their gross income for purposes of applying the 80/20 
test. For this purpose, a group would be defined to include the 
U.S. corporation making the payment, as well as any subsidiary 
in which that corporation owns, directly or indirectly, at 
least 50 percent of the stock.

                             Effective Date

    The proposal would apply to interest or dividends paid or 
accrued more than 30 days after the date of enactment.

                              Prior Action

    A similar proposal was included in the President's fiscal 
year 1999 budget proposal.

                                Analysis

    The 80/20 test generally is applied based on the gross 
income of a ``tested'' U.S. corporation (i.e., the corporation 
paying the interest or dividend) during a three-year lookback 
period. In some cases this three-year lookback period may be 
subject to manipulation and can result in the improper 
avoidance of U.S. withholding tax with respect to certain 
distributions attributable to the U.S.-source earnings of a 
U.S. subsidiary of the payor corporation. For instance, 
dividends paid by a ``tested'' U.S. corporation attributable to 
the U.S.-source earnings of a U.S. subsidiary of such 
corporation can be timed in such a manner that the earnings are 
not included in the three-year lookback period. Some assert 
that such a dividend timing strategy is not unlike other 
dividend timing strategies (or so-called ``rhythm methods''), 
such as those previously used to maximize section 902 foreign 
tax credits prior to the adoption in 1986 of the pooling 
concept for a foreign subsidiary's earnings and profits and 
taxes.
    Advocates of the proposal argue that applying the 80/20 
test on a group basis will significantly restrict the improper 
avoidance of U.S. withholding tax through manipulation of the 
three-year lookback rule. For this purpose, the group would be 
narrowly defined to include only the tested U.S. corporation 
and 50-percent owned subsidiaries of such corporation.
    Some may argue that a group approach by its nature may not 
be sufficiently targeted to the specific timing issues raised 
by the three-year lookback rule. The proposal also may affect 
U.S. income tax treaties that contain provisions that 
incorporate the 80/20 test (e.g., the U.S.-UK income tax treaty 
which provides that the reduced rates of tax on dividends, 
interest and royalties do not apply to certain 80/20 
companies); the interaction of this proposal with the affected 
treaties would require further clarification.

4. Modify foreign office material participation exception applicable to 
        certain inventory sales

                              Present Law

    Foreign persons are subject to U.S. tax on income that is 
effectively connected with the conduct of a U.S. trade or 
business; the U.S. tax on such income is calculated in the same 
manner and at the same graduated rates as the tax on U.S. 
persons (secs. 871(b) and 882). Detailed rules apply for 
purposes of determining whether income is treated as 
effectively connected with a U.S. trade or business (sec. 
864(c)). Under these rules, foreign-source income is treated as 
effectively connected with a U.S. trade or business only in 
limited circumstances (sec. 864(c)(4)).
    Income derived from the sale of personal property other 
than inventory property generally is sourced based on the 
residence of the seller (sec. 865(a)). Income derived from the 
sale of inventory property generally is sourced where the sale 
occurs (i.e., where title to the property passes from the 
seller to the buyer) (secs. 865(b) and 861(a)(6)). However, a 
special rule applies in the case of certain sales by foreign 
persons. If a foreign person maintains an office or other fixed 
place of business in the United States, income from a sale of 
personal property (including inventory property) attributable 
to such office or place of business is sourced in the United 
States (sec. 865(e)(2)(A)). This special rule does not apply, 
however, in the case of inventory property that is sold by the 
foreign person for use, disposition or consumption outside the 
United States if an office or other fixed place of business of 
such person outside the United States materially participated 
in the sale (sec. 865(e)(2)(B)). Accordingly, income from the 
sale by a foreign person of inventory property attributable to 
an office or other fixed place of business of such foreign 
person in the United States is sourced based on where the sale 
occurs, provided that the inventory property is sold for use 
outside the United States and a foreign office or other fixed 
place of business of such person materially participated in the 
sale. Income that is sourced outside the United States under 
this rule is not treated as effectively connected with a U.S. 
trade or business.

                        Description of Proposal

    Under the proposal, the foreign office material 
participation rule would apply only if an income tax equal to 
at least 10 percent of the income from the sale actually is 
paid to a foreign country with respect to such income. 
Accordingly, income from the sale by a foreign person of 
inventory property attributable to an office or other fixed 
place of business of such person in the United States would be 
sourced in the United States if an income tax of at least 10 
percent of the income from the sale is not paid to a foreign 
country. Income sourced in the United States under this 
proposal would be treated as effectively connected with a U.S. 
trade or business conducted by the foreign person.

                             Effective Date

    The proposal would be effective for transactions occurring 
on or after the date of enactment.

                              Prior Action

    The proposal was included in the President's fiscal year 
1999 budget proposal.

                                Analysis

    Under present law, a foreign person that maintains an 
office in the United States is not subject to U.S. tax on 
income derived from sales of inventory property attributable to 
such office provided that the property is sold for use outside 
the United States and a foreign office materially participated 
in the sale. The foreign person is not subject to U.S. tax on 
such income even if no foreign country imposes tax on the 
income. The proposal would modify this material participation 
rule so that it would apply only if an income tax of at least 
10 percent is paid to a foreign country with respect to such 
income.
    The proposal reflects the view that the United States 
should not cede its jurisdiction to tax income from sales of 
inventory property attributable to an office in the United 
States unless the income from such sale is subject to foreign 
tax at some minimal level. Under present law, a similar rule 
applies in the case of certain sales by a U.S. person of 
personal property (other than inventory property) attributable 
to an office or other fixed place of business outside the 
United States; such income is sourced outside the United 
States, but only if a foreign income tax of at least 10 percent 
is paid with respect to such income.

5. Modify controlled foreign corporation exemption from U.S. tax on 
        transportation income

                              Present Law

    The United States generally imposes a 4-percent tax on the 
U.S.-source gross transportation income of foreign persons that 
is not effectively connected with the foreign person's conduct 
of a U.S. trade or business (sec. 887). Foreign persons 
generally are subject to U.S. tax at regular graduated rates on 
net income, including transportation income, that is 
effectively connected with a U.S. trade or business (secs. 
871(b) and 882).
    Transportation income is any income derived from, or in 
connection with, the use (or hiring or leasing for use) of a 
vessel or aircraft (or a container used in connection 
therewith) or the performance of services directly related to 
such use (sec. 863(c)(3)). Income attributable to 
transportation that begins and ends in the United States is 
treated as derived from sources in the United States (sec. 
863(c)(1)). Transportation income attributable to 
transportation that either begins or ends (but not both) in the 
United States is treated as derived 50 percent from U.S. 
sources and 50 percent from foreign sources (sec. 863(c)(2)). 
U.S.-source transportation income is treated as effectively 
connected with a foreign person's conduct of a U.S. trade or 
business only if the foreign person has a fixed place of 
business in the United States that is involved in the earning 
of such income and substantially all of such income of the 
foreign person is attributable to regularly scheduled 
transportation (sec. 887(b)(4)).
    An exemption from U.S. tax is provided for income derived 
by a nonresident alien individual or foreign corporation from 
the international operation of a ship or aircraft, provided 
that the foreign country in which such individual is resident 
or such corporation is organized grants an equivalent exemption 
to individual residents of the United States or corporations 
organized in the United States (secs. 872(b)(1) and (2) and 
883(a)(1) and (2)). In the case of a foreign corporation, this 
exemption does not apply if 50 percent or more of the stock of 
the foreign corporation by value is owned by individuals who 
are not residents of a country that provides such an exemption 
unless the foreign corporation satisfies one of two alternative 
tests (sec. 883(c)). Under these alternative tests, the 
exemption applies to a foreign corporation without regard to 
the residence of the corporation's shareholders either if the 
foreign corporation is a controlled foreign corporation (a 
``CFC'') or if the stock of the corporation is primarily and 
regularly traded on an established securities market in the 
United States or in a foreign country that provides an 
equivalent exemption. Accordingly, the exemption for 
transportation income applies to any CFC formed in a country 
that provides an equivalent exemption, regardless of whether 
the owners of the stock of the CFC are residents of such a 
country.
    A foreign corporation is a CFC if U.S. persons own more 
than 50 percent of the corporation's stock (measured by vote or 
by value), taking into account only those U.S. persons that own 
at least 10 percent of the stock (measured by vote only) (secs. 
957 and 951(b)). For this purpose, a U.S. partnership is 
considered a U.S. person (secs. 957(c) and 7701(a)(30)). The 
U.S. 10-percent shareholders of a CFC are required to include 
in income currently for U.S. tax purposes their pro rata shares 
of certain income of the CFC and their pro rata shares of the 
CFC's earnings invested in U.S. property (sec. 951).

                        Description of Proposal

    The proposal would modify the provision under which a CFC 
organized in a country that provides an equivalent exemption is 
eligible for the exemption from U.S. tax for transportation 
income without regard to the residence of the shareholders of 
the CFC. Under the proposal, a CFC would qualify for this 
exemption only if the CFC is more than 50-percent owned 
(directly, indirectly or constructively) by U.S. shareholders 
that are individuals or corporations required to include in 
gross income the subpart F income of the CFC. A CFC that does 
not satisfy this test would be eligible for the exemption for 
transportation income only if it satisfies either the 
requirement as to the residence of its shareholders or the 
public trading test of present law.

                             Effective Date

    The proposal would be effective for taxable years beginning 
after the date of enactment.

                              Prior Action

    The proposal was included in the President's fiscal year 
1999 budget proposal.

                                Analysis

    The proposal is intended to prevent the use of the CFC test 
by foreign persons that are not residents of a country that 
grants an equivalent exemption to obtain the benefit of the 
exemption from U.S. tax for transportation income. Under 
present law, if 50 percent or more of the stock of a foreign 
corporation is owned by individuals who are residents of 
countries that do not provide an equivalent exemption, such 
foreign corporation generally is not eligible for the exemption 
from U.S. tax for transportation income (even though the 
corporation is itself organized in an equivalent exemption 
country). However, if such persons hold the stock of the 
foreign corporation through a U.S. partnership, the corporation 
will constitute a CFC and therefore under present law will 
qualify for the exemption. The proposal would prevent this 
result and would permit CFCs to qualify for the exemption from 
U.S. tax for transportation income only if U.S. persons subject 
to U.S. tax (i.e., individuals or corporations) own more than 
50 percent of the stock of the CFC (directly, indirectly or 
constructively).
    The proposal could give rise to double taxation in certain 
circumstances. The U.S. 10-percent shareholders of a CFC are 
required to include in income currently their pro rata shares 
of certain income of the CFC, including certain shipping 
income. Under the proposal, a CFC that does not satisfy the 
ownership requirements set forth in the proposal would not be 
eligible for an exemption from the U.S. 4-percent tax on 
transportation income. Thus, income of such a CFC would be 
subject to the U.S. 4-percent tax at the CFC-level and also 
could be includible in the incomes, and therefore subject to 
U.S. tax, of any U.S. 10-percent shareholders. It should be 
noted that the same potential for double taxation could occur 
under present law in the case of a CFC organized in a foreign 
country that does not grant an equivalent exemption.

6. Replace sales-source rules with activity-based rules

                              Present Law

    U.S. persons are subject to U.S. tax on their worldwide 
income. Foreign taxes may be credited against U.S. tax on 
foreign-source income of the taxpayer. For purposes of 
computing the foreign tax credit, the taxpayer's income from 
U.S. sources and from foreign sources must be determined.
    Income from the sale or exchange of inventory property that 
is produced (in whole or in part) within the United States and 
sold or exchanged outside the United States, or produced (in 
whole or in part) outside the United States and sold or 
exchanged within the United States, is treated as partly from 
U.S. sources and partly from foreign sources. Treasury 
regulations provide that 50 percent of such income is treated 
as attributable to production activities and 50 percent is 
treated as attributable to sales activities. Alternatively, the 
taxpayer may elect to determine the portion of such income that 
is attributable to production activities based upon an 
available independent factory price (i.e., the price at which 
the taxpayer makes a sale to a wholly independent distributor 
in a transaction that reasonably reflects the income earned 
from the production activity). With advance permission of the 
Internal Revenue Service, the taxpayer instead may elect to 
determine the portion of its income attributable to production 
activities and the portion attributable to sales activities 
based upon its books and records.
    The portion of the income that is considered attributable 
to production activities generally is sourced based on the 
location of the production assets. The portion of the income 
that is considered attributable to sales activities generally 
is sourced where the sale occurs. Treasury regulations provide 
that the place of sale will be presumed to be the United States 
if the property is wholly produced in the United States and is 
sold for use, consumption, or disposition in the United States.
    Specific rules apply for purposes of determining the source 
of income from the sale of products derived from natural 
resources within the United States and sold outside the United 
States or derived from natural resources outside the United 
States and sold within the United States.

