[Senate Report 108-192]
[From the U.S. Government Publishing Office]



                                                       Calendar No. 381
108th Congress                                                   Report
                                 SENATE
 1st Session                                                    108-192

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



 
               JUMPSTART OUR BUSINESS STRENGTH (JOBS) ACT

                                _______
                                

                November 7, 2003.--Ordered to be printed

                                _______
                                

  Mr. Grassley, from the Committee on Finance, submitted the following

                              R E P O R T

                             together with

                     ADDITIONAL AND MINORITY VIEWS

                         [To accompany S. 1637]

      [Including cost estimate of the Congressional Budget Office]

    The Committee on Finance, to which was referred the bill 
(S. 1637) to amend the Internal Revenue Code of 1986 to comply 
with the World Trade Organization rulings on the FSC/ETI 
benefit in a manner that preserves jobs and production 
activities in the United States, to reform and simplify the 
international taxation rules of the United States, and for 
other purposes, reports favorably thereon with an amendment in 
the nature of a substitute and recommends that the bill, as 
amended, to pass.

                                CONTENTS

                                                                   Page
  I. Legislative Background...........................................6
     Title I--Provisions Relating to Repeal of Exclusion for 
     Extraterritorial Income..........................................7
          A. Repeal of Extraterritorial Income Regime............     7
               1. Repeal of Exclusion for Extraterritorial Income 
                  (sec. 101 of the bill and secs. 114 and 941 
                  through 943 of the Code).......................     7
               2. Deduction relating to income attributable to 
                  United States production activities (sec. 102 
                  of the bill and new sec. 199 of the Code)......    11
     Title II--International Tax Provisions..........................14
          A. International Tax Reform............................    14
               1. Revision of foreign tax credit carryforward and 
                  carryback periods (sec. 201 of the bill and 
                  sec. 904 of the Code)..........................    14
               2. Look-through rules to apply to dividends from 
                  noncontrolled section 902 corporations (sec. 
                  202 of the bill and sec. 904 of the Code)......    16
               3. Foreign tax credit under alternative minimum 
                  tax (sec. 203 of the bill and secs. 53-59 of 
                  the Code)......................................    17
               4. Recharacterization of overall domestic loss 
                  (sec. 204 of the bill and sec. 904 of the Code)    18
               5. Interest expense allocation rules (sec. 205 of 
                  the bill and sec. 864 of the Code).............    20
               6. Determination of foreign personal holding 
                  company income with respect to transactions in 
                  commodities (sec. 206 of the bill and sec. 954 
                  of the Code)...................................    25
          B. International Tax Simplification....................    27
               1. Repeal of foreign personal holding company 
                  rules and foreign investment company rules 
                  (sec. 211 of the bill and secs. 542, 551-558, 
                  954, 1246, and 1247 of the Code)...............    27
               2. Expansion of de minimis rule under subpart F 
                  (sec. 212 of the bill and sec. 954 of the Code)    28
               3. Attribution of stock ownership through 
                  partnerships to apply in determining section 
                  902 and 960 credits (sec. 213 of the bill and 
                  secs. 901, 902, and 960 of the Code)...........    29
               4. Application of uniform capitalization rules for 
                  foreign persons (sec. 214 of the bill and sec. 
                  263A of the Code)..............................    31
               5. Repeal of withholding tax on dividends from 
                  certain foreign corporations (sec. 215 of the 
                  bill and sec. 871 of the Code).................    32
               6. Repeal of special capital gains tax on aliens 
                  present in the United States for 183 days or 
                  more (sec. 216 of the bill and sec. 871 of the 
                  Code)..........................................    34
          C. Additional International Tax Provisions.............    36
               1. Subpart F exception for active aircraft and 
                  vessel leasing income (sec. 221 of the bill and 
                  sec. 954 of the Code)..........................    36
               2. Look-through treatment of payments between 
                  related controlled foreign corporations under 
                  foreign personal holding company income rules 
                  (sec. 222 of the bill and sec. 954 of the Code)    38
               3. Look-through treatment under subpart F for 
                  sales of partnership interests (sec. 223 of the 
                  bill and sec. 954 of the Code).................    39
               4. Election not to use average exchange rate for 
                  foreign tax paid other than in functional 
                  currency (sec. 224 of the bill and sec. 986 of 
                  the Code)......................................    40
               5. Foreign tax credit treatment of ``base 
                  difference'' items (sec. 225 of the bill and 
                  sec. 904 of the Code)..........................    41
               6. Modification of exceptions under subpart F for 
                  active financing (sec. 226 of the bill and sec. 
                  954 of the Code)...............................    42
               7. United States property not to include certain 
                  assets of controlled foreign corporation (sec. 
                  227 of the bill and sec. 956 of the Code)......    45
               8. Provide equal treatment for interest paid by 
                  foreign partnerships and foreign corporations 
                  (sec. 228 of the bill and sec. 861 of the Code)    47
               9. Foreign tax credit treatment of deemed payments 
                  under section 367(d) (sec. 229 of the bill and 
                  sec. 367 of the Code)..........................    48
              10. Modify FIRPTA rules for real estate investment 
                  trusts (sec. 230 of the bill and secs. 857 and 
                  897 of the Code)...............................    49
              11. Temporary rate reduction for certain dividends 
                  received from controlled foreign corporations 
                  (sec. 231 of the bill and new sec. 965 of the 
                  Code)..........................................    50
              12. Exclusion of certain horse-racing and dog-
                  racing gambling winnings from the income of 
                  nonresident alien individuals (sec. 232 of the 
                  bill and sec. 872 of the Code).................    52
              13. Limitation of withholding on U.S.-source 
                  dividends paid to Puerto Rico corporation (sec. 
                  233 of the bill and secs. 881 and 1442 of the 
                  Code)..........................................    53
              14. Require Commerce Department report on adverse 
                  decisions of the World Trade Organization (sec. 
                  234 of the bill)...............................    55
              15. Study of impact of international tax law on 
                  taxpayers other than large corporations (sec. 
                  235 of the bill)...............................    55
              16. Consultative role for Senate Committee on 
                  Finance in connection with the review of 
                  proposed tax treaties (sec. 236 of the bill)...    57
     Title III--Domestic Manufacturing and Business Provisions.......58
          A. Domestic Manufacturing and Business Provisions......    58
               1. Expansion of qualified small-issue bond program 
                  (sec. 301 of the bill and sec. 144 of the Code)    58
               2. Expensing of investment in broadband equipment 
                  (sec. 302 of the bill and new sec. 191 of the 
                  Code)..........................................    59
               3. Exemption for natural aging process from 
                  interest capitalization (sec. 303 of the bill 
                  and sec. 263(A) of the Code)...................    61
               4. Section 355 ``active business test'' applied to 
