[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
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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
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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.
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\9\ This rule applies whether or not the plan is subsidized by the
employer.
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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).
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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.
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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.
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\14\ Accordingly, the present-law restriction on eligible holders
of qualified zone academy bonds would not apply to bonds issued after
December 31, 1999.
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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.
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\15\ For this purpose, the term construction includes land upon
which a school facility is to be constructed.
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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.
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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.
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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.
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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.
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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.
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\25\ For a discussion of the returns to expenditures on research
and development see Part I.G.4 of this pamphlet.
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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.
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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\
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\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\
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\36\ This same result follows regardless of the effective tax rate
of the corporate donor.
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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.
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\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.
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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.
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\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.
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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.
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\39\ Defaulted borrowers of direct or guaranteed loans may also be
required to repay through an income-contingent plan for a minimum
period.
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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.
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\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.
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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.
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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.
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\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.
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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.
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\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\
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\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.
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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\
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\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.
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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.
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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.
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\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.
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\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.
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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.
---------------------------------------------------------------------------
\61\ U.S. Department of Housing and Urban Development, Evaluation
of the Low-Income Housing Tax Credit: Final Report, February 1991.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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).
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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.
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\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.
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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.
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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.
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\79\ GAO Report, Community Development Information on the Use of
Empowerment Zone and Enterprise Community Tax Incentives (GAO/RCED-98-
203), June 1998.
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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.
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\82\ Another credit proposal, a production credit for electricity
produced from wind or biomass, is discussed below.
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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.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\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.
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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\
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\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\
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\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\
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\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\
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\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\
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\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.
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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.
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\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.
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\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.
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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)).
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\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\
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\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.
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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\
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\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).
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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.
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\150\ Treas. Reg. sec. 29.112(b)(11)-2, 1953-1 C.B. 143.
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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.
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\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.
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\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.
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\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.
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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:
---------------------------------------------------------------------------
\157\ Industrial development bonds were subsumed into the category
of ``private activity bonds'' by the 1986 Act.
---------------------------------------------------------------------------
(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\
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\168\ This provision was enacted in section 1028 of the Taxpayer
Relief Act of 1997.
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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.
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\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.
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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.
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\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\
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\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.
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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.
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\173\ See, e.g., ACM v. Commissioner, 157 F. 3d 231 (1998).
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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.
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\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.
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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.
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\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.
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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.
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\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.
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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:
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\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\
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\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\
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\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).
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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.
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\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\
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\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\
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\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).
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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\
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\188\ See H. Rept. 104-281, p. 61.
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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.
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\189\ To the extent the employer securities are distributed to
participants, any untaxed appreciation may be taxed as long-term
capital gain.
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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.
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\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.
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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
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\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.
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\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.
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\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).
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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.
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\195\ 872 F.2d 519 (2d Cir. 1989); see also Peracchi v.
Commissioner, 134 F.3d 487 (9th Circ. 1998).
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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.
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\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).
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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)).
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\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)).
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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.
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\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.
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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.
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\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.
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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.
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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.).
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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\
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\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.
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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.
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\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.
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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\
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\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\
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\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.
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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\
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\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).
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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\
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\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.
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\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.''
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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\
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\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.
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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.
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\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\
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\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.
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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\
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\235\ See Rev. Rul. 94-28, 1994-1 C.B. 86.
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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).
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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.
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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\
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\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.
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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\
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\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.
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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\
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\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).
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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).
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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\
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\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.
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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.
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\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.
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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\
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\258\ Treas. Regs. sec. 1.381(c)(4)-1(c)(2).
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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.
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\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.
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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.
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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.
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\262\ The net proceeds equal the gross loan proceeds less the
direct expenses of obtaining the loan.
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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\
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\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\
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\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.
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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\
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\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\
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\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.
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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.
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\268\ Treas. Regs. sec. 1.195-1.
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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.
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\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)).
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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:
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\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.
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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\
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\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.
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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.
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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\
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\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.
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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.
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\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.
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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)).
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\284\ The electioneering activities covered by section 527 are
somewhat different than the lobbying and political activities covered
by section 162(e).
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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.
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\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.
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\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).
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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\
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\290\ Community-property States include Arizona, California, Idaho,
Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. Alaska
has an elective regime.
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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.
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\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.
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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.
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\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'').
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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.
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\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.
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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.
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\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.
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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.
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\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.
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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.
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\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.
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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.
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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\
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\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)).
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\299\ All IRA distributions are treated as if includible in income
for purposes of this rule.
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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.
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\300\ Code section 4973.
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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\
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\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).
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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\
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\303\ Rev. Rul. 58-145, 1958-1 C.B. 360.
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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.
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\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.
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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.
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\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).
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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.
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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\
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\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.
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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.
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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\
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\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\
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\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.
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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.
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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).
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\322\ A proof gallon is a liquid gallon consisting of 50 percent
alcohol.
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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\
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\323\ The Appendix to the Fiscal Year 2000 Budget incorrectly
states that this provision will expire in 2002 (p. 870).
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Description of Proposal
The proposal would extend the DVA disclosure
provision.\324\
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\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).
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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.