                        Description of Proposal

    Under the proposal, income from the sale or exchange of 
inventory property that is produced in the United States and 
sold or exchanged abroad, or produced abroad and sold or 
exchanged in the United States, would be apportioned between 
production activities and sales activities based on actual 
economic activity. The proposal would not modify the rules 
regarding the source of income derived from natural resources.

                             Effective Date

    The proposal would apply to taxable years beginning after 
the date of enactment.

                              Prior Action

    The proposal was included in the President's fiscal year 
1998 and 1999 budget proposals.

                                Analysis

    The 50/50 source rule of present law may be viewed as 
drawing an arbitrary line in determining the portion of income 
that is treated as attributable to production activities and 
the portion that is treated as attributable to sales 
activities. The proposal could be viewed as making this 
determination more closely reflect the economic components of 
the export sale. Some further argue that the present-law rule 
is advantageous only to U.S. companies that also have 
operations in high-tax foreign countries. In many cases, the 
income from a taxpayer's export sales is not subject to tax in 
the foreign jurisdiction and therefore does not give rise to 
foreign tax credits. The present-law treatment of 50 percent of 
the income from a taxpayer's export sales of property it 
manufactured in the United States as foreign-source income 
therefore has the effect of allowing the taxpayer to use excess 
foreign tax credits, if any, that arise with respect to other 
operations. It is argued that the proposal would prevent what 
might be viewed as the inappropriate use of such excess foreign 
tax credits.
    Others argue that the 50/50 source rule of present law is 
important to the U.S. economy and should be retained. It is 
further argued that the rule is needed to counter-balance 
various present-law restrictions on the foreign tax credit that 
can operate to deny the taxpayer a credit for foreign taxes 
paid with respect to foreign operations, thereby causing the 
taxpayer to be subject to double tax on such income. Moreover, 
the 50/50 source rule of present law can be viewed as having 
the advantage of administrative simplicity; the proposal to 
apportion income between the taxpayer's production activities 
and its sales activities based on actual economic activity has 
the potential to raise complex factual issues similar to those 
raised under the section 482 transfer pricing rules that apply 
in the case of transactions between related parties.

7. Modify rules relating to foreign oil and gas extraction income

                              Present Law

    U.S. persons are subject to U.S. income tax on their 
worldwide income. A credit against U.S. tax on foreign-source 
income is allowed for foreign taxes paid or accrued (or deemed 
paid). The foreign tax credit is available only for foreign 
income, war profits, and excess profits taxes and for certain 
taxes imposed in lieu of such taxes. Other foreign levies 
generally are treated as deductible expenses only. Treasury 
regulations provide detailed rules for determining whether a 
foreign levy is a creditable income tax. A levy generally is a 
tax if it is a compulsory payment under the authority of a 
foreign country to levy taxes and is not compensation for a 
specific economic benefit provided by a foreign country. A 
taxpayer that is subject to a foreign levy and that also 
receives a specific economic benefit from such country is 
considered a ``dual-capacity taxpayer.'' Treasury regulations 
provide that the portion of a foreign levy paid by a dual-
capacity taxpayer that is considered a tax is determined based 
on all the facts and circumstances. Alternatively, under a safe 
harbor provided in the regulations, the portion of a foreign 
levy paid by a dual-capacity taxpayer that is considered a tax 
is determined based on the foreign country's generally 
applicable tax or, if the foreign country has no general tax, 
the U.S. tax (Treas. Reg. sec. 1.901-2A(e)).
    The amount of foreign tax credits that a taxpayer may claim 
in a year is subject to a limitation that prevents taxpayers 
from using foreign tax credits to offset U.S. tax on U.S.-
source income. The foreign tax credit limitation is calculated 
separately for specific categories of income. The amount of 
creditable taxes paid or accrued (or deemed paid) in any 
taxable year which exceeds the foreign tax credit limitation is 
permitted to be carried back two years and carried forward five 
years. Under a special limitation, taxes on foreign oil and gas 
extraction income are creditable only to the extent that they 
do not exceed a specified amount (e.g., 35 percent of such 
income in the case of a corporation). For this purpose, foreign 
oil and gas extraction income is income derived from foreign 
sources from the extraction of minerals from oil or gas wells 
or the sale or exchange of assets used by the taxpayer in such 
extraction. A taxpayer must have excess limitation under the 
special rules applicable to foreign extraction taxes and excess 
limitation under the general foreign tax credit provisions in 
order to utilize excess foreign oil and gas extraction taxes in 
a carryback or carryforward year. A recapture rule applicable 
to foreign oil and gas extraction losses treats income that 
otherwise would be foreign oil and gas extraction income as 
foreign-source income that is not considered oil and gas 
extraction income; the taxes on such income retain their 
character as foreign oil and gas extraction taxes and continue 
to be subject to the special limitation imposed on such taxes.

                        Description of Proposal

    The proposal would deny the foreign tax credit with respect 
to all amounts paid or accrued (or deemed paid) to any foreign 
country by a dual-capacity taxpayer if the country does not 
impose a generally applicable income tax. A dual-capacity 
taxpayer would be a person that is subject to a foreign levy 
and also receives (or will receive) directly or indirectly a 
specific economic benefit from such foreign country. A 
generally applicable income tax would be an income tax that is 
imposed on income derived from business activities conducted 
within that country, provided that the tax has substantial 
application (by its terms and in practice) to persons who are 
not dual-capacity taxpayers and to persons who are citizens or 
residents of the foreign country. If the foreign country 
imposes a generally applicable income tax, the foreign tax 
credit available to a dual-capacity taxpayer would not exceed 
the amount of tax that is paid pursuant to the generally 
applicable income tax or that would be paid if the generally 
applicable income tax were applicable to the dual-capacity 
taxpayer. Amounts for which the foreign tax credit is denied 
could constitute deductible expenses. The proposal would not 
apply to the extent contrary to any treaty obligation of the 
United States.
    The proposal would replace the special limitation rules 
applicable to foreign oil and gas extraction income with a 
separate foreign tax credit limitation under section 904(d) 
with respect to foreign oil and gas income. For this purpose, 
foreign oil and gas income would include foreign oil and gas 
extraction income and foreign oil related income. Foreign oil 
related income is income derived from foreign sources from the 
processing of minerals extracted from oil or gas wells into 
their primary products, the transportation, distribution or 
sale of such minerals or primary products, the disposition of 
assets used by the taxpayer in one of the foregoing businesses, 
or the performance of any other related service. The proposal 
would repeal both the special carryover rules applicable to 
excess foreign oil and gas extraction taxes and the recapture 
rule for foreign oil and gas extraction losses.

                             Effective Date

    The proposal with respect to the treatment of dual-capacity 
taxpayers would apply to foreign taxes paid or accrued in 
taxable years beginning after the date of enactment. The 
proposal with respect to the foreign tax credit limitation 
generally would apply to taxable years beginning after the date 
of enactment.

                              Prior Action

    The proposal was included in the President's fiscal year 
1998 and 1999 budget proposals. The proposal in the fiscal year 
1998 budget proposal also included an additional modification 
with respect to the treatment of foreign oil and gas income 
under subpart F of the Code which is not included in this 
proposal.

                                Analysis

    The proposal with respect to the treatment of dual-capacity 
taxpayers addresses the distinction between creditable taxes 
and non-creditable payments for a specific economic benefit. 
The proposal would modify rules currently provided under the 
Treasury regulations and would deny a foreign tax credit for 
amounts paid by a dual-capacity taxpayer to any foreign country 
that does not have a tax that satisfies the definition of a 
generally applicable income tax. Thus, neither the present-law 
facts and circumstances test nor the present-law safe harbor 
based on the U.S. tax rate would apply in determining whether 
any portion of a foreign levy constitutes a tax.
    Proponents of the proposal argue that the safe harbor of 
the present regulations allows taxpayers to claim foreign tax 
credits for payments that are more appropriately characterized 
as royalty expenses. Opponents of the proposal argue that the 
mere fact that a foreign country does not impose a tax that 
qualifies under the specific definition of a generally 
applicable income tax should not cause all payments to such 
country by a dual-capacity taxpayer to be treated as royalties 
rather than taxes. Moreover, applying such a rule to dual-
capacity taxpayers could disadvantage them relative to other 
persons that are subject to a levy in a country that does not 
impose a tax that satisfies the specific definition of a 
generally applicable income tax but that do not also receive a 
specific economic benefit from such country (e.g., a taxpayer 
that is not in a natural resources business); a taxpayer that 
is not a dual-capacity taxpayer would not be subject to this 
disallowance rule and therefore could continue to claim foreign 
tax credits for payments to a foreign country that does not 
impose a generally applicable income tax. In addition, issues 
necessarily would continue to arise in determining whether a 
taxpayer is a dual-capacity taxpayer and whether a foreign 
country has a generally applicable income tax.
    Under the proposal, a separate foreign tax credit 
limitation (or ``basket'') would apply to foreign oil and gas 
income, which would include both foreign oil and gas extraction 
income and foreign oil related income. In addition, the 
present-law special limitation for extraction taxes would be 
eliminated. The proposed single basket rule may provide some 
simplification by eliminating issues that arise under present 
law in distinguishing between income that qualifies as 
extraction income and income that qualifies as oil related 
income. The proposal also would have the effect of allowing the 
foreign taxes on extraction income, which may be imposed at 
relatively high rates, to be used to offset the U.S. tax on 
foreign oil related income, which may be subject to lower-rate 
foreign taxes.

                         K. Pension Provisions

1. Increase elective withholding rate for nonperiodic distributions 
        from deferred compensation plans

                              Present Law

    Present law provides that income tax withholding is 
required on designated distributions from employer deferred 
compensation plans (whether or not such plans are tax 
qualified), individual retirement arrangements (``IRAs''), and 
commercial annuities unless the payee elects not to have 
withholding apply. A designated distribution does not include 
any payment (1) that is wages, (2) the portion of which it is 
reasonable to believe is not includible in gross income,\299\ 
(3) that is subject to withholding of tax on nonresident aliens 
and foreign corporations (or would be subject to such 
withholding but for a tax treaty), or (4) that is a dividend 
paid on certain employer securities (as defined in sec. 
404(k)(2)).
---------------------------------------------------------------------------
    \299\ All IRA distributions are treated as if includible in income 
for purposes of this rule.
---------------------------------------------------------------------------
    Tax is generally withheld on the taxable portion of any 
periodic payment as if the payment is wages to the payee. A 
periodic payment is a designated distribution that is an 
annuity or similar periodic payment.
    In the case of a nonperiodic distribution, tax generally is 
withheld at a flat 10-percent rate unless the payee makes an 
election not to have withholding apply. A nonperiodic 
distribution is any distribution that is not a periodic 
distribution. Under current administrative rules, an individual 
receiving a nonperiodic distribution can designate an amount to 
be withheld in addition to the 10-percent otherwise required to 
be withheld.
    Under present law, in the case of a nonperiodic 
distribution that is an eligible rollover distribution, tax is 
withheld at a 20-percent rate unless the payee elects to have 
the distribution rolled directly over to an eligible retirement 
plan (i.e., an IRA, a qualified plan (sec. 401(a)) that is a 
defined contribution plan permitting direct deposits of 
rollover contributions, or a qualified annuity plan (sec. 
403(a)). In general, an eligible rollover distribution includes 
any distribution to an employee of all or any portion of the 
balance to the credit of the employee in a qualified plan or 
qualified annuity plan. An eligible rollover distribution does 
not include any distribution that is part of a series of 
substantially equal periodic payments made (1) for the life (or 
life expectancy) of the employee or for the joint lives (or 
joint life expectancies) of the employee and the employee's 
designated beneficiary, or (2) over the a specified period of 
10 years or more. An eligible rollover distribution also does 
not include any distribution required under the minimum 
distribution rules of section 401(a)(9), hardship distributions 
from section 401(k) plans, or the portion of a distribution 
that is not includible in income. The payee of an eligible 
rollover distribution can only elect not to have withholding 
apply by making the direct rollover election.

                        Description of Proposal

    Under the proposal, the withholding rate for nonperiodic 
distributions would be increased from 10 percent to 15 percent. 
As under present law, unless the distribution was an eligible 
rollover distribution, the payee could elect not to have 
withholding apply. The proposal would not modify the 20-percent 
withholding rate that applies to any distribution that is an 
eligible rollover distribution.