                  chains of affiliated corporations (sec. 304 of 
                  the bill and sec. 355 of the Code).............    62
               5. Exclusion of certain indebtedness of small 
                  business investment companies from acquisition 
                  indebtedness (sec. 305 of the bill and sec. 514 
                  of the Code)...................................    63
               6. Modified taxation of imported archery products 
                  (sec. 306 of the bill and sec. 4161 of the 
                  Code)..........................................    65
               7. Modification to cooperative marketing rules to 
                  include value added processing involving 
                  animals (sec. 307 of the bill and sec. 1388 of 
                  the Code)......................................    66
               8. Extension of declaratory judgment procedures to 
                  farmers' cooperative organizations (sec. 308 of 
                  the bill and sec. 7428 of the Code)............    66
               9. Temporary suspension of personal holding 
                  company tax (sec. 309 of the bill and sec. 541 
                  of the Code)...................................    67
              10. Increase section 179 expensing (sec. 310 of the 
                  bill and sec. 179 of the Code).................    70
              11. Three-year carryback of net operating losses 
                  (sec. 311 of the bill and sec. 172 of the Code)    71
          B. Manufacturing Relating to Films.....................    73
               1. Special rules for certain film and television 
                  production (sec. 321 of the bill and new sec. 
                  181 of the Code)...............................    73
               2. Modification of application of income forecast 
                  method of depreciation (sec. 322 of the bill 
                  and sec. 167 of the Code)......................    75
          C. Manufacturing Relating to Timber....................    77
               1. Expensing of reforestation expenses (sec. 331 
                  of the bill and sec. 194 of the Code)..........    77
               2. Election to treat cutting of timber as a sale 
                  or exchange (sec. 332 of the bill and sec. 
                  631(a) of the Code)............................    78
               3. Capital gains treatment to apply to outright 
                  sales of timber by landowner (sec. 333 of the 
                  bill and sec. 631(b) of the Code)..............    79
               4. Modified safe harbor rules for timber REITs 
                  (sec. 334 of the bill and sec. 857 of the Code)    79
     Title IV--Additional Provisions.................................83
          A. Provisions Designed to Curtail Tax Shelters.........    83
               1. Clarification of the economic substance 
                  doctrine (sec. 401 of the bill and sec. 7701 of 
                  the Code)......................................    83
               2. Penalty for failing to disclose reportable 
                  transaction (sec. 402 of the bill and sec. 
                  6707A of the Code).............................    89
               3. Accuracy-related penalty for listed 
                  transactions and other reportable transactions 
                  having a significant tax avoidance purpose 
                  (sec. 403 of the bill and sec. 6662A of the 
                  Code)..........................................    92
               4. Penalty for understatements attributable to 
                  transactions lacking economic substance, etc. 
                  (sec. 404 of the bill and sec. 6662B of the 
                  Code)..........................................    96
               5. Modifications of substantial understatement 
                  penalty for nonreportable transactions (sec. 
                  405 of the bill and sec. 6662 of the Code).....    99
               6. Tax shelter exception to confidentiality 
                  privileges relating to taxpayer communications 
                  (sec. 406 of the bill and sec. 7525 of the 
                  Code)..........................................   100
               7. Disclosure of reportable transactions (secs. 
                  407 and 408 of the bill and secs. 6111 and 6707 
                  of the Code)...................................   101
               8. Modification of penalties for failure to 
                  register tax shelters or maintain lists of 
                  investors (secs. 407 and 409 of the bill and 
                  secs. 6112 and 6708 of the Code)...............   104
               9. Modification of actions to enjoin certain 
                  conduct related to tax shelters and reportable 
                  transactions (sec. 410 of the bill and sec. 
                  7408 of the Code)..............................   106
              10. Understatement of taxpayer's liability by 
                  income tax return preparer (sec. 411 of the 
                  bill and sec. 6694 of the Code)................   106
              11. Penalty on failure to report interests in 
                  foreign financial accounts (sec. 412 of the 
                  bill and sec. 5321 of Title 31, United States 
                  Code)..........................................   107
              12. Frivolous tax submissions (sec. 413 of the bill 
                  and sec. 6702 of the Code).....................   109
              13. Regulation of individuals practicing before the 
                  Department of Treasury (sec. 414 of the bill 
                  and sec. 330 of Title 31, United States Code)..   113
              14. Penalty on promoters of tax shelters (sec. 415 
                  of the bill and sec. 6700 of the Code).........   111
              15. Statute of limitations for taxable years for 
                  which required listed transactions not 
                  disclosed (sec. 416 of the bill and sec. 6501 
                  of the Code)...................................   112
              16. Denial of deduction for interest on 
                  underpayments attributable to nondisclosed 
                  reportable and noneconomic substance 
                  transactions (sec. 417 of the bill and sec. 163 
                  of the Code)...................................   113
              17. Authorization of appropriations for tax law 
                  enforcement (sec. 418 of the bill).............   113
          B. Other Corporate Governance Provisions...............   114
               1. Affirmation of consolidated return regulation 
                  authority (sec. 421 of the bill and sec. 502 of 
                  the Code)......................................   114
               2. Chief Executive Officer required to sign 
                  corporate income tax returns (sec. 422 of the 
                  bill and sec. 6062 of the Code)................   118
               3. Denial of deduction for certain fines, 
                  penalties, and other amounts (sec. 423 of the 
                  bill and sec. 162 of the Code).................   119
               4. Denial of deduction for punitive damages (sec. 
                  424 of the bill and sec. 162 of the Code)......   122
               5. Increase the maximum criminal fraud penalty for 
                  individuals to the amount of the tax at issue 
                  (sec. 425 of the bill and secs. 7201, 7203, and 
                  7206 of the Code)..............................   123
          C. Enron-Related Tax Shelter Provisions................   124
               1. Limitation on transfer and importation of 
                  built-in losses (sec. 431 of the bill and secs. 
                  362 and 334 of the Code).......................   124
               2. No reduction of basis under section 734 in 
                  stock held by partnership in corporate partner 
                  (sec. 432 of the bill and sec. 755 of the Code)   126
               3. Repeal of special rules for FASITs (sec. 433 of 
                  the bill and secs. 860H through 860L of the 
                  Code)..........................................   127
               4. Expanded disallowance of deduction for interest 
                  on convertible debt (sec. 434 of the bill and 
                  sec. 163 of the Code)..........................   133
               5. Expanded authority to disallow tax benefits 
                  under section 269 (sec. 435 of the bill and 
                  sec. 269 of the Code)..........................   135
               6. Modification of interaction between subpart F 
                  and passive foreign investment company rules 
                  (sec. 436 of the bill and sec. 1297 of the 
                  Code)..........................................   136
          D. Provisions to Discourage Expatriation...............   139
               1. Tax treatment of inversion transactions (sec. 