                             Effective Date

    The proposal would be effective for distributions made 
after December 31, 1999.

                              Prior Action

    No prior action.

                                Analysis

10-percent withholding rate

    The present-law rules require a recipient of a nonperiodic 
distribution (other than an eligible rollover distribution) to 
have withholding on the nonperiodic distribution at a 10-
percent rate or to elect to have no withholding apply. Because 
this 10-percent withholding rate is less than the lowest 
individual income tax rate of 15 percent, the rate of 
withholding will be too low in the case of an individual who 
would like to have the proper amount withheld from his or her 
distribution. Such an individual may be required to make 
estimated tax payments if he or she does not have sufficient 
wage income from which an adequate amount can be withheld.
    An increase in the 10-percent withholding rate will 
generally ensure that an individual who wants to have 
withholding apply to a nonperiodic distribution (other than an 
eligible rollover distribution) will be more likely to have the 
proper amount withheld. However, an increase in the rate of 
withholding may also have the effect of causing some 
individuals who otherwise would not elect out of withholding to 
make the election out.
    Under the present-law rules, distributions from qualified 
plans will be subject to either the elective withholding rules 
for periodic distributions or the 20-percent mandatory 
withholding rate on eligible rollover distributions for which a 
plan participant does not make a direct rollover election. 
Thus, the 10-percent elective withholding rate for nonperiodic 
distributions is primarily applicable only to distributions 
from nonqualified deferred compensation arrangements, IRAs, 
commercial annuities and certain hardship distributions from 
section 401(k) plans. Some may question whether withholding on 
distributions from such arrangements or annuities should be 
elective or mandatory. In addition, individuals receiving 
distributions from such arrangements will often be subject to 
at least the 28 percent marginal income tax rate, which 
suggests that the 15-percent rate proposed by the 
Administration may still be too low to ensure that an adequate 
amount of tax is withheld.

Withholding with respect to eligible rollover distributions

    The rationale for the 20-percent withholding rate on 
eligible rollover distributions from qualified pension plans is 
to encourage individuals to elect the direct rollover option 
and, thereby, to keep retirement plan assets saved for 
retirement. It may be appropriate to consider, in connection 
with a proposal to modify the 10-percent elective withholding 
rate, whether this 20-percent rate is sufficient incentive to 
individuals to make the direct rollover election.

Roth IRAs

    Under present law, the rule that provides that the amount 
of a distribution that is subject to withholding does not 
include any portion that it is reasonable to believe is not 
includible in gross income does not apply to IRAs. Thus, under 
the present-law rules, all distributions from IRAs are subject 
to withholding unless the recipient elects not to have 
withholding apply. In the case of a qualified distribution from 
a Roth IRA, the payor is required to have the recipient make 
the election not to have withholding apply even though the 
payor has reason to believe that the distribution is not 
includible in gross income. Thus, consideration should be given 
to including Roth IRAs under the rule that provides that 
withholding does not apply if it is reasonable to believe the 
distribution is not includible in gross income.

2. Increase section 4973 excise tax on excess IRA contributions

                              Present Law

Excise tax on excess contributions

    Under present law, an excise tax is imposed on an 
individual equal to six percent of the amount of any excess 
contributions to such individual's (1) traditional individual 
retirement arrangement (``IRA'') (sec. 408), (2) Roth IRA (sec. 
408A), (3) medical savings account (sec. 220), (4) custodial 
account treated as an annuity contract under section 403(b)(7), 
or (5) education IRA (sec. 530).\300\ The excise tax generally 
continues to apply in each year until the excess contributions 
have been distributed to the individual. However, the excise 
tax cannot exceed 6 percent of the value of such account or 
annuity at the end of the taxable year.
---------------------------------------------------------------------------
    \300\ Code section 4973.
---------------------------------------------------------------------------
    In general, an excess contribution includes any 
contribution to an account or annuity that exceeds the 
applicable contribution limit for such account or annuity for 
the taxable year. An excess contribution generally does not 
include any amount that is distributed to the individual before 
the due date (including extensions) of the individual's tax 
return for the taxable year. Thus, present law provides a 
mechanism by which an individual can correct any excess 
contributions without triggering the excise tax.

Distributions from Roth IRAs

    Under present law, a qualified distribution from a Roth IRA 
is not includible in gross income (sec. 408A(d)). A qualified 
distribution generally includes any distribution (1) on or 
after the date on which the Roth IRA owner attains age 59-1/2, 
(2) made to a beneficiary on or after the death of the Roth IRA 
owner, (3) attributable to the Roth IRA owner's becoming 
disabled, or (4) qualified first-time homebuyer distributions 
(sec. 72(t)(8)). A distribution from a Roth IRA is not a 
qualified distribution if it is made within the first five 
taxable years beginning with the taxable year for which the 
individual made a contribution to a Roth IRA (or such 
individual's spouse made a contribution to a Roth IRA) 
established for the individual.
    A distribution from a Roth IRA that is not a qualified 
distribution is required to be included in income to the extent 
such distribution is attributable to earnings on the taxpayer's 
Roth IRA contributions. A distribution is not a qualified 
distribution if it is a return of excess contributions that is 
not subject to the excise tax (i.e., if it is a distribution of 
excess contributions and net income allocated to such 
contributions made on or before the due date for the 
individual's tax return for the year, including extensions). 
However, if an excess contribution to a Roth IRA is subject to 
the excise tax and is subsequently withdrawn, such excess 
contribution could be a qualified distribution from the Roth 
IRA that is not includible in gross income.

                        Description of Proposal

    The proposal would increase the section 4973 excise tax on 
excess contributions to IRAs to 10 percent for each taxable 
year after the taxable year for which such excess contribution 
was made. The increase would not apply to excess contributions 
to medical savings accounts or education IRAs. Thus, the excise 
tax would be 6 percent for the taxable year for which such 
excess contribution was made and 10 percent for each succeeding 
taxable year.

                             Effective Date

    The proposal would be effective for excess contributions 
made for taxable years beginning after December 31, 1999.

                              Prior Action

    No prior action.

                                Analysis

    The increase in the excise tax on excess contributions is 
proposed to prevent taxpayers from making excess contributions 
to Roth IRAs, paying the excise tax on the excess 
contributions, and subsequently withdrawing amounts 
attributable to such excess contributions as a qualified 
distribution from a Roth IRA that is not includible in gross 
income. Under present law, if the rate of return on such excess 
contributions is sufficiently high, the taxpayer is better off 
by making the excess contributions and paying the excise tax.
    Whether the increase in the excise tax on excess 
contributions will be sufficient to prevent taxpayers from 
intentionally making excess contributions to Roth IRAs will 
depend upon the rate of return the taxpayer expects to receive 
on such contributions. Depending on the rate of return, the 
taxpayer may still have an incentive to make the excess 
contributions.
    An option that could be adopted in addition to, or in lieu 
of, the proposal would be to provide that a withdrawal from a 
Roth IRA that is attributable to an excess contribution is not 
a qualified distribution and, therefore, not excludable from 
gross income.
    For the 1996 tax year, the amount of the excise tax on 
excess IRA contributions that was paid totaled approximately 
$2.5 million. This amount represents the amount of the excise 
tax collected only with respect to traditional IRAs. In 1997, 
medical savings accounts were included in the excise tax and in 
1998, Roth IRAs and education IRAs were included.

3. Impose limitation on prefunding of welfare benefits

                              Present Law

    Under present law, contributions to a welfare benefit fund 
generally are deductible when paid, but only to the extent 
permitted under the rules of Code sections 419 and 419A. The 
amount of an employer's deduction in any year for contributions 
to a welfare benefit fund cannot exceed the fund's qualified 
cost for the year. The term qualified cost means the sum of (1) 
the amount that would be deductible for benefits provided 
during the year if the employer paid them directly and was on 
the cash method of accounting, and (2) within limits, the 
amount of any addition to a qualified asset account for the 
year. A qualified asset account includes any account consisting 
of assets set aside for the payment of disability benefits, 
medical benefits, supplemental unemployment compensation or 
severance pay benefits, or life insurance benefits. The account 
limit for a qualified asset account for a taxable year is 
generally the amount reasonably and actuarially necessary to 
fund claims incurred but unpaid (as of the close of the taxable 
year) for benefits with respect to which the account is 
maintained and the administrative costs incurred with respect 
to those claims. Specific additional reserves are allowed for 
future provision of post-retirement medical and life insurance 
benefits.
    The present-law deduction limits for contributions to 
welfare benefit funds do not apply in the case of certain 10-
or-more employer plans. A plan is a 10-or-more employer plan if 
(1) more than one employer contributes to it, (2) no employer 
is normally required to contribute more than 10 percent of the 
total contributions under the plan by all employers, and (3) 
the plan does not maintain experience-rating arrangements with 
respect to individual employers.

                        Description of Proposal

    Under the proposal, the present-law exception to the 
deduction limit for 10-or-more employer plans would be limited 
to plans that provide only medical, disability, and group-term 
life insurance benefits. This exception would no longer be 
available with respect to plans that provide supplemental 
unemployment compensation, severance pay, and disability 
benefits. Thus, the generally applicable deduction limits 
(sections 419 and 419A) would apply to plans providing these 
benefits.
    In addition, the proposal states that rules would be added 
to prevent amounts that are deductible pursuant to the 10-or-
more employer exception from being used to provide benefits 
other than medical, disability, and group-term life insurance.
    Under the proposal, no inference is intended with respect 
to the validity of any 10-or-more employer arrangement under 
the provisions of present law.

                             Effective Date

    The proposal would be effective with respect to 
contributions paid after the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    The exception to the present-law deduction limit for 10-or-
more employer plans was originally adopted because, under such 
a plan, the relationship of a participating employer to the 
plan is more in the nature of the relationship of an insured to 
an insurer. However, this exception was not intended to apply 
if the liability of any employer under the plan is determined 
on the basis of experience rating because, under those 
circumstances, the employer's interest with respect to the plan 
is more similar to the relationship of a single employer to a 
welfare benefit fund than that of an insured to an insurer. If 
each employer contributing to the plan is, in effect, liable 
for losses incurred with respect to all other participating 
employers (e.g., its contributions will be used to pay benefits 
for other employers' employees), then it is unlikely that any 
one employer will have an incentive to contribute more than is 
necessary under the arrangement.
    In some cases, the 10-or-more employer exception has been 
utilized in ways that are not consistent with the original 
intent of the exception. In Notice 95-34,\301\ the IRS 
identified certain types of trust arrangements that do not 
satisfy the requirements of the 10-or-more employer exception. 
In general, these trust arrangements created separate accounts 
for each employer participating in the plan and had the effect 
of providing experience rating for these participating 
employers. In addition, the Tax Court ruled in 1997 that an 
arrangement that utilized such a separate accounting system did 
not qualify under the 10-or-more employer exception.\302\
---------------------------------------------------------------------------
    \301\ Notice 95-34, 1995-1 C.B. 309.
    \302\ Robert D. Booth and Janice Booth v. Commissioner, 108 T.C. 
No. 25 (June 17, 1997).
---------------------------------------------------------------------------
    It is not clear whether a separate account concept will be 
adequate to address the ways in which welfare benefit funds may 
be disguising experience rating. The Administration proposes to 
address some of the problems that have been identified by 
limiting the benefits for which the 10-or-more employer 
exception will be available. It is argued that it is 
particularly difficult to identify whether experience rating is 
occurring with respect to the provision of certain benefits, 
such as severance pay and certain death benefits, because of 
the complexity of the arrangements.
    The potential abuses from these types of arrangements can 
be acute in the case of small closely-held businesses. The 10-
or-more employer exception may be utilized to provide an 
alternative approach to funding retirement benefits without the 
dollar limitations and other rules applicable to qualified 
pension plans.

4. Subject signing bonuses to employment taxes

                              Present Law

    Under present law, bonuses paid to individuals for signing 
contracts of employment are required to be included in gross 
income in the taxable year in which paid. However, if the 
contract does not contain a provision requiring the performance 
of future services, then the bonus payment does not constitute 
remuneration for services performed and, accordingly, does not 
constitute wages for income tax withholding purposes.\303\
---------------------------------------------------------------------------
    \303\ Rev. Rul. 58-145, 1958-1 C.B. 360.
---------------------------------------------------------------------------
    In addition, under present law, taxes under the Federal 
Insurance Contributions Act (``FICA taxes'') are imposed on 
wages paid to employees. Similar rules apply to taxes under the 
Federal Unemployment Tax Act (``FUTA taxes''). For these 
purposes, wages are defined in general as including all 
remuneration for employment.\304\ The term by which such 
remuneration is defined (e.g., salaries, fees, bonuses, or 
commissions) is irrelevant;\305\ if it is intended to provide 
remuneration for employment, a payment is treated as wages. For 
example, the IRS has held that amounts paid to a college on 
behalf of a professional baseball player under a ``College 
Scholarship Plan'' were wages for FICA tax purposes.\306\ The 
Scholarship Plan was considered to be a part of the employment 
contract under which the player agreed to play baseball for 
three months for a specified monthly remuneration. Further, the 
baseball club was relieved of its obligation under the 
Scholarship Plan if the player failed to report for spring 
training at the direction of the club.
---------------------------------------------------------------------------
    \304\ Code section 3121(a).
    \305\ Treas. Reg. sec. 31.3121(a)-1(c).
    \306\ Rev. Rul. 71-532, 1971-2 C.B. 356, modifying Rev. Rul. 69-
424, 1969-2 C.B. 15.
---------------------------------------------------------------------------

                        Description of Proposal

    The proposal would provide that signing bonuses are subject 
to income tax withholding and are included in the definition of 
wages for FICA and FUTA purposes. The proposal would apply 
without regard to whether the signing bonus is conditioned upon 
the performance of services by the recipient. The proposal 
states that no inference is intended with respect to the 
application of the present-law withholding rules to such 
signing bonuses.

                             Effective Date

    The proposal would be effective for signing bonuses paid 
after the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    Under present law, the line between whether a signing bonus 
or similar payment negotiated as part of an employment contract 
is includible in wages for FICA and FUTA tax purposes and is 
subject to income tax withholding is determined by whether the 
payment is contingent upon the performance of future services. 
If an individual is not required to perform future services 
after receipt of the signing bonus or other type of payment, 
then such bonus or payment is not considered remuneration for 
employment. On the other hand, if the payor is not obligated to 
make the payment unless the individual agrees to perform future 
services for the payor, then the payment is considered 
remuneration for employment.
    It can be argued that payments negotiated in connection 
with an employment contract are intrinsically linked to the 
performance of services for the payor. The payor does not make 
the payment to the individual for altruistic purposes. The 
payment is inherently related to the expectation that the 
individual will perform future services for the payor. Thus, it 
could be argued that any payment to an individual that is made 
as part of a contract of employment and that is not a 
reimbursement for expenses or similar payments should be 
treated as wages subject to income tax withholding and to FICA 
and FUTA taxes.
    On the other hand, signing bonuses are often used, 
particularly in the case of professional athletics, as an 
inducement to individuals to sign a contract of employment, not 
necessarily as advance payment for the performance of future 
services. For example, most individuals who are selected in the 
Major League Baseball Amateur Draft are either graduating high 
school students or individuals who have completed two or three 
years of college. These individuals are not required under NCAA 
rules and regulations to declare their intention to forego 
eligibility to compete in college in order to be selected in 
the Amateur Draft. An individual who is selected in the Amateur 
Draft and does not reach an agreement to play in a major league 
organization may complete his college eligibility. The signing 
bonuses provided to these individuals could be characterized 
not so much as remuneration for future services as an incentive 
to forego eligibility as a college baseball player. There is at 
least a question whether such payments are, in fact, 
remuneration for employment and, therefore, should be subject 
to FICA and FUTA taxes.
    Similarly, there is a question whether a signing bonus that 
is not paid under an employment contract should be subject to 
FICA and FUTA taxes. For example, if an individual is paid an 
amount in exchange for an agreement to negotiate an employment 
contract with only a single organization, then it can be argued 
that the bonus payment is not remuneration for future services. 
In such a situation, the payment is clearly not conditioned 
upon the expected performance of future services. On the other 
hand, if this type of payment is not considered remuneration 
for employment, then it would be a relatively simple matter to 
sever an employment contract into two components--a contract 
with a signing bonus that is an agreement to negotiate and a 
separate contract detailing the terms of employment. In such a 
case, payment under the first contract would then not be 
subject to FICA and FUTA taxes.
    The issue of income tax withholding on signing bonuses is 
separable from the issue of treating such bonuses as wages for 
FICA and FUTA tax purposes. Because signing bonuses are 
included in gross income for the taxable year in which 
received, compliance could be improved by requiring that such 
bonuses be treated as wages for income tax withholding 
purposes. In addition, such an approach might reduce the number 
of individuals required to make estimated tax payments during a 
taxable year (and the number of individuals subject to a 
penalty for failure to make the required estimated tax 
payments).

                        L. Compliance Provisions

1. Expand reporting of cancellation of indebtedness income

                              Present Law

    Under section 61(a)(12), a taxpayer's gross income includes 
income from the discharge of indebtedness. Section 6050P 
requires ``applicable entities'' to file information returns 
with the IRS regarding any discharge of indebtedness of $600 or 
more.
    The information return must set forth the name, address, 
and taxpayer identification number of the person whose debt was 
discharged, the amount of debt discharged, the date on which 
the debt was discharged, and any other information that the IRS 
requires to be provided. The information return must be filed 
in the manner and at the time specified by the IRS. The same 
information also must be provided to the person whose debt is 
discharged by January 31 of the year following the discharge.
    ``Applicable entities'' include: (1) the FDIC, the RTC, the 
National Credit Union Administration, and any successor or 
subunit of any of them; (2) any financial institution (as 
described in sec. 581 (relating to banks) or sec. 591(a) 
(relating to savings institutions)); (3) any credit union; (4) 
any corporation that is a direct or indirect subsidiary of an 
entity described in (2) or (3) which, by virtue of being 
affiliated with such entity, is subject to supervision and 
examination by a Federal or State agency regulating such 
entities; and (5) an executive, judicial, or legislative agency 
(as defined in 31 U.S.C. sec. 3701(a)(4)).
    The penalties for failure to file correct information 
reports with the IRS and to furnish statements to taxpayers are 
similar to those imposed with respect to a failure to provide 
other information returns. For example, the penalty for failure 
to furnish statements to taxpayers is generally $50 per 
failure, subject to a maximum of $100,000 for any calendar 
year. These penalties are not applicable if the failure is due 
to reasonable cause and not to willful neglect.

                        Description of Proposal

    The proposal would require that information reporting on 
discharges of indebtedness also be done by any entity involved 
in the trade or business of lending money (such as finance 
companies and credit card companies whether or not affiliated 
with financial institutions).

                             Effective Date

    The proposal would be effective with respect to discharges 
of indebtedness on or after the date of enactment.

                              Prior Action

    The proposal was included in H.R. 4250 (The Patient 
Protection Act of 1998), which passed the House of 
Representatives on July 24, 1998 (sec. 3304). That provision 
would have applied to discharges of indebtedness after December 
31, 1998.

                                Analysis

    Under present law, some taxpayers who have gross income 
from the discharge of indebtedness receive an information 
return on that income, while others do not; whether or not they 
do is based upon the business form of the entity discharging 
the debt. The proposal would eliminate this disparity by 
requiring all similarly situated entities to provide these 
information reports.

2. Modify the substantial understatement penalty for large corporations

                              Present Law

    A 20-percent penalty applies to any portion of an 
underpayment of income tax required to be shown on a return 
that is attributable to a substantial understatement of income 
tax. For this purpose, an understatement is considered 
``substantial'' if it exceeds the greater of (1) 10 percent of 
the tax required to be shown on the return, or (2) $5,000 
($10,000 in the case of a corporation other than an S 
corporation or a personal holding company). Generally, the 
amount of an ``understatement'' of income tax is the excess of 
the tax required to be shown on the return over the tax shown 
on the return (reduced by any rebates of tax). The substantial 
understatement penalty does not apply if there was a reasonable 
cause for the understatement and the taxpayer acted in good 
faith with respect to the understatement (the ``reasonable 
cause exception''). The determination as to whether the 
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.

                        Description of Proposal

    The proposal would treat a corporation's deficiency of more 
than $10 million as substantial for purposes of the substantial 
understatement penalty, regardless of whether it exceeds 10 
percent of the taxpayer's total tax liability.

                             Effective Date

    The proposal would be effective for taxable years beginning 
after the date of enactment.

                              Prior Action

    The proposal was included in the President's fiscal years 
1998 and 1999 budget proposals.

                                Analysis

    Opponents might argue that altering the present-law penalty 
to make it apply automatically to large corporations might be 
viewed as violating the policy basis for this penalty, which is 
to punish an understatement that is substantial or material in 
the context of the taxpayer's own tax return. Proponents might 
respond that a deficiency of more that $10 million is material 
in and of itself, regardless of the proportion it represents of 
that taxpayer's total tax return.

3. Repeal exemption for withholding on certain gambling winnings

                              Present Law

    In general, proceeds from a wagering transaction are 
subject to withholding at a rate of 28 percent if the proceeds 
exceed $5,000 and are at least 300 times as large as the amount 
wagered. The proceeds from a wagering transaction are 
determined by subtracting the amount wagered from the amount 
received. Any non-monetary proceeds that are received are taken 
into account at fair market value.
    In the case of sweepstakes, wagering pools, or lotteries, 
proceeds from a wager are subject to withholding at a rate of 
28 percent if the proceeds exceed $5,000, regardless of the 
odds of the wager.
    No withholding tax is imposed on winnings from bingo or 
keno.

                        Description of Proposal

    The proposal would impose withholding on proceeds from 
bingo or keno wagering transactions at a rate of 28 percent if 
such proceeds exceed $5,000, regardless of the odds of the 
wager.

                             Effective Date

    The proposal would be effective for payments made after the 
beginning of the first month that begins at least 10 days after 
the date of enactment.

                              Prior Action

    The proposal was included in the President's fiscal years 
1998 and 1999 budget proposals.

                                Analysis

    It is generally believed that imposing withholding on 
winnings from bingo and keno will improve tax compliance and 
enforcement.

4. Increase penalties for failure to file correct information returns

                              Present Law

    Any person who fails to file a correct information return 
with the IRS on or before the prescribed filing date is subject 
to a penalty that varies based on when, if at all, the correct 
information return is filed. If a person files a correct 
information return after the prescribed filing date but on or 
before the date that is 30 days after the prescribed filing 
date, the penalty is $15 per return, with a maximum penalty of 
$75,000 per calendar year. If a person files a correct 
information return after the date that is 30 days after the 
prescribed filing date but on or before August 1 of that year, 
the penalty is $30 per return, with a maximum penalty of 
$150,000 per calendar year. If a correct information return is 
not filed on or before August 1, the amount of the penalty is 
$50 per return, with a maximum penalty of $250,000 per calendar 
year.
    There is a special rule for de minimis failures to include 
the required, correct information. This exception applies to 
incorrect information returns that are corrected on or before 
August 1. Under the exception, if an information return is 
originally filed without all the required information or with 
incorrect information and the return is corrected on or before 
August 1, then the original return is treated as having been 
filed with all of the correct required information. The number 
of information returns that may qualify for this exception for 
any calendar year is limited to the greater of (1) 10 returns 
or (2) one-half of one percent of the total number of 
information returns that are required to be filed by the person 
during the calendar year.
    In addition, there are special, lower maximum levels for 
this penalty for small businesses. For this purpose, a small 
business is any person having average annual gross receipts for 
the most recent three taxable years ending before the calendar 
year that do not exceed $5 million. The maximum penalties for 
small businesses are: $25,000 (instead of $75,000) if the 
failures are corrected on or before 30 days after the 
prescribed filing date; $50,000 (instead of $150,000) if the 
failures are corrected on or before August 1; and $100,000 
(instead of $250,000) if the failures are not corrected on or 
before August 1.
    If a failure to file a correct information return with the 
IRS is due to intentional disregard of the filing requirement, 
the penalty for each such failure is generally increased to the 
greater of $100 or ten percent of the amount required to be 
reported correctly, with no limitation on the maximum penalty 
per calendar year (sec. 6721(e)). The increase in the penalty 
applies regardless of whether a corrected information return is 
filed, the failure is de minimis, or the person subject to the 
penalty is a small business.