                  441 of the bill and new sec. 7874 of the Code).   139
               2. Impose mark-to-market tax on individuals who 
                  expatriate (sec. 442 of the bill and secs. 102, 
                  877, 2107, 2501, 7701 and 6039G of the Code)...   145
               3. Excise tax on stock compensation of insiders of 
                  inverted corporations (sec. 443 of the bill and 
                  new sec. 5000A of the Code)....................   156
               4. Reinsurance agreements (sec. 444 of the bill 
                  and sec. 845 of the Code)......................   160
               5. Reporting of taxable mergers and acquisitions 
                  (sec. 445 of the bill and new sec. 6043A of the 
                  Code)..........................................   162
          E. International Tax...................................   163
               1. Clarification of banking business for purposes 
                  of determining investment of earnings in U.S. 
                  property (sec. 451 of the bill and sec. 956 of 
                  the Code)......................................   163
               2. Prohibition on nonrecognition of gain through 
                  complete liquidation of holding company (sec. 
                  452 of the bill and sec. 332 of the Code)......   165
               3. Prevention of mismatching of interest and 
                  original issue discount deductions and income 
                  inclusions in transactions with related foreign 
                  persons (sec. 453 of the bill and secs. 163 and 
                  267 of the Code)...............................   166
               4. Effectively connected income to include certain 
                  foreign source income (sec. 454 of the bill and 
                  sec. 864 of the Code)..........................   168
               5. Recapture of overall foreign losses on sale of 
                  controlled foreign corporation stock (sec. 455 
                  of the bill and sec. 904 of the Code)..........   171
               6. Minimum holding period for foreign tax credit 
                  on withholding taxes on income other than 
                  dividends (sec. 456 of the bill and sec. 901 of 
                  the Code)......................................   173
          F. Other Revenue Provisions............................   174
               1. Treatment of stripped interests in bond and 
                  preferred stock funds, etc. (sec. 461 of the 
                  bill and secs. 305 and 1286 of the Code).......   174
               2. Application of earnings-stripping rules to 
                  partnerships and S corporations (sec. 462 of 
                  the bill and sec. 163 of the Code).............   177
               3. Recognition of cancellation of indebtedness 
                  income realized on satisfaction of debt with 
                  partnership interest (sec. 463 of the bill and 
                  sec. 108 of the Code)..........................   179
               4. Modification of straddle rules (sec. 464 of the 
                  bill and sec. 1092 of the Code)................   180
               5. Denial of installment sale treatment for all 
                  readily tradable debt (sec. 465 of the bill and 
                  sec. 453 of the Code)..........................   183
               6. Modify treatment of transfers to creditors in 
                  divisive reorganizations (sec. 466 of the bill 
                  and secs. 357 and 361 of the Code).............   184
               7. Clarify definition of nonqualified preferred 
                  stock (sec. 467 of the bill and sec. 351(g) of 
                  the Code)......................................   185
               8. Modify definition of controlled group of 
                  corporations (sec. 468 of the bill and sec. 
                  1563 of the Code)..............................   187
               9. Mandatory basis adjustments in connection with 
                  partnership distributions and transfers of 
                  partnership interests (sec. 469 of the bill and 
                  secs. 734, 743 and 754 of the Code)............   188
              10. Extend the present-law intangible amortization 
                  provisions to acquisitions of sports franchises 
                  (sec. 471 of the bill and sec. 197 of the Code)   190
              11. Lease term to include certain service contracts 
                  (sec. 472 of the bill and sec. 168 of the Code)   192
              12. Establish specific class lives for utility 
                  grading costs (sec. 473 of the bill and sec. 
                  168 of the Code)...............................   193
              13. Expansion of limitation on expensing of certain 
                  passenger automobiles (sec. 474 of the bill and 
                  sec. 179 of the Code)..........................   194
              14. Provide consistent amortization period for 
                  intangibles (sec. 475 of the bill and secs. 
                  195, 248, and 709 of the Code).................   196
              15. Limitation of tax benefits for leases to 
                  certain tax exempt entities (sec. 476 of the 
                  bill and new sec. 470 of the Code).............   197
              16. Clarification of rules for payment of estimated 
                  tax for certain deemed asset sales (sec. 481 of 
                  the bill and sec. 338 of the Code).............   200
              17. Extension of IRS user fees (sec. 482 of the 
                  bill and sec. 7529 of the Code)................   201
              18. Doubling of certain penalties, fines, and 
                  interest on underpayments related to certain 
                  offshore financial arrangements (sec. 483 of 
                  the bill)......................................   202
              19. Authorize IRS to enter into installment 
                  agreements that provide for partial payment 
                  (sec. 484 of the bill and sec. 6159 of the 
                  Code)..........................................   205
              20. Extension of customs user fees (sec. 485 of the 
                  bill)..........................................   206
              21. Deposits made to suspend the running of 
                  interest on potential underpayments (sec. 486 
                  of the bill and new sec. 6603 of the Code).....   207
              22. Qualified tax collection contracts (sec. 487 of 
                  the bill and new sec. 6306 of the Code)........   210
              23. Add vaccines against hepatitis A to the list of 
                  taxable vaccines (sec. 491 of the bill and sec. 
                  4132 of the Code)..............................   212
              24. Exclusion of like-kind exchange property from 
                  nonrecognition treatment on the sale or 
                  exchange of a principal residence (sec. 492 of 
                  the bill and sec. 121 of the Code).............   213
              25. Modify qualification rules for tax-exempt 
                  property and casualty insurance companies (sec. 
                  493 of the bill and secs. 501(c)(15) and 831(b) 
                  of the Code)...................................   214
              26. Definition of insurance company for property 
                  and casualty insurance company tax rules (sec. 
                  494 of the bill and sec. 831(c) of the Code)...   216
              27. Limit deduction for charitable contributions of 
                  patents and similar property (sec. 495 of the 
                  bill and secs. 170 and 6050L of the Code)......   217
              28. Repeal of ten-percent rehabilitation tax credit 
                  (sec. 496 of the bill and sec. 47(a)(1) of the 
                  Code)..........................................   222
              29. Increase age limit under section 1(g) (sec. 497 
                  of the bill and sec. 1 of the Code)............   223
 II. Budget Effects of the Bill.....................................225
          A. Committee Estimates.................................   225
          B. Budget Authority and Tax Expenditures...............   232
          C. Consultation with Congressional Budget Office.......   232
III. Votes of the Committee.........................................237
 IV. Regulatory Impact and Other Matters............................238
          A. Regulatory Impact...................................   238
          B. Unfunded Mandates Statement.........................   239
          C. Tax Complexity Analysis.............................   240
               1. Deduction relating to income attributable to 
                  United States production activities (sec. 102 
                  of the bill)...................................   240
  V. Additional Views...............................................246
 VI. Minority Views.................................................247
VII. Changes in Existing Law Made by the Bill, as Reported..........249