                        Description of Proposal

    The proposal would increase the penalty for failure to file 
information returns correctly on or before August 1 from $50 
for each return to the greater of $50 or 5 percent of the 
amount required to be reported correctly but not so reported. 
The $250,000 maximum penalty for failure to file correct 
information returns during any calendar year ($100,000 with 
respect to small businesses) would continue to apply under the 
proposal.
    The proposal also would provide for an exception to this 
increase where substantial compliance has occurred. The 
proposal would provide that this exception would apply with 
respect to a calendar year if the aggregate amount that is 
timely and correctly reported for that calendar year is at 
least 97 percent of the aggregate amount required to be 
reported under that section of the Code for that calendar year. 
If this exception applies, the present-law penalty of $50 for 
each return would continue to apply.
    The proposal would not affect the following provisions of 
present law: (1) the reduction in the $50 penalty where 
correction is made within a specified period; (2) the exception 
for de minimis failures; (3) the lower limitations for persons 
with gross receipts of not more than $5,000,000; (4) the 
increase in the penalty in cases of intentional disregard of 
the filing requirement; (5) the penalty for failure to furnish 
correct payee statements under section 6722; (6) the penalty 
for failure to comply with other information reporting 
requirements under section 6723; and (7) the reasonable cause 
and other special rules under section 6724.

                             Effective Date

    The proposal would apply to information returns the due 
date for which (without regard to extensions) is more than 90 
days after the date of enactment.

                              Prior Action

    The proposal was included in the President's fiscal year 
1998 and 1999 budget proposals.

                                Analysis

    Some of the information returns subject to this proposed 
increased penalty report amounts that are income, such as 
interest and dividends. Other information returns subject to 
this proposed increased penalty report amounts that are gross 
proceeds.\307\ Imposing the penalty as a percentage of the 
amount required to be reported might be viewed as 
disproportionately affecting businesses that file information 
returns reporting gross proceeds.
---------------------------------------------------------------------------
    \307\ Gross proceeds reports are useful to indicate that a 
potentially income-producing event has occurred, even though the amount 
reported on the information return bears no necessary relationship to 
the amount of income ultimately reported on the income tax return.
---------------------------------------------------------------------------

              M. Miscellaneous Revenue-Increase Provisions

1. Modify deposit requirement for Federal unemployment (``FUTA'') taxes

                              Present Law

    If an employer's liability for Federal unemployment 
(``FUTA'') taxes is over $100 for any quarter, the tax must be 
deposited by the last day of the first month after the end of 
the quarter. Smaller amounts are subject to less frequent 
deposit rules.

                        Description of Proposal

    The proposal would require an employer to pay Federal and 
State unemployment taxes on a monthly basis in a given year if 
the employer's FUTA tax liability in the prior year was $1,100 
or more. The deposit with respect to wages paid during a month 
would be required to be made by the last day of the following 
month. A safe harbor would be provided for the required 
deposits for the first two months of each calendar quarter. For 
the first month in each quarter, the payment would be required 
to be the lesser of 30 percent of the actual FUTA liability for 
the quarter or 90 percent of the actual FUTA liability for the 
month. The cumulative deposits paid in the first two months of 
each quarter would be required to be the lesser of 60 percent 
of the actual FUTA liability for the quarter or 90 percent of 
the actual FUTA liability for the two months. The employer 
would be required to pay the balance of the actual FUTA 
liability for each quarter by the last day of the month 
following the quarter. States would be required to establish a 
monthly deposit mechanism but would be permitted to adopt a 
similar safe harbor mechanism for paying State unemployment 
taxes.

                             Effective Date

    The proposal would be effective for months beginning after 
December 31, 2004.

                              Prior Action

    A substantially similar proposal was included in the 
President's fiscal year 1998 and 1999 budget proposals.

                                Analysis

    Proponents of the proposal argue that the proposed deposit 
requirements would: (1) provide a regular inflow of money to 
State funds to offset the regular payment of benefits; and (2) 
reduce losses to the Federal unemployment trust funds caused by 
employer delinquencies. Opponents respond that the State trust 
funds already have sufficient funds for the payment of benefits 
and find no evidence that more frequent deposits reduce 
employer delinquencies. Further, opponents contend that the 
proposal's administrative burden significantly outweighs its 
benefits.

2. Reinstate Oil Spill Liability Trust Fund excise tax

                              Present Law

    A 5-cents-per-barrel excise tax was imposed before January 
1, 1995. Revenues from this tax were deposited in the Oil Spill 
Liability Trust Fund. The tax did not apply during any calendar 
quarter when the Treasury Department determined that the 
unobligated balance in this Trust Fund exceeded $1 billion.

                        Description of Proposal

    The proposal would reinstate the Oil Spill Liability Trust 
Fund excise tax during the period after the date of the 
proposal's enactment and before October 1, 2009. The proposal 
also would increase the $1 billion limit on the unobligated 
balance in the Oil Spill Liability Trust Fund to $5 billion.

                             Effective Date

    The proposal would be effective on the date of enactment.

                              Prior Action

    The President's fiscal year 1998 and 1999 budget proposals 
included a similar proposal.

                                Analysis

    Some view the Oil Spill Liability Trust Fund excise tax as 
a tax on oil producers and consumers to fund an insurance pool 
against potential environmental risks that arise from the 
transport of petroleum. In this view, the tax is an insurance 
premium in a mandated scheme of risk pooling. While the first 
liability for damage from an oil spill remains with the owner 
of oil, the tax funds a Trust Fund that may be drawn upon to 
meet unrecovered claims that may arise from an oil spill either 
upon the high seas or from ruptured domestic pipelines. The tax 
and the Trust Fund represent a social insurance scheme with 
risks spread across all consumers of petroleum. The analogy to 
insurance is imperfect, however. The tax assessed reflects an 
imperfect pricing of risks. For example, the prior-law Oil 
Spill Liability Trust Fund tax was imposed at the same rate 
regardless of whether the importer employed more difficult to 
rupture double-hulled or single-hulled tankers.
    Proponents of reimposing the Oil Spill Liability Trust Fund 
excise tax suggest that the revenues would provide a cushion 
for future Trust Fund program activities. However, the 
Congressional authorizing committees have not notified the tax-
writing committees of either a shortfall in the amounts 
required for currently authorized expenditures or of plans to 
expand or extend those authorizations. Opponents of reimposing 
the taxes suggest that this action should be undertaken only in 
combination with such authorizing legislation.
    The unobligated balance in the Oil Spill Liability Trust 
Fund of the close of the 1998 fiscal year was $1.076 billion.

3. Simplify foster child definition under the earned income credit

                              Present Law

    For purposes of the earned income credit (``EIC''), 
qualifying children may include foster children who reside with 
the taxpayer for a full year, if the taxpayer cares for the 
foster children as the taxpayer's own children. (Code sec. 
32(c)(3)(B)(iii)(I)). All EIC qualifying children (including 
foster children) must either be under the age of 19 (24 if a 
full-time student) or permanently and totally disabled. There 
is no requirement that the foster child either be (1) placed in 
the household by a foster care agency or (2) a relative of the 
taxpayer.

                        Description of Proposal

    For purposes of the EIC, a foster child would be defined as 
a child who (1) is cared for by the taxpayer as if he or she 
were the taxpayer's own child, and (2) either is the taxpayer's 
sibling (or descendant of the taxpayer's sibling), or was 
placed in the taxpayer's home by an agency of a State or one of 
its political subdivisions or by a tax-exempt child placement 
agency licensed by a State.

                             Effective Date

    The proposal would be effective for taxable years beginning 
after December 31, 1999.

                              Prior Action

    A similar proposal was included in the President's fiscal 
year 1999 budget proposal.

                                Analysis

    Some advocates of this proposal contend that the element of 
present law which requires that a foster child be cared for by 
the taxpayer as the taxpayer's own child is open to intentional 
noncompliance by some taxpayers. They continue that the 
vagueness of this element of present law also creates a 
compliance burden on the IRS as well as the taxpayer. They 
believe that this proposal would: (1) reduce potential abuse by 
tax cheats; (2) prevent unintentional errors by confused 
taxpayers; and (3) provide better guidance to the IRS when 
investigating questionable EIC claims.
    Opponents respond that there are legitimate family living 
arrangements (e.g., care for a godchild) where a taxpayer 
deserves the EIC because the taxpayer is caring for the foster 
child even though that child meets neither the proposed 
familial relationship with the taxpayer, nor was formally 
placed with the taxpayer by an agency of the State or a tax-
exempt child placement agency licensed by the State. Further, 
they contend that this proposal does not reduce any ambiguity 
found in present law. Since the EIC requirement that the foster 
child be cared for by the taxpayer as the taxpayer's own child 
is retained for all foster children, both the IRS and taxpayers 
with foster children will still be required to interpret its 
meaning.

4. Repeal percentage depletion for non-fuel minerals mined on Federal 
        and formerly Federal lands

                              Present Law

    Taxpayers are allowed to deduct a reasonable allowance for 
depletion relating to the acquisition and certain related costs 
of mines or other hard mineral deposits. The depletion 
deduction for any taxable year is calculated under either the 
cost depletion method or the percentage depletion method, 
whichever results in the greater allowance for depletion for 
the year.
    Under the cost depletion method, the taxpayer deducts that 
portion of the adjusted basis of the property which is equal to 
the ratio of the units sold from that property during the 
taxable year, to the estimated total units remaining at the 
beginning of that year.
    Under the percentage depletion method, a deduction is 
allowed in each taxable year for a statutory percentage of the 
taxpayer's gross income from the property. The statutory 
percentage for gold, silver, copper, and iron ore is 15 
percent; the statutory percentage for uranium, lead, tin, 
nickel, tungsten, zinc, and most other hard rock minerals is 22 
percent. The percentage depletion deduction for these minerals 
may not exceed 50 percent of the net income from the property 
for the taxable year (computed without allowance for 
depletion). Percentage depletion is not limited to the 
taxpayer's basis in the property; thus, the aggregate amount of 
percentage depletion deductions claimed may exceed the amount 
expended by the taxpayer to acquire and develop the property.
    The Mining Law of 1872 permits U.S. citizens and businesses 
to prospect freely for hard rock minerals on Federal lands, and 
allows them to mine the land if an economically recoverable 
deposit is found. No Federal rents or royalties are imposed 
upon the sale of the extracted minerals. A prospecting entity 
may establish a claim to an area that it believes may contain a 
mineral deposit of value and preserve its right to that claim 
by paying an annual holding fee of $100 per claim. Once a 
claimed mineral deposit is determined to be economically 
recoverable, and at least $500 of development work has been 
performed, the claim holder may apply for a ``patent'' to 
obtain title to the surface and mineral rights. If approved, 
the claimant can obtain full title to the land for $2.50 or 
$5.00 per acre.

                        Description of Proposal

    The proposal would repeal the present-law percentage 
depletion provisions for non-fuel minerals mined on Federal 
lands where the mining rights were originally acquired under 
the Mining Law of 1872, and on private lands acquired under the 
1872 law.

                             Effective Date

    The proposal would be effective for taxable years beginning 
after the date of enactment.

                              Prior Action

    A similar proposal was included in the President's fiscal 
year 1997, 1998, and 1999 budget proposals.

                                Analysis

    The percentage depletion provisions generally can be viewed 
as providing an incentive for mineral production. The Mining 
Act of 1872 also provides incentives for mineral production by 
allowing claimants to acquire mining rights on Federal lands 
for less than fair market value. In cases where a taxpayer has 
obtained mining rights relatively inexpensively under the 
provisions of the Mining Act of 1872, it can be argued that 
such taxpayers should not be entitled to the additional 
benefits of the percentage depletion provisions. However, the 
Administration proposal would appear to repeal the percentage 
depletion provisions not only for taxpayers who acquired their 
mining rights directly from the Federal Government under the 
Mining Act of 1872, but also for those taxpayers who purchased 
such rights from a third party who had obtained the rights 
under the Mining Act of 1872. In cases where mining rights have 
been transferred to an unrelated party for full value since 
being acquired from the Federal Government (and before the 
effective date), there is little rationale for denying the 
benefits of the percentage depletion provisions to the taxpayer 
currently mining the property on the basis that the original 
purchaser obtained benefits under the Mining Act of 1872.

5. Impose excise tax on purchase of structured settlements

                              Present Law

    Present law provides tax-favored treatment for structured 
settlement arrangements for the payment of damages on account 
of personal injury or sickness.
    Under present law, an exclusion from gross income is 
provided for amounts received for agreeing to a qualified 
assignment to the extent that the amount received does not 
exceed the aggregate cost of any qualified funding asset (sec. 
130). A qualified assignment means any assignment of a 
liability to make periodic payments as damages (whether by suit 
or agreement) on account of a personal injury or sickness (in a 
case involving physical injury or physical sickness), provided 
the liability is assumed from a person who is a party to the 
suit or agreement, and the terms of the assignment satisfy 
certain requirements. Generally, these requirements are that 
(1) the periodic payments are fixed as to amount and time; (2) 
the payments cannot be accelerated, deferred, increased, or 
decreased by the recipient; (3) the assignee's obligation is no 
greater than that of the assignor; and (4) the payments are 
excludable by the recipient under section 104(a)(2) as damages 
on account of personal injuries or sickness.
    A qualified funding asset means an annuity contract issued 
by an insurance company licensed in the U.S., or any obligation 
of the United States, provided the annuity contract or 
obligation meets statutory requirements. An annuity that is a 
qualified funding asset is not subject to the rule requiring 
current inclusion of the income on the contract which generally 
applies to annuity contract holders that are not natural 
persons (e.g., corporations) (sec. 72(u)(3)(C)). In addition, 
when the payments on the annuity are received by the structured 
settlement company and included in income, the company 
generally may deduct the corresponding payments to the injured 
person, who, in turn, excludes the payments from his or her 
income (sec. 104). Thus, neither the amount received for 
agreeing to the qualified assignment of the liability to pay 
damages, nor the income on the annuity that funds the liability 
to pay damages, generally is subject to tax.
    Present law provides that the payments to the injured 
person under the qualified assignment cannot be accelerated, 
deferred, increased, or decreased by the recipient. Consistent 
with these requirements, it is understood that contracts under 
structured settlement arrangements generally contain anti-
assignment clauses. It is understood, however, that injured 
persons may nonetheless be willing to accept discounted lump 
sum payments from certain ``factoring'' companies in exchange 
for their payment streams. The tax effect on the parties of 
these transactions may not be completely clear under present 
law.

                        Description of Proposal

    The proposal would impose an excise tax on any person 
acquiring a payment stream under a structured settlement 
arrangement. The amount of the excise tax would be 40 percent 
of the difference between (1) the amount paid by the acquirer 
to the injured person and (2) the undiscounted value of the 
acquired income stream. The excise tax would not be imposed if 
the acquisition were pursuant to a court order finding that the 
extraordinary and unanticipated needs of the original recipient 
of the payment stream render the acquisition desirable.

                             Effective Date

    The proposal would be effective for acquisitions occurring 
after the date of enactment. No inference would be intended as 
the contractual validity of the acquisition transaction or its 
effect on the tax treatment of any party other than the 
acquirer.

                              Prior Action

    The proposal \308\ is similar to a provision contained in 
the President's budget proposal for fiscal year 1999, except 
that under that proposal, the amount of the excise tax would 
have been 20 percent of the consideration for acquiring the 
payment stream.
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    \308\ This proposal is similar to H.R. 263, ``The Structured 
Settlement Protection Act,'' (106th Cong., 1st Sess., introduced by Mr. 
Shaw and others). H.R. 263 provides for a 50-percent tax on the amount 
equal to the excess of (1) the aggregate undiscounted amount of 
structured settlement payments being acquired, over (2) the total 
amount actually paid by the acquirer to the seller.
---------------------------------------------------------------------------

                                Analysis

    The proposal responds to the social policy 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. The potential for deep 
discounting of the value of the payment stream may financially 
disadvantage injured persons that the provision was designed, 
in part, to protect.
    By imposing the excise tax on the amount of the discount, 
rather than on the entire amount of the payment stream, it 
could be said that this proposal is more targeted than the 
prior Administration proposal to the aspect of the transaction 
that could financially disadvantage the injured person: the 
amount of the discount. It could nevertheless be argued that 
acquirers still have an economic incentive to acquire payment 
streams, so long as the tax on the discount is less than the 
rate which would discourage the acquisition transactions 
completely. Thus, if 40 percent is not the tax rate at which 
transactions could no longer be profitable for the acquirers, 
it could be said that the provision does not achieve the 
purpose of protecting the injured person by preventing the sale 
of the payment stream. Conversely, if 40 percent is that tax 
rate, then the proposal could be assessed as effective at 
achieving that purpose. If transactions were to continue after 
imposition of the tax, sellers of payment streams would be 
worse off than before the tax, because acquirers would discount 
more deeply the purchase of the payment stream to achieve the 
same profit level they did before the tax. Critics could argue 
that if the tax rate is set at a level that does not totally 
discourage the transactions, then the proposal would fail to 
achieve its goal of protecting the original recipients of 
payment streams.
    An additional result of the proposal may be to limit the 
uncertainty arising under present law from the acquisition with 
respect to the tax treatment of payors under existing 
structured settlement arrangements. It could be argued that 
limiting or stopping the acquisition transactions through 
imposition of tax on them is not the most efficient way to 
provide certainty in the tax law. Other alternatives might be 
explicitly to provide that the acquisition of the payment 
stream either does, or does not, violate the requirement of 
present law section 130 that the payments cannot be 
accelerated, deferred, increased, or decreased by the 
recipient.
    It could also be argued that it is not the function of the 
tax law to prevent injured persons or their legal 
representatives from transferring rights to payment. Arguably, 
consumer protection and similar regulation is more properly the 
role of the States than of the Federal government. It could 
further be argued that it is not economically efficient for tax 
rules to hinder the operation of a market in structured 
settlement streams.
    On the other hand, the tax law already provides an 
incentive for structured settlement arrangements, and if 
practices have evolved that are inconsistent with its purpose, 
addressing them should be viewed as proper.

6. Require taxpayers to include rental income of residence in income 
        without regard to period of rental

                              Present Law

    Gross income for purposes of the Internal Revenue Code 
generally includes all income from whatever source derived, 
including rents. The Code (sec. 280A(g)) provides a de minimis 
exception to this rule where a dwelling unit is used during the 
taxable year by the taxpayer as a residence and such dwelling 
unit is actually rented for less than 15 days during the 
taxable year. In this case, the income from such rental is not 
included in gross income and no deductions arising from such 
rental use are allowed as a deduction.

                        Description of Proposal

    The proposal would repeal the 15-day rules of section 
280A(g). A taxpayer would include in gross income rental income 
from the rental of the taxpayer's residence regardless of the 
period of rental. Also, a taxpayer could deduct a pro rata 
share of the expenses attributable to the rental of such 
property. The proposal does not change the present-law 
treatment of expenses allowable to the taxpayer without regard 
to the rental of the property (e.g., certain interest, taxes 
and casualty losses).

                             Effective Date

    The proposal would apply to taxable years beginning after 
December 31, 1999.

                              Prior Action

    The House version of the Taxpayer Relief Act of 1997 
contained a similar proposal, which was not included in the 
conference agreement.

                                Analysis

    Present law allows certain taxpayers to exclude from income 
rental payments for the short-term rental of the taxpayer's 
residence. Proponents of the proposal believe that such amounts 
should be included in income of the taxpayers, like any other 
source of income. Opponents of the proposal argue that any 
additional tax revenue from the taxation of the rental payments 
from the short-term rental of a residence is outweighed by the 
imposition of the additional complexity placed on affected 
taxpayers by eliminating the de minimis exception from section 
280A.

               III. OTHER PROVISIONS THAT AFFECT RECEIPTS

A. Reinstate Superfund Excise Taxes and Corporate Environmental Income 
                                  Tax

                              Present Law

    Before January 1, 1996, four taxes were imposed to fund the 
Hazardous Substance Superfund Trust Fund (``Superfund'') 
program:
    (1) An excise tax on petroleum and imported refined 
products (sec. 4611(c)(2)(A));
    (2) An excise tax on certain hazardous chemicals, imposed 
at rates that varied from $0.22 to $4.87 per ton (sec. 4661);
    (3) An excise tax on imported substances made with the 
chemicals subject to the tax in (2), above (sec. 4671); and
    (4) An income tax on corporations calculated using the 
alternative minimum tax rules (sec. 59A).

                        Description of Proposal

    The proposal would reinstate the three Superfund excise 
taxes during the period after the date of the proposal's 
enactment and before October 1, 2009. The corporate 
environmental income tax would be reinstated for taxable years 
beginning after December 31, 1998, and before January 1, 2010.
    Revenues from reinstatement of these taxes would be 
deposited in the Superfund.

                             Effective Date

    The proposal would be effective on the date of enactment.

                              Prior Action

    The President's fiscal year 1998 and 1999 budget proposals 
included a similar proposal.

                                Analysis

    The Superfund provides for certain environmental 
remediation expenses. The prior-law taxes were imposed on 
petroleum products, chemical products, and more generally on 
large businesses. Thus, the taxes were imposed on those 
taxpayers who generally were believed to represent the parties 
liable for past environmental damage rather than on taxpayers 
perceived to benefit from the expenditure program. Depending on 
their incidence, these taxes may inexactly recoup damages from 
parties held responsible for past environmental damage. For 
example, the burden may fall on the current owners of 
enterprises rather than those who were the owners at the time 
the damage occurred. On the other hand, to the extent that 
taxable products continue to create environmental harm, the 
taxes may discourage overuse of such products.
    Proponents of reimposing the Superfund excise taxes suggest 
that the revenues can provide a cushion for ongoing Superfund 
program costs, and that reimposition of these taxes is a 
necessary complement to reauthorization and possible 
modification of the Superfund program. Opponents suggest that 
the taxes should be reimposed only as part of pending program 
reform legislation. These persons suggest, in particular, that 
proposals to address issues associated with so-called 
``retroactive liability'' may require budgetary offsets which 
could be provided by reimposing the Superfund taxes as a 
component of such authorizing legislation.
    The current unobligated balance in the Superfund at the 
close of the 1998 fiscal year was $2.154 billion.

 B. Convert a Portion of the Excise Taxes Deposited in the Airport and 
Airway Trust Fund to Cost-Based User Fees Assessed for Federal Aviation 
                        Administration Services

                              Present Law

Airport and Airway Trust Fund excise taxes with scheduled expiration 
        dates
    Excise taxes are imposed on commercial and noncommercial 
\309\ aviation to finance programs administered through the 
Airport and Airway Trust Fund (the ``Airport Trust Fund''). 
These excise taxes were modified and extended (through 
September 30, 2007) by the Taxpayer Relief Act of 1997 (the 
``1997 Act''). The following describes the current aviation 
excise taxes.
---------------------------------------------------------------------------
    \309\ Noncommercial aviation is defined to include transportation 
that does not involve the carrying of passengers or freight ``for 
hire'' (e.g., corporate aircraft transporting corporate employees).
---------------------------------------------------------------------------
            Commercial air passenger transportation
    Commercial passenger air transportation generally is 
subject to one of two taxes. First, domestic air passenger 
transportation is subject to a tax equal to the total of 7.5 
percent of the gross amount paid by the passenger for the 
transportation plus a $3 per flight segment tax.\310\ These tax 
rates currently are being phased-in, as follows: \311\ October 
1, 1998-September 30, 1999: 8 percent of the fare, plus $2 per 
domestic flight segment; and October 1, 1999-December 31, 1999: 
7.5 percent of the fare, plus $2.25 per domestic flight 
segment.
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    \310\ A flight segment is transportation involving a single take-
off and a single landing.
    \311\ For the period October 1, 1997 through September 30, 1998, 
the tax rates were 9 percent of the fare, plus $1 per domestic flight 
segment.
---------------------------------------------------------------------------
    After December 31, 1999, the ad valorem rate will remain at 
7.5 percent. The domestic flight segment component of the tax 
will increase to $2.50 (January 1, 2000-December 31, 2000), to 
$2.75 (January 1, 2001-December 31, 2001), and to $3 (January 
1, 2002-December 31, 2002). On January 1, 2003, and on each 
January 1 thereafter, the fixed dollar amount per flight 
segment will be indexed annually for inflation occurring after 
2001.
    Second, commercial air passengers arriving in the United 
States from another country or departing the United States for 
another country are subject to a $12.20 tax per arrival or 
departure. This rate, which was $12.00 through December 31, 
1998, is indexed annually for inflation.
    Further, amounts paid to air carriers (in cash or in kind) 
for the right to award or otherwise distribute free or reduced-
rate air transportation are treated as amounts paid for taxable 
air transportation, subject to a 7.5-percent ad valorem rate. 
This tax applies to payments, whether made within the United 
States or elsewhere, if the rights to transportation for which 
payments are made can be used in whole or in part for 
transportation that, if purchased directly, would be subject to 
either the domestic or international passenger taxes, described 
above.
            Commercial air cargo transportation
    Domestic commercial transportation of cargo by air is 
subject to a 6.25-percent excise tax.
            Noncommercial aviation
    Noncommercial aviation is subject to taxes on fuels 
consumed. Aviation gasoline is taxed at 15 cents per gallon and 
aviation jet fuel is taxed at 17.5 cents per gallon.
Permanent aviation fuels excise tax
    In addition to the taxes described above, aviation gasoline 
and jet fuel is subject to a permanent 4.3-cents-per-gallon 
excise tax rate. Receipts from this tax (since October 1, 
1997), like the aviation taxes with scheduled expiration dates, 
are deposited in the Airport Trust Fund.
Airport Trust Fund expenditures
    For the past several fiscal years, Airport Trust Fund 
revenues have provided funds for approximately 60 percent of 
Federal Aviation Administration (``FAA'') program costs.\312\
---------------------------------------------------------------------------
    \312\ In fiscal 1998, Airport Trust Fund expenditures funded $1.5 
billion in FAA grants-in-aid for airports, $2.2 billion in FAA 
facilities and equipment purchases, $0.2 billion in FAA research, 
engineering, and development, and $1.9 billion in general operation of 
the FAA, for a total Airport Trust Fund outlay of $5.869 billion out of 
total FAA outlays of $9.243 billion, or 63.5 percent. Office of 
Management and Budget, Budget of the United States Government, Fiscal 
Year 2000: Appendix, p. 741.
---------------------------------------------------------------------------