                       I. LEGISLATIVE BACKGROUND


                                OVERVIEW

    The Committee on Finance marked up S. 1637 (the ``Jumpstart 
Our Business Strength (JOBS) Act'') on October 1, 2003, and 
ordered the bill favorably reported by a vote of 19 Ayes and 2 
Nays.

                                HEARINGS

    The Committee held public hearings during the 108th 
Congress on various topics related to the provisions included 
in the bill.
     An Examination of U.S. Tax Policy and Its Effect 
on the International Competitiveness of U.S.-Owned Foreign 
Operations (July 15, 2003).
     An Examination of U.S. Tax Policy and Its Effect 
on the Domestic and International Competitiveness of U.S.-Based 
Operations (July 8, 2003).
     Enron: The Joint Committee on Taxation's 
Investigative Report (February 13, 2003).
     Revenue Proposals in the President's FY 2004 
Budget (February 5, 2003).

        TITLE I--PROVISIONS RELATING TO REPEAL OF EXCLUSION FOR 
                        EXTRATERRITORIAL INCOME


              A. Repeal of Extraterritorial Income Regime


1. Repeal of Exclusion for Extraterritorial Income (sec. 101 of the 
        bill and secs. 114 and 941 through 943 of the Code)

                              PRESENT LAW

    Like many other countries, the United States has long 
provided export-related benefits under its tax law. In the 
United States, for most of the last two decades, these benefits 
were provided under the foreign sales corporation (``FSC'') 
regime. In 2000, the European Union succeeded in having the FSC 
regime declared a prohibited export subsidy by the World Trade 
Organization (``WTO''). In response to this WTO finding, the 
United States repealed the FSC rules and enacted a new regime, 
under the FSC Repeal and Extraterritorial Income Exclusion Act 
of 2000. The European Union immediately challenged the 
extraterritorial income (``ETI'') regime in the WTO, and in 
January of 2002 the WTO Appellate Body found that the ETI 
regime also constituted a prohibited export subsidy under the 
relevant trade agreements.
    Under the ETI regime, an exclusion from gross income 
applies with respect to ``extraterritorial income,'' which is a 
taxpayer's gross income attributable to ``foreign trading gross 
receipts.'' This income is eligible for the exclusion to the 
extent that it is ``qualifying foreign trade income.'' 
Qualifying foreign trade income is the amount of gross income 
that, if excluded, would result in a reduction of taxable 
income by the greatest of: (1) 1.2 percent of the foreign 
trading gross receipts derived by the taxpayer from the 
transaction; (2) 15 percent of the ``foreign trade income'' 
derived by the taxpayer from the transaction; \1\ or (3) 30 
percent of the ``foreign sale and leasing income'' derived by 
the taxpayer from the transaction.\2\
---------------------------------------------------------------------------
    \1\ ``Foreign trade income'' is the taxable income of the taxpayer 
(determined without regard to the exclusion of qualifying foreign trade 
income) attributable to foreign trading gross receipts.
    \2\ ``Foreign sale and leasing income'' is the amount of the 
taxpayer's foreign trade income (with respect to a transaction) that is 
properly allocable to activities that constitute foreign economic 
processes. Foreign sale and leasing income also includes foreign trade 
income derived by the taxpayer in connection with the lease or rental 
of qualifying foreign trade property for use by the lessee outside the 
United States.
---------------------------------------------------------------------------
    Foreign trading gross receipts are gross receipts derived 
from certain activities in connection with ``qualifying foreign 
trade property'' with respect to which certain economic 
processes take place outside of the United States. 
Specifically, the gross receipts must be: (1) from the sale, 
exchange, or other disposition of qualifying foreign trade 
property; (2) from the lease or rental of qualifying foreign 
trade property for use by the lessee outside the United States; 
(3) for services which are related and subsidiary to the sale, 
exchange, disposition, lease, or rental of qualifying foreign 
trade property (as described above); (4) for engineering or 
architectural services for construction projects located 
outside the United States; or (5) for the performance of 
certain managerial services for unrelated persons. A taxpayer 
may elect to treat gross receipts from a transaction as not 
foreign trading gross receipts. As a result of such an 
election, a taxpayer may use any related foreign tax credits in 
lieu of the exclusion.
    Qualifying foreign trade property generally is property 
manufactured, produced, grown, or extracted within or outside 
the United States that is held primarily for sale, lease, or 
rental in the ordinary course of a trade or business for direct 
use, consumption, or disposition outside the United States. No 
more than 50 percent of the fair market value of such property 
can be attributable to the sum of: (1) the fair market value of 
articles manufactured outside the United States; and (2) the 
direct costs of labor performed outside the United States. With 
respect to property that is manufactured outside the United 
States, certain rules are provided to ensure consistent U.S. 
tax treatment with respect to manufacturers.

                           REASONS FOR CHANGE

    While recognizing that there are problems with the WTO 
dispute settlement system that need to be addressed, the 
Committee believes it is important that the United States, and 
all members of the WTO, make every effort to come into 
compliance with their WTO obligations. The Appellate Body has 
found that the ETI regime constitutes a prohibited export-
contingent subsidy contrary to U.S. obligations under the WTO. 
The Committee believes that the replacement tax regime provided 
for in this bill is consistent with U.S. obligations under the 
WTO and will bring the United States into compliance with the 
Appellate Body decision. To mitigate the economic impact of 
repealing the ETI provisions, the Committee believes that it is 
necessary and appropriate to provide a transition to complement 
the phase-in of the replacement tax regime included in this 
bill. In developing a transition for this bill, the Committee 
was guided by the latitude demonstrated by the United States 
toward the European Union in the context of the so-called 
``Bananas'' dispute. With respect to both the Bananas and FSC/
ETI disputes, the efforts to comply with the applicable WTO 
decisions entail the sizable disruption of commercial relations 
and expectations that developed over the course of decades.
    In the Bananas case, the United States joined other 
complainants in challenging the European Union's banana import 
regime under the WTO. The United States and the European Union 
eventually reached an Understanding to resolve the WTO dispute 
over the European Union's import regime for bananas. By virtue 
of that Understanding, the European Union imposed a 
transitional banana import regime that will not end until seven 
years after the initial deadline established by the WTO for the 
European Union to come into compliance. The European Union 
subsequently obtained from the Doha Ministerial Conference of 
the WTO a waiver from paragraphs 1 and 2 of Article XIII of the 
GATT 1994 with respect to its transitional banana import 
regime. That waiver was necessary for the transitional banana 
import regime to remain consistent with the WTO obligations of 
the European Union. The United States did not object to that 
waiver. The United States also did not object to a second 
waiver granted to the European Union by the Doha Ministerial 
Conference, under which paragraph 1 of Article I of the GATT 
1994 was waived with respect to the European Union's 
preferential tariff treatment for products originating in the 
African, Caribbean and Pacific (``ACP'') Group of States. This 
latter waiver extends until December 31, 2007. As a result of 
the foregoing waivers consented to bythe United States, the 
European Union will not be required to grant non-discriminatory market 
access for bananas until a full nine years after the compliance 
deadline established by the WTO.\3\ The Committee notes that the 
transition provided for in this bill expires well before the nine-year 
anniversary of the compliance deadline established by the WTO with 
respect to the FSC regime. Just as the European Union approached the 
issue of compliance in the Bananas dispute, the Committee believes that 
it is necessary and appropriate to provide a reasonable transition 
period during which the affected businesses may adjust to the new 
environment following repeal of the ETI regime.
---------------------------------------------------------------------------
    \3\ The Committee notes with concern that, to date, the European 
Union has failed to publish full details of its enlargement policy for 
the accession of ten new members in May 2004. In particular, the 
European Union has not announced the post-enlargement licensing 
application process for bananas. This lack of transparency may well 
result in the disruption of trade in bananas, to the point where the 
mutually agreed-upon terms of the Understanding between the United 
States and the European Union for a transitional banana import regime 
are not fully adhered to after enlargement. The Committee intends to 
monitor this situation closely.
---------------------------------------------------------------------------
    In developing the transition provided for in this bill, it 
is also the intent of the Committee to eliminate objections to 
such transition, and avoid the need to seek any waiver from the 
WTO for such transition, by removing any element of export 
contingency from the transition. Thus, eligibility for the 
transition deduction under this bill is entirely decoupled from 
actual exports during the transition period. Consequently, a 
principal rationale for the European Union's challenge to the 
FSC/ETI regimes is not implicated by the transition.
    A second transitional element provided for in this bill is 
the grandfathering of existing contracts entered into under the 
FSC and ETI tax regimes. These contracts are comprised 
primarily of long-term leasing arrangements. These arrangements 
typically entail a U.S. lessor purchasing the manufactured good 
from the manufacturer and subsequently entering into a long-
term lease with a foreign lessee. Under these circumstances, 
the FSC/ETI tax benefit accrues to the lessor rather than the 
manufacturer of the leased good. The lessor must report the 
FSC/ETI tax benefit immediately for purposes of financial 
statement accounting under generally accepted accounting 
principles (``GAAP'').
    Leasing is a service and is recognized as such within the 
WTO. The provision of non-discriminatory subsidies to service 
suppliers is not prohibited under the WTO General Agreement on 
Trade in Services (``GATS''). Thus, an extension of FSC/ETI 
benefits for suppliers of leasing services under existing long-
term contracts does not appear to be inconsistent with the WTO 
obligations of the United States under GATS. Moreover, the 
extension of FSC/ETI benefits for existing long-term leasing 
contracts will have no effect on future exports. Accordingly, a 
principal rationale for the European Union's challenge to the 
FSC/ETI regimes is not implicated because future trade patterns 
will not be distorted by virtue of the grandfather clause. On 
the other hand, the absence of a grandfather clause for 
existing long-term contracts would effectively dictate winners 
and losers based upon preexisting contractual relationships, 
and would inflict additional harm by forcing lessors to restate 
their financial statements. Neither of those outcomes is 
equitable in the view of the Committee, nor did the architects 
of the WTO dispute settlement system contemplate such punitive 
results. Accordingly, the Committee believes it is necessary 
and appropriate to continue to provide FSC and ETI tax benefits 
to existing long-term contracts that currently benefit from the 
FSC/ETI tax regimes.
    The Committee also believes that Congress should use the 
opportunity afforded by repealing the ETI regime to enact a 
replacement tax regime that benefits all domestic 
manufacturers, including small manufacturing firms, as well as 
to enact changes that rationalize the international tax laws 
and strengthen the international competitiveness of U.S. 
businesses. In addition, the Committee believes that the 
history of the ETI regime and its predecessors demonstrates the 
need for WTO members to reexamine the treatment of various tax 
systems under the WTO rules.

                        EXPLANATION OF PROVISION

    The provision repeals the exclusion for extraterritorial 
income. However, the provision provides that the 
extraterritorial income exclusion provisions remain in effect 
for transactions in the ordinary course of a trade or business 
if such transactions are pursuant to a binding contract between 
the taxpayer and an unrelated person and such contract is in 
effect on September 17, 2003, and at all times thereafter.
    The provision permits foreign corporations that have 
elected to be treated as U.S. corporations pursuant to the 
extraterritorial income exclusion provisions to revoke their 
elections. Such revocations are effective on the date of 
enactment of this provision. A corporation revoking its 
election is treated as a U.S. corporation that transfers all of 
its property to a foreign corporation in connection with an 
exchange described in section 354 of the Code. In general, the 
corporation shall not recognize any gain or loss on such deemed 
transfer. However, a revoking corporation shall recognize any 
gain on any asset held by the corporation if: (1) the basis of 
such asset is determined (in whole or in part) by reference to 
the basis of such asset in the hands of the person from whom 
the corporation acquired such asset; (2) the asset was acquired 
by an actual transfer (rather than as a result of the U.S. 
corporation election by the corporation) occurring on or after 
the first day on which the U.S. corporation election by the 
corporation was effective; and (3) a principal purpose of the 
acquisition was the reduction or avoidance of tax.
    The provision also provides a deduction for taxable years 
of certain corporations ending after the date of enactment of 
the provision and beginning before January 1, 2007.\4\ The 
amount of the deduction for each such taxable year is equal to 
a specified percentage of the amount that, for the taxable year 
of a corporation beginning in 2002, was excludable from the 
gross income of the corporation under the extraterritorial 
income exclusion provisions or was treated by the corporation 
as exempt foreign trade income of related FSCs from property 
acquired by the FSCs from the corporation.\5\ However, this 
aggregate amount does not include any amount attributable to a 
transaction involving a lease by the corporation unless the 
corporation manufactured or produced (in whole or in part) the 
leased property.
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    \4\ The deduction also is available to cooperatives engaged in the 
marketing of agricultural or horticultural products.
    \5\ In the case of a short taxable year that ends after the date of 
enactment and begins before January 1, 2007, the Treasury Secretary 
shall prescribe guidance for determining the amount of the deduction, 
including guidance that limits the amount of the deduction for a short 
taxable year based upon the proportion that the number of days in the 
short taxable year bears to 365.
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    The specified percentage to be used in determining the 
deduction is: 80 percent for calendar years 2004 and 2005; 60 
percent for calendar year 2006; and 0 percent for calendar 
years 2007 and thereafter. For calendar year 2003, the 
specified percentage is the amount that bears the same ratio to 
100 percent as the number of days after the date of enactment 
of this provision bears to 365. In the case of a corporation 
with a taxable year that is not the calendar year (i.e., a 
fiscal year corporation), a special rule is provided for 
determining a weighted average specified percentage based upon 
the calendar years that are included in the taxable year.
    The deduction for a taxable year generally is reduced by 
the specified percentage of exempted FSC income and excluded 
extraterritorial income of the corporation for the taxable year 
from transactions pursuant to a binding contract.

                             EFFECTIVE DATE

    The provision is effective for transactions occurring after 
the date of enactment.

2. Deduction relating to income attributable to United States 
        production activities (sec. 102 of the bill and new sec. 199 of 
        the Code)

                              PRESENT LAW

    Under present law, there is no provision in the Code that 
permits taxpayers to claim a deduction from taxable income 
attributable to domestic production activities, other than 
allowable deductions of costs incurred to produce such income.

                           REASONS FOR CHANGE

    The Committee believes that creating new jobs is an 
essential element of economic recovery and expansion, and that 
tax policies designed to foster job creation also must reverse 
the recent declines in manufacturing sector employment levels. 
To accomplish this objective, the Committee believes that 
Congress should enact tax laws that enhance the ability of 
domestic businesses, and domestic manufacturing firms in 
particular, to compete in the global marketplace. The Committee 
further believes Congress should enact tax laws that enable 
small businesses to maintain their position as the primary 
source of new jobs in this country.
    The Committee understands that simply repealing the ETI 
regime will diminish the prospects for recovery from the recent 
economic downturn by the manufacturing sector. Consequently, 
the Committee believes that it is necessary and appropriate to 
replace the ETIregime with new provisions that reduce the tax 
burden on domestic manufacturers, including small businesses engaged in 
manufacturing.