                        Description of Proposal

    The proposal states that legislation to reduce aviation 
excise taxes and to replace those taxes with cost-based user 
fees will be proposed at a later date. Under the proposal, the 
aviation excise taxes would be reduced beginning in fiscal year 
2000. The proposal envisions that excise tax rates and fees 
would be set at levels sufficient to yield monies equal to the 
total budget resources requested for the FAA for the succeeding 
fiscal year. Other details of the proposal have not been 
specified.

                              Prior Action

    The proposal is similar to a proposal contained in the 
President's fiscal year 1998 budget, for which details were not 
submitted to the Congress and the proposal also is similar to a 
proposal contained in the President's fiscal year 1999 budget, 
for which details were not submitted to the Congress. The 
structure and level of aviation excise taxes to support the FAA 
were addressed in the Taxpayer Relief Act of 1997. That Act 
enacted the current excise tax structure, provided that the 
taxes with scheduled expiration dates would be imposed through 
September 30, 2007, and transferred receipts from the permanent 
4.3-cents-per-gallon aviation fuels tax (previously retained in 
the General Fund) to the Airport Trust Fund.

                                Analysis

    Because details of the proposal have not been transmitted 
to the Congress, it is not possible to comment on specifics; 
however, several general issues regarding substitution of 
aviation user fees for excise taxes which were raised before 
the Congress during consideration of the 1997 Act may be 
noted.\313\
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    \313\ For a more discussion of these issues, see, Joint Committee 
on Taxation, Present Law and Background Information on Federal 
Transportation Excise Taxes and Trust Fund Expenditure Programs (JCS-
10-96), November 14, 1996.
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Budget Act scorekeeping
    The current excise taxes imposed to finance FAA activities 
are classified as Federal revenues, with gross receipts from 
the taxes being deposited in the Airport Trust Fund. Because of 
interactions with the Federal income tax, net revenues to the 
Federal Government are less than the gross receipts from these 
taxes (i.e., ``net revenues'' equal approximately 75 percent of 
gross excises taxes). Spending from the Airport Trust Fund is 
classified as discretionary domestic spending, subject to 
aggregate annual appropriation limits (``caps'') that apply to 
this spending as well as other types of discretionary domestic 
spending. These caps most recently were set as part of the 1997 
balanced budget agreement. Because spending from the Airport 
Trust Fund is subject to the discretionary domestic spending 
caps, deposit of amounts in excess of net revenues from these 
taxes in the Airport Trust Fund does not impact Federal budget 
scorekeeping.
    Proponents of changing FAA financing to user fees typically 
argue that current spending levels are too low because of the 
general discretionary spending caps. These persons suggest 
that, if the FAA were permitted to impose cost-based user fees, 
it could spend the entire amount collected outside of the 
regular budgetary process. However, if FAA financing and 
spending were restructured using user fees and expenditures not 
requiring appropriation, the discretionary domestic spending 
caps established by the 1997 balanced budget agreement would 
have to be reduced to prevent increases in other programs that 
might produce deficit spending. Further, if the user fees were 
classified as Federal revenues and the FAA were allowed to 
spend more than the net revenues produced (as opposed to the 
gross receipts), from a budgetary standpoint, the agency would 
be engaged in deficit spending.
    Under the current financing and spending structure, Airport 
Trust Fund spending levels may be less than net excise tax 
revenues. Any excess net revenues received are included in 
calculations of the Federal deficit or surplus under the Budget 
Enforcement Act. If the excise taxes were repealed, and were 
not replaced by similarly treated revenue sources equal at 
least to the excess of collections over expenditures, Federal 
deficit or surplus calculations would be affected.
Tax vs. fee
    Proponents of cost-based user fees suggest that the FAA, 
not the Congress, should establish and collect appropriate fees 
for the services it provides. These persons suggest that 
imposition of fees by the FAA would enable that agency to 
operate in a more businesslike manner. However, others point 
out that care must be taken to ensure that any FAA-imposed fees 
are not legally ``taxes'' because the taxing power cannot 
constitutionally be delegated by the Congress.\314\ In general, 
a true user fee (which an Executive agency may be authorized to 
levy) may be imposed only on the class that directly avails 
itself of a governmental program and may be used solely to 
finance that program rather than to finance the costs of 
Government generally. The amount of the fee charged to any 
payor generally may not exceed the costs of providing the 
specific services with respect to which the fee is charged. 
Fees are not imposed on the general public; there must be a 
reasonable connection between the payors of the fee and the 
agency or function receiving the fee. Those paying a fee must 
have the choice of not utilizing the governmental service or 
avoiding the regulated activity and thereby avoiding the 
charge. If the FAA were authorized to establish and collect 
cost-based user fees, the fees would have to satisfy these 
criteria to avoid being subject to challenge as 
unconstitutional delegations of the taxing power. When the 
Congress modified and extended the aviation excise taxes in 
1997, the FAA was reported to have no comprehensive cost 
accounting system upon which it could base such fees. Further, 
over 50 percent of FAA costs were identified in the then most 
recently conducted cost allocation study as ``common'' costs to 
many sectors, requiring allocation rules. Such allocation rules 
may be viewed by some as imprecise and subject to 
challenge.\315\
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    \314\ Article I, Section 8 of the U.S. Constitution includes the 
enumerated powers of Congress the ``. . . Power To lay and collect 
Taxes, Duties, Imposts, and Excises. . . .''
    \315\ See, e.g., Asiana Airlines v. Federal Aviation 
Administration, No. 97-135 (D.C. Cir., January 30, 1998), holding that 
certain international overflight fees imposed by the FAA based on this 
cost allocation study violated a statutory requirement that the fees be 
cost-based.
---------------------------------------------------------------------------
Cost allocation and Airport and Airway Trust fund excise tax efficiency
    Setting taxes or fees on the basis of cost allocation 
generally is an attempt to have the tax or fee reflect the 
average cost of providing the service. Many view such pricing 
as an equitable manner to recover costs. However, cost 
allocation as a basis of air transportation excise tax design 
may create an economically inefficient tax structure. The 
provision of transportation services often requires substantial 
capital investments. Fixed costs tend to be large compared with 
marginal costs. For example, the construction of a bridge 
across the Mississippi River requires a substantial fixed 
capital investment. The additional resource costs (wear and 
tear) imposed by one additional automobile on an uncongested 
bridge, once the bridge has been built, is quite small in 
comparison. This means that the provision of many 
transportation services is often characterized by ``economies 
of scale.'' Provision of a good or service is said to be 
characterized by economies of scale when the average cost of 
providing the good or service exceeds the marginal cost of 
providing that good or service. When this occurs, the average 
cost of providing the good or service is falling with each 
additional unit of the good or service provided. Economists 
proffer setting prices or taxes equal to marginal cost to 
obtain economically efficient outcomes. However, in the 
presence of substantial economies of scale, the marginal cost 
is less than the average cost of providing the transportation 
service and the revenues collected from equating taxes to 
marginal costs would not cover the full expenditure required to 
provide the service. That is, provision of the service may 
require a subsidy beyond the revenues provided by the 
economically efficient tax.\316\
---------------------------------------------------------------------------
    \316\ Some argue that the presence of economies of scale justify 
Government involvement in certain infrastructure investments. They 
argue that when the economies of scale are great, the potential for 
cost recovery and profit from market prices may be insufficient for 
private providers to undertake the investment, even though provision of 
the service would create marginal benefits that exceed marginal costs.
---------------------------------------------------------------------------
    Cost allocation would set the price or taxes for air 
transportation services at rates equal to the average cost of 
services. In the presence of substantial economics of scale, 
average cost pricing implies that consumers are being charged 
prices in excess of marginal resource costs and that less than 
the economically efficient level of transportation services are 
provided. Indeed, an expansion of services would lead to a 
decline in the average cost of the service to each user. If 
each user could be charged that lower average price, the price 
paid would still exceed the marginal cost of the provision of 
the service, all costs would be recovered and net economic 
well-being (efficiency) would increase. Thus, the principle of 
cost allocation involves a trade-off between economic 
efficiency and cost recovery.\317\
---------------------------------------------------------------------------
    \317\ For a discussion of ways of decreasing the inefficiencies 
that arise from diverging from marginal cost pricing while raising 
revenue to cover substantial fixed costs, see Congressional Budget 
Office, Paying for Highways, Airways and Waterways: How Can Users Be 
Charged? May 1992.
---------------------------------------------------------------------------
Congressional oversight
    The current financing and Airport Trust Fund spending 
process involves oversight of at least four Congressional 
committees in each House of Congress. Taxes are imposed and 
dedicated to the Airport Trust Fund by the tax-writing 
committees. Overall expenditure levels for domestic spending 
are set by the budget committees. Specific expenditure purposes 
are authorized by the House Committee on Transportation and 
Infrastructure and the Senate Committee on Commerce, Science 
and Transportation. Further, expenditures are appropriated by 
the appropriations committees of each House. Proponents of 
changing FAA financing and spending authority as proposed by 
the Administration suggest that such extensive Congressional 
oversight is unnecessary. At a minimum, the Administration's 
proposal could eliminate or reduce the oversight roles of the 
tax-writing and appropriations committees. Others suggest that 
the involvement of multiple Congressional committees promotes 
better prioritization of actual FAA spending needs within the 
framework of the overall system of Federal revenues and outlays 
and a more efficient use of FAA resources.
    The balance in the Airport and Airway Trust Fund at the 
close of the 1998 fiscal year was $9.1 billion.

              C. Increase Excise Taxes on Tobacco Products

                              Present Law

Excise taxes on tobacco products
    Excise taxes are imposed on cigarettes, cigars, chewing 
tobacco and snuff, pipe tobacco, and cigarette papers and tubes 
(Code sec. 5701). In addition, tax will be extended to ``roll-
your-own tobacco'' at the same rates as pipe tobacco, effective 
on January 1, 2000. These taxes are imposed upon removal \318\ 
of the taxable tobacco products by the manufacturer, or on 
importation into the United States.\319\ The current tax rates 
are shown in the table below.
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    \318\ Taxable tobacco products are removed when they are taken from 
the factory, from internal revenue bond, or are released from customs 
custody. Removal also occurs at the time such articles are smuggled or 
otherwise unlawfully imported into the United States (sec. 5702(k)).
    \319\ The term United States includes the 50 States and the 
District of Columbia.

 
            Tobacco product                          Tax rate
 
Cigarettes:
    Small cigarettes...................  $12.00 (24 cents per pack of
                                          20).
    Large cigarettes...................  $25.20 per thousand.
Cigars:
    Small cigars.......................  $1.125 per thousand.
    Large cigars.......................  12.75% of manufacturer's price,
                                          up to $30 per thousand.
Chewing tobacco........................  $0.12 per pound (\3/4\ cents
                                          per ounce container).
Snuff..................................  $0.36 per pound.
Pipe Tobacco...........................  $0.675 per pound.
Cigarette papers.......................  $0.0075 per 50 papers or
                                          fraction thereof.
Cigarette tubes........................  $0.015 per 50 tubes or fraction
                                          thereof.
 