                        EXPLANATION OF PROVISION

In general

    The provision provides a deduction equal to a portion of 
the taxpayer's qualified production activities income. For 
taxable years beginning after 2008, the deduction is nine 
percent of such income. For taxable years beginning in 2003, 
2004, 2005, 2006, 2007 and 2008, the deduction is one, one, 
two, three, six, and six percent of income, respectively. 
However, the deduction for a taxable year is limited to 50 
percent of the wages paid by the taxpayer during such taxable 
year.\6\ In the case of corporate taxpayers that are members of 
certain affiliated groups, the deduction is determined by 
treating all members of such groups as a single taxpayer.
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    \6\ For purposes of this provision, ``wages'' include the sum of 
the aggregate amounts of wages (as defined in section 3401(a) without 
regard to exclusions for remuneration paid for services performed in 
possessions of the United States) and elective deferrals (as defined in 
sections 402(g)(3) and 402A) that the taxpayer is required to include 
on statements with respect to the employment of employees of the 
taxpayer during the taxpayer's taxable year. Any wages taken into 
account for purposes of determining the wage limitation under this 
provision cannot also be taken into account for purposes of determining 
any credit allowable under sections 30A or 936.
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Qualified production activities income

    In general, ``qualified production activities income'' is 
the modified taxable income \7\ of a taxpayer that is 
attributable to domestic production activities. Income 
attributable to domestic production activities generally is 
equal to domestic production gross receipts, reduced by the sum 
of: (1) the costs of goods sold that are allocable to such 
receipts; \8\ (2) other deductions, expenses, or losses that 
are directly allocable to such receipts; and (3) a proper share 
of other deductions, expenses, and losses that are not directly 
allocable to such receipts or another class of income.\9\
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    \7\ ``Modified taxable income'' is taxable income of the taxpayer 
computed without regard to the deduction provided by the provision. 
Qualified production activities income is limited to the modified 
taxable income of the taxpayer.
    \8\ For purposes of determining such costs, any item or service 
that is imported into the United States without an arm's length 
transfer price shall be treated as acquired by purchase, and its cost 
shall be treated as not less than its fair market value when it entered 
the United States. A similar rule shall apply in determining the 
adjusted basis of leased or rented property where the lease or rental 
gives rise to domestic production gross receipts. With regard to 
property previously exported by the taxpayer for further manufacture, 
the increase in cost or adjusted basis shall not exceed the difference 
between the fair market value of the property when exported and the 
fair market value of the property when re-imported into the United 
States after further manufacture.
    \9\ The Secretary shall prescribe rules for the proper allocation 
of items of income, deduction, expense, and loss for purposes of 
determining income attributable to domestic production activities. 
Where appropriate, such rules shall be similar to and consistent with 
relevant present-law rules (e.g., secs. 263A and 861).
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    For taxable years beginning before 2013, qualified 
production activities income is reduced by virtue of a fraction 
(not to exceed one), the numerator of which is the value of the 
domestic production of the taxpayer and the denominator of 
which is the value of the worldwide production of the taxpayer 
(the ``domestic/worldwide fraction'').\10\ For taxable years 
beginning in 2010, 2011, and 2012, the reduction in qualified 
production activities income by virtue of this fraction is 
reduced by 25, 50, and 75 percent, respectively. For taxable 
years beginning after 2012, there is no reduction in qualified 
production activities income by virtue of this fraction.
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    \10\ For purposes of the domestic/worldwide fraction, the value of 
domestic production is the excess of domestic production gross receipts 
(as defined below) over the cost of deductible purchased inputs that 
are allocable to such receipts. Similarly, the value of worldwide 
production is the excess of worldwide production gross receipts over 
the cost of deductible purchased inputs that are allocable to such 
receipts. For purposes of determining the domestic/worldwide fraction, 
purchased inputs include: purchased services (other than employees) 
used in manufacture, production, growth, or extraction activities; 
purchased items consumed in connection with such activities; and 
purchased items incorporated as part of the property being 
manufactured, produced, grown, or extracted. In the case of corporate 
taxpayers that are members of certain affiliated groups, the domestic/
worldwide fraction is determined by treating all members of such groups 
as a single taxpayer.
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Domestic production gross receipts

    ``Domestic production gross receipts'' are gross receipts 
of a taxpayer that are derived in the actual conduct of a trade 
or business from any sale, exchange or other disposition, or 
any lease, rental or license, of qualifying production property 
that was manufactured, produced, grown or extracted (in whole 
or in significant part) by the taxpayer within the United 
States or any possession of the United States.\11\ ``Qualifying 
production property'' generally is any tangible personal 
property, computer software, or property described in section 
168(f)(3) or (4) of the Code.\12\ However, qualifying 
production property does not include: (1) consumable property 
that is sold, leased or licensed as an integral part of the 
provision of services; (2) oil or gas (other than certain 
primary products thereof);\13\ (3) electricity; (4) water 
supplied by pipeline to the consumer; (5) utility services; and 
(6) any film, tape, recording, book, magazine, newspaper or 
similar property the market for which is primarily topical or 
otherwise essentially transitory in nature.
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    \11\ Domestic production gross receipts include gross receipts of a 
taxpayer derived from any sale, exchange or other disposition of 
agricultural products with respect to which the taxpayer performs 
storage, handling or other processing activities (but not 
transportation activities) within the United States, provided such 
products are consumed in connection with, or incorporated into, the 
manufacturing, production, growth or extraction of qualifying 
production property (whether or not by the taxpayer).
    \12\ For purposes of the definition of qualified production 
property, property described in section 168(f)(3) or (4) of the Code 
includes underlying copyrights and trademarks. In addition, gross 
receipts from the sale, exchange, lease, rental, license or other 
disposition of property described in section 168(f)(3) or (4) are 
treated as domestic production gross receipts if more than 50 percent 
of the aggregate development and production costs of such property are 
incurred by the taxpayer within the United States. For this purpose, 
property that is acquired by the taxpayer after development or 
production has commenced, but before such property generates 
substantial gross receipts, shall be treated as developed or produced 
by the taxpayer.
    \13\ Qualifying production property does not include extracted but 
unrefined oil or gas, but generally includes primary products of oil 
and gas that are produced by the taxpayer. Examples of primary products 
for this purpose include motor fuels, chemical feedstocks and 
fertilizer. However, primary products do not include the output of a 
natural gas processing plant. Natural gas processing plants generally 
are located at or near the producing gas field that supplies the 
facility, and the facility serves to separate impurities from the 
natural gas liquids recovered from the field for the purpose of selling 
the liquids for future production and preparation of the natural gas 
for pipeline transportation.
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Other rules

            Qualified production activities income of passthrough 
                    entities (other than cooperatives)
    With respect to domestic production activities of an S 
corporation, partnership, estate, trust or other passthrough 
entity (other than an agricultural or horticultural 
cooperative), the deduction under this provision generally is 
determined at the shareholder, partner or similar level by 
taking into account at such level the proportionate share of 
qualified production activities income of the entity.\14\ The 
Treasury Secretary is directed to prescribe rules for the 
application of this provision to passthrough entities, 
including reporting requirements and rules relating to 
restrictions on the allocation of the deduction to taxpayers at 
the partner or similar level.
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    \14\ However, the wage limitation described above is determined at 
the entity level in computing the deduction with respect to qualified 
production activities income of a passthrough entity.
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            Qualified production activities income of agricultural and 
                    horticultural cooperatives
    With regard to member-owned agricultural and horticultural 
cooperatives formed under Subchapter T of the Code, the 
provision provides the same treatment of qualified production 
activities income derived from products marketed through 
cooperatives as it provides for qualified production activities 
income of other taxpayers (i.e., the cooperative may claim a 
deduction from qualified production activities income). In 
addition, the provision provides that the amount of any 
patronage dividends or per-unit retain allocations paid to a 
member of anagricultural or horticultural cooperative (to which 
Part I of Subchapter T applies), which is allocable to the portion of 
qualified production activities income of the cooperative that is 
deductible under the provision, is excludible from the gross income of 
the member. In order to qualify, such amount must be designated by the 
organization as allocable to the deductible portion of qualified 
production activities income in a written notice mailed to its patrons 
not later than the payment period described in section 1382(d). The 
cooperative cannot reduce its income under section 1382 (e.g., cannot 
claim a dividends-paid deduction) for such amounts.
            Alternative minimum tax
    The deduction provided by the provision is allowed for 
purposes of the alternative minimum tax (including adjusted 
current earnings). The deduction is determined by reference to 
modified alternative minimum taxable income.
            Coordination with ETI repeal
    For purposes of this provision, domestic production gross 
receipts does not include gross receipts from any transaction 
that produces excluded extraterritorial income pursuant to the 
binding contract exception to the ETI repeal provisions of the 
bill.
    Qualified production activities income is determined 
without regard to any deduction provided by the ETI repeal 
provisions of the bill.

                             EFFECTIVE DATE

    The provision is effective for taxable years ending after 
the date of enactment.

                 TITLE II--INTERNATIONAL TAX PROVISIONS


                      A. International Tax Reform


1. Revision of foreign tax credit carryforward and carryback periods 
        (sec. 201 of the bill and sec. 904 of the Code)

                              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 a portion of the taxpayer's 
U.S. tax which portion is calculated by multiplying the 
taxpayer's total U.S. tax by a fraction, the numerator of which 
is the taxpayer's foreign-source taxable income (i.e., foreign-
source gross income less allocable expenses or deductions) and 
the denominator of which is the taxpayer's worldwide taxable 
income for the year.\15\
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    \15\ Section 904(a).
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    In addition, this limitation is calculated separately for 
various categories of income, generally referred to as 
``separate limitation categories.'' The total amount of the 
foreign tax credit used to offset the U.S. tax on income in 
each separate limitation category may not exceed the proportion 
of the taxpayer's U.S. tax which the taxpayer's foreign-source 
taxable income in that category bears to its worldwide taxable 
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 to the two 
immediately preceding taxable years (to the earliest year 
first) and carried forward five taxable years (in chronological 
order) and credited (not deducted) to the extent that the 
taxpayer otherwise has excess foreign tax credit limitation for 
those years. Excess credits that are carried back or forward 
are usable only to the extent that there is excess foreign tax 
credit limitation in such carryover or carryback year. 
Consequently, foreign tax credits arising in a taxable year are 
utilized before excess credits from another taxable year may be 
carried forward or backward. In addition, excess credits are 
carried forward or carried back on a separate limitation basis. 
Thus, if a taxpayer has excess foreign tax credits in one 
separate limitation category for a taxable year, those excess 
credits may be carried back and forward only as taxes allocable 
to that category, notwithstanding the fact that the taxpayer 
may have excess foreign tax credit limitation in another 
category for that year. If credits cannot be so utilized, they 
are permanently disallowed.

                           REASONS FOR CHANGE

    The Committee is concerned that excessive double taxation 
of foreign earnings may result from the expiration of foreign 
tax credits under present law. The Committee believes that the 
purposes of the foreign tax credit would be better served by 
providing a larger window within which credits may be used, 
thereby reducing the likelihood that credits may expire.

                        EXPLANATION OF PROVISION

    The provision extends the excess foreign tax credit 
carryforward period to twenty years and limits the carryback 
period to one year.

                             EFFECTIVE DATE

    The extension of the carryforward period is effective for 
excess foreign tax credits that may be carried to any taxable 
years ending after the date of enactment of the provision; the 
limited carryback period is effective for excess foreign tax 
credits arising in taxable years beginning after the date of 
enactment of the provision.

2. Look-through rules to apply to dividends from noncontrolled section 
        902 corporations (sec. 202 of the bill and sec. 904 of the 
        Code)

                              PRESENT LAW

    U.S. persons may credit foreign taxes against U.S. tax on 
foreign-source income. In general, 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 also 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''). Dividends paid by a 10/50 company that is 
not a passive foreign investment company 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).\16\ 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 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 10/50 company's earnings and profits attributable 
to income in such foreign tax credit limitation category to its 
total earnings and profits (a ``look-through'' approach).
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    \16\ 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.
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    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.

                           REASONS FOR CHANGE

    The Committee believes that significant simplification can 
be achieved by eliminating the requirement that taxpayers 
segregate the earnings and profits of 10/50 companies on the 
basis of when such earnings and profits arose.

                        EXPLANATION OF PROVISION

    The provision generally applies the look-through approach 
to 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\17\ and eliminates the separate basket 
for dividends from 10/50 companies. If the Secretary of the 
Treasury determines that a taxpayer has inadequately 
substantiated that it assigned a dividend from a 10/50 company 
to the proper foreign tax credit limitation category, the 
dividend is treated as passive category income for foreign tax 
credit basketing purposes.\18\
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    \17\ This look-through treatment also applies to dividends that a 
controlled foreign corporation receives from a 10/50 company and then 
distributes to a U.S. shareholder.
    \18\ The Committee expects that Treasury will reconsider the 
operation of the foreign tax credit regulations to ensure that the high 
tax income rules apply appropriately to dividends treated as passive 
category income because of inadequate substantiation.
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    The provision also provides transition rules regarding the 
use of pre-effective date foreign tax credits associated with a 
10/50-company separate limitation category in post-effective 
date years. Look-through principles similar to those applicable 
to post-effective date dividends from a 10/50 company apply to 
determine the appropriate foreign tax credit limitation 
category or categories with respect to carrying forward foreign 
tax credits into future years. The provision allows the 
Treasury Secretary to issue regulations addressing the 
carryback of foreign tax credits associated with a dividend 
from a 10/50 company to pre-effective date years.

                             EFFECTIVE DATE

    The provision is effective for taxable years beginning 
after December 31, 2002.