    Effective on January 1, 2000, the tax rate on small 
cigarettes is scheduled to increase by $5 per thousand (to 34 
cents per pack of 20 small cigarettes). The tax rates on other 
taxable tobacco products will increase by a proportionate 
amount. For example, the tax on chewing tobacco will increase 
to 17 cents per pound (1.06 cents per one ounce container).
    Effective on January 1, 2002, a further increase of $2.50 
per thousand (to 39 cents per pack of 20 small cigarettes) is 
scheduled to become effective. Tax rates on other taxable 
tobacco products will increase proportionately on that date as 
well.
    Generally, excise taxes on tobacco products that are sold 
or distributed for sale during any semimonthly period must be 
paid by the 14th day after the last day of such semimonthly 
period (sec. 5703(b)(2)(A)). However, taxes on tobacco products 
removed during the period beginning on September 16 and ending 
on September 26 must be paid no later than September 29 (sec. 
5703(b)(2)(D)). A similar rule applies to the excise taxes on 
certain other items, including alcoholic beverages, during the 
same September 16th through 26th period (sec. 5061(d)(4)).

                        Description of Proposal

    The proposal would accelerate the scheduled ten and five 
cents per pack increases in the excise tax on small cigarettes, 
and further increase the tax rate on small cigarettes by $0.55 
per pack, effective October 1, 1999. The scheduled increases in 
excise tax rates on other tobacco products likewise would be 
accelerated and increased proportionately.
    The following table shows the excise tax rates that would 
be effective as of October 1, 1999 under the proposal.

 
            Tobacco product                          Tax rate
 
Cigarettes:
    Small cigarettes...................  $47.00 per thousand (94 cents
                                          per pack of 20).
    Large cigarettes...................  $98.70 per thousand.
Cigars:
    Small cigars.......................  $4.406 per thousand.
    Large cigars.......................  49.99% of manufacturer's price,
                                          up to $98.75 per thousand.
Chewing tobacco........................  $0.47 per pound (2.9 cents per
                                          ounce container).
Snuff..................................  $1.41 per pound.
Pipe Tobacco...........................  $2.64 per pound.
Cigarette papers.......................  $0.029 per 50 papers or
                                          fraction thereof.
Cigarette tubes........................  $0.059 per 50 tubes or fraction
                                          thereof.
 


    A floor stocks tax would be imposed to conform the tax on 
tobacco products held for sale on the effective date with the 
tax on tobacco products that are acquired for sale after the 
effective date.
    In addition, the special rules that require that require 
payment by September 29 of taxes on tobacco products and 
alcoholic beverages that are removed during the period that 
begins on September 16 and ends on September 26 would not apply 
during 1999.

                             Effective Date

    The proposal to increase the tobacco excise tax would be 
effective on October 1, 1999. The proposal to suspend 
application of the special rules relating to the deposit of 
excise taxes on tobacco and alcoholic beverages removed between 
September 16 and September 26 would apply during 1999.

                              Prior Action

    The Taxpayer Relief Act of 1997, as reported by the Senate 
Committee on Finance and passed by the Senate, would have 
increased the tax on small cigarettes by $10 per thousand (20 
cents per pack of 20 cigarettes) effective October 1, 1997, 
with a proportionate increase in the tax rates on other taxable 
tobacco products. A floor stocks tax would have been provided.

                                Analysis

    Raising taxes on tobacco products will discourage the use 
of such products, particularly by children and teenagers. This 
may help many Americans avoid the hazards associated with long-
term tobacco use. However, the burden of increased tobacco 
taxes is expected to fall most heavily on those smokers with 
lower incomes. Increasing the price of tobacco products through 
additional taxes may also adversely affect tobacco farmers.

     D. Change Harbor Maintenance Excise Tax to Cost-Based User Fee

                              Present Law

    Under present law, an excise tax (``harbor maintenance 
tax'') of 0.125 percent is imposed on the value of commercial 
cargo (including the value of passenger fares) loaded or 
unloaded at U.S. ports (sec. 4461). The statute provides that 
the tax applies equally to imported and exported cargo. The tax 
does not apply to cargo donated for overseas use. The tax also 
does not apply to cargo (other than cargo destined for a 
foreign port) shipped between the U.S. mainland and Alaska 
(other than crude oil), Hawaii, or a U.S. possession. In 
addition, the tax does not apply to passenger ferry boats 
operating between points within the United States or between 
the United States and Canada or Mexico.
    Revenues from the harbor maintenance excise tax go to the 
Harbor Maintenance Trust Fund (``Harbor Trust Fund''), 
generally to finance costs of operating and maintaining U.S. 
ports.
    Art. I, sec. 9, cl. 5 of the United States Constitution 
provides that ``No Tax or Duty shall be laid on Articles 
exported from any State.'' In 1998, the U.S. Supreme Court 
ruled that the harbor maintenance tax, as applied to goods 
loaded at U.S. ports for export, violated the Constitution's 
export clause (Art. I, sec. 9, cl. 5), as such tax did not 
qualify as a user fee. United States v. United States Shoe 
Corp., 118 S. Ct. 1290 (1998).

                        Description of Proposal

    The proposal would replace the current ad valorem harbor 
maintenance excise tax with a cost-based user fee referred to 
as the ``harbor services user fee.'' The user fee would be 
available to finance harbor construction, operation, and 
maintenance activities performed by the Army Corps of 
Engineers, the costs of operating and maintaining the Saint 
Lawrence Seaway, and the costs of administering the fee.\320\
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    \320\ The details regarding the administration, application, and 
operation of the proposed user fee were not provided to the Congress in 
the President's fiscal year 2000 budget proposal.
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                             Effective Date

    The proposal would apply after the date of enactment.

                              Prior Action

    No prior action.

                                Analysis

    In general, a true user fee is a charge levied on a class 
that directly avails itself of a governmental program, and is 
used solely to finance that program rather than to finance the 
costs of government generally. The amount of the fee charged to 
any payor generally may not exceed the costs of providing the 
services with respect to which the fee is charged. Fees are not 
imposed on the general public; there must be a reasonable 
connection between the payors of the fee and the agency or 
function receiving the fee.\321\
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    \321\ For a discussion of the constitutional limitations on and 
congressional jurisdiction over fees and taxes, see Joint Committee on 
Taxation, Present Law and Background Information on Federal 
Transportation Excise Taxes and Trust Fund Expenditure Programs (JCS-
10-96), November 14, 1996, and Joint Committee on Taxation, Background 
and Present Law Relating to Funding Mechanisms of the ``E-Rate'' 
Telecommunications Program (JCX-59-98), July 31, 1998.
---------------------------------------------------------------------------
    In United States v. United States Shoe Corp., 118 S. Ct. 
1290 (1998), the U.S. Supreme Court ruled that the harbor 
maintenance excise tax of section 4461 was an ad valorem tax on 
exports which violated the Export Clause of the Constitution 
(Art. I., sec. 9, cl. 5). In so holding, the Court noted that 
the section 4461 expressly ``imposed a tax on any port use,'' 
which was determined solely on an ad valorem basis. The Supreme 
Court did recognize that exporters could legally be subject to 
user fees which help defray the cost of harbor development and 
maintenance, so long as these fees ``fairly match the 
exporters'' use of port services and facilities'' and lack the 
attributes of a generally applicable tax or duty. The charges 
must be designed as compensation for government-supplied 
services, facilities, or benefits.

 E. Additional Provisions Requiring Amendment of the Internal Revenue 
                                  Code

1. Increase amount of rum excise tax that is covered over to Puerto 
        Rico and the U.S. Virgin Islands

                              Present Law

    A $13.50 per proof gallon \322\ excise tax is imposed on 
distilled spirits produced in or imported (or brought) into the 
United States (sec. 5001). The excise tax does not apply to 
distilled spirits that are exported from the United States or 
to distilled spirits that are consumed in U.S. possessions 
(e.g., Puerto Rico and the Virgin Islands).
---------------------------------------------------------------------------
    \322\ A proof gallon is a liquid gallon consisting of 50 percent 
alcohol.
---------------------------------------------------------------------------
    The Code provides for coverover (payment) of $10.50 per 
proof gallon of the excise tax imposed on rum imported (or 
brought) into the United States (without regard to the country 
of origin) to Puerto Rico and the Virgin Islands (sec. 7652). 
During the 5-year period ending on September 30, 1998, the 
amount covered over was $11.35 per proof gallon. This temporary 
increase was enacted in 1993 as transitional relief 
accompanying a reduction in certain tax benefits for 
corporations operating in Puerto Rico and the Virgin Islands 
(sec. 936).
    Amounts covered over to Puerto Rico and the Virgin Islands 
are deposited in the treasuries of the two possessions.

                        Description of Proposal

    The President's budget states that a proposal will be made 
to increase the rum excise tax coverover rate from $10.50 to 
$13.50 per proof gallon for Puerto Rico and the Virgin Islands 
during the 5-year period beginning on October 1, 1999.
    The budget further states that this proposal will provide 
that $0.50 per gallon of the amount covered over to Puerto Rico 
be dedicated to the Puerto Rico Conservation Trust, a private, 
non-profit section 501(c)(3) organization operating in Puerto 
Rico.

                             Effective Date

    The proposal would be effective for rum imported (or 
brought) into the United States after September 30, 1999, and 
before October 1, 2004.
2. Allow members of the clergy to revoke exemption from Social Security 
        and Medicare coverage
    Under present law, ministers of a church who are opposed to 
participating in the Social Security and Medicare programs on 
religious principles may reject coverage by filing with the 
Internal Revenue Service before the tax filing date for their 
second year of work in the ministry. This proposal would 
provide an opportunity for members of the clergy to revoke 
their exemptions from Social Security and Medicare coverage.
3. Restore premiums for the United Mine Workers of America Combined 
        Benefit Fund
    The proposal would restore the previous calculation of 
premiums charged to coal companies that employed the retired 
miners that have been assigned to them. The proposal would 
reserve the court decision of National Coal v. Chater.
4. Disclosure of tax return information for administration of certain 
        veterans programs

                              Present Law

    The Internal Revenue Code prohibits disclosure of tax 
returns and return information, except to the extent 
specifically authorized by the Internal Revenue Code (sec. 
6103). Unauthorized disclosure is a felony punishable by a fine 
not exceeding $5,000 or imprisonment of not more than five 
years, or both (sec. 7213). An action for civil damages also 
may be brought for unauthorized disclosure (sec. 7431). No tax 
information may be furnished by the Internal Revenue Service 
(``IRS'') to another agency unless the other agency establishes 
procedures satisfactory to the IRS for safeguarding the tax 
information it receives (sec. 6103(p)).
    Among the disclosures permitted under the Code is 
disclosure to the Department of Veterans Affairs (``DVA'') of 
self-employment tax information and certain tax information 
supplied to the IRS and Social Security Administration by third 
parties. Disclosure is permitted to assist DVA in determining 
eligibility for, and establishing correct benefit amounts 
under, certain of its needs-based pension, health care, and 
other programs (sec. 6103(1)(7)(D)(viii)). The income tax 
returns filed by the veterans themselves are not disclosed to 
DVA.
    The DVA is required to comply with the safeguards currently 
contained in the Code and in section 1137(c) of the Social 
Security Act (governing the use of disclosed tax information). 
These safeguards include independent verification of tax data, 
notification to the individual concerned, and the opportunity 
to contest agency findings based on such information.
    The DVA disclosure provision is scheduled to expire after 
September 30, 2003.\323\
---------------------------------------------------------------------------
    \323\ The Appendix to the Fiscal Year 2000 Budget incorrectly 
states that this provision will expire in 2002 (p. 870).
---------------------------------------------------------------------------

                        Description of Proposal

    The proposal would extend the DVA disclosure 
provision.\324\
---------------------------------------------------------------------------
    \324\ It is not clear from the budget documents whether this 
provision would be permanently extended or whether it would be extended 
only through the end of the current budget window. It is also not clear 
from the budget documents whether the entire DVA provision would be 
extended, or only the portion relating to determining eligibility for 
pension benefits (this is the only portion mentioned on p. 870 of the 
Appendix to the Fiscal Year 2000 Budget).
---------------------------------------------------------------------------

                             Effective Date

    The proposal would be effective after September 30, 2003.

                                Analysis

    Some might argue that it is appropriate to permit the 
disclosure of otherwise confidential tax information to ensure 
the correctness of these government benefit payments. Others 
might respond that tax information should be used only for tax 
purposes and should not be subject to widespread redisclosure 
by the IRS.

                                