3. Foreign tax credit under alternative minimum tax (sec. 203 of the 
        bill and secs. 53-59 of the Code)

                              PRESENT LAW

            In general
    Under present law, taxpayers are subject to an alternative 
minimum tax (``AMT''), which is payable, in addition to all 
other tax liabilities, to the extent that it exceeds the 
taxpayer's regular income tax liability. The tax is imposed at 
a flat rate of 20 percent, in the case of corporate taxpayers, 
on alternative minimum taxable income (``AMTI'') in excess of 
an exemption amount that phases out. AMTI is the taxpayer's 
taxable income increased for certain tax preferences and 
adjusted by determining the tax treatment of certain items in a 
manner that limits the tax benefits resulting from the regular 
tax treatment of such items.
            Foreign tax credit
    Taxpayers are permitted to reduce their AMT liability by an 
AMT foreign tax credit. The AMT foreign tax credit for a 
taxable year is determined under principles similar to those 
used in computing the regular tax foreign tax credit, except 
that: (1) the numerator of the AMT foreign tax credit 
limitation fraction is foreign source AMTI; and (2) the 
denominator of that fraction is total AMTI. Taxpayers may elect 
to use as their AMT foreign tax credit limitation fraction the 
ratio of foreign source regular taxable income to total AMTI.
    The AMT foreign tax credit for any taxable year generally 
may not offset a taxpayer's entire pre-credit AMT. Rather, the 
AMT foreign tax credit is limited to 90 percent of AMT computed 
without any AMT net operating loss deduction and the AMT 
foreign tax credit. For example, assume that a corporation has 
$10 million of AMTI, has no AMT net operating loss deduction, 
and has no regular tax liability. In the absence of the AMT 
foreign tax credit, the corporation's tax liability would be $2 
million. Accordingly, the AMT foreign tax credit cannot be 
applied to reduce the taxpayer's tax liability below $200,000. 
Any unused AMT foreign tax credit may be carried back two years 
and carried forward five years for use against AMT in those 
years under the principles of the foreign tax credit carryback 
and carryover rules set forth in section 904(c).

                           REASONS FOR CHANGE

    The Committee does not view the foreign tax credit as a tax 
preference item, and thus views the 90-percent limit under 
present law as inappropriate.

                        EXPLANATION OF PROVISION

    The provision repeals the 90-percent limitation on the 
utilization of the AMT foreign tax credit.

                             EFFECTIVE DATE

    The provision is effective for taxable years beginning 
after December 31, 2004.

4. Recharacterization of overall domestic loss (sec. 204 of the bill 
        and sec. 904 of the Code)

                              PRESENT LAW

    The United States provides a credit for foreign income 
taxes paid or accrued. The foreign tax credit generally is 
limited to the U.S. tax liability on a taxpayer's foreign-
source income, in order to ensure that the credit serves the 
purpose of mitigating double taxation of foreign-source income 
without offsetting the U.S. tax on U.S.-source income. This 
overall limitation is calculated by prorating a taxpayer's pre-
credit U.S. tax on its worldwide income between its U.S.-source 
and foreign-source taxable income. The ratio (not exceeding 100 
percent) of the taxpayer's foreign-source taxable income to 
worldwide taxable income ismultiplied by its pre-credit U.S. 
tax to establish the amount of U.S. tax allocable to the taxpayer's 
foreign-source income and, thus, the upper limit on the foreign tax 
credit for the year.
    In addition, this limitation is calculated separately for 
various categories of income, generally referred to as 
``separate limitation categories.'' The total amount of the 
foreign tax credit used to offset the U.S. tax on income in 
each separate limitation category may not exceed the proportion 
of the taxpayer's U.S. tax which the taxpayer's foreign-source 
taxable income in that category bears to its worldwide taxable 
income.
    If a taxpayer's losses from foreign sources exceed its 
foreign-source income, the excess (``overall foreign loss,'' or 
``OFL'') may offset U.S.-source income. Such an offset reduces 
the effective rate of U.S. tax on U.S.-source income.
    In order to eliminate a double benefit (that is, the 
reduction of U.S. tax previously noted and, later, full 
allowance of a foreign tax credit with respect to foreign-
source income), present law includes an OFL recapture rule. 
Under this rule, a portion of foreign-source taxable income 
earned after an OFL year is recharacterized as U.S.-source 
taxable income for foreign tax credit purposes (and for 
purposes of the possessions tax credit). Unless a taxpayer 
elects a higher percentage, however, generally no more than 50 
percent of the foreign-source taxable income earned in any 
particular taxable year is recharacterized as U.S.-source 
taxable income. The effect of the recapture is to reduce the 
foreign tax credit limitation in one or more years following an 
OFL year and, therefore, the amount of U.S. tax that can be 
offset by foreign tax credits in the later year or years.
    Losses for any taxable year in separate foreign limitation 
categories (to the extent that they do not exceed foreign 
income for the year) are apportioned on a proportionate basis 
among (and operate to reduce) the foreign income categories in 
which the entity earns income in the loss year. A separate 
limitation loss recharacterization rule applies to foreign 
losses apportioned to foreign income pursuant to the above 
rule. If a separate limitation loss was apportioned to income 
subject to another separate limitation category and the loss 
category has income for a subsequent taxable year, then that 
income (to the extent that it does not exceed the aggregate 
separate limitation losses in the loss category not previously 
recharacterized) must be recharacterized as income in the 
separate limitation category that was previously offset by the 
loss. Such recharacterization must be made in proportion to the 
prior loss apportionment not previously taken into account.
    A U.S.-source loss reduces pre-credit U.S. tax on worldwide 
income to an amount less than the hypothetical tax that would 
apply to the taxpayer's foreign-source income if viewed in 
isolation. The existence of foreign-source taxable income in 
the year of the U.S.-source loss reduces or eliminates any net 
operating loss carryover that the U.S.-source loss would 
otherwise have generated absent the foreign income. In 
addition, as the pre-credit U.S. tax on worldwide income is 
reduced, so is the foreign tax credit limitation. Moreover, any 
U.S.-source loss for any taxable year is apportioned among (and 
operates to reduce) foreign income in the separate limitation 
categories on a proportionate basis. As a result, some foreign 
tax credits in the year of the U.S.-source loss must be 
credited, if at all, in a carryover year. Tax on U.S.-source 
taxable income in a subsequent year may be offset by a net 
operating loss carryforward, but not by a foreign tax credit 
carryforward. There is currently no mechanism for 
recharacterizing such subsequent U.S.-source income as foreign-
source income.
    For example, suppose a taxpayer generates a $100 U.S.-
source loss and earns $100 of foreign-source income in Year 1, 
and pays $30 of foreign tax on the $100 of foreign-source 
income. Because the taxpayer has no net taxable income in Year 
1, no foreign tax credit can be claimed in Year 1 with respect 
to the $30 of foreign taxes. If the taxpayer then earns $100 of 
U.S.-source income and $100 of foreign-source income in Year 2, 
present law does not recharacterize any portion of the $100 of 
U.S.-source income as foreign-source income to reflect the fact 
that the previous year's $100 U.S.-source loss reduced the 
taxpayer's ability to claim foreign tax credits.

                           REASONS FOR CHANGE

    The Committee believes that the overall foreign loss rules 
continue to represent sound tax policy, but that concerns of 
parity dictate that overall domestic loss rules be provided to 
address situations in which a domestic loss may restrict a 
taxpayer's ability to claim foreign tax credits.

                        EXPLANATION OF PROVISION

    The provision applies a re-sourcing rule to U.S.-source 
income in cases in which a taxpayer's foreign tax credit 
limitation has been reduced as a result of an overall domestic 
loss. Under the provision, a portion of the taxpayer's U.S.-
source income for each succeeding taxable year is 
recharacterized as foreign-source income in an amount equal to 
the lesser of: (1) the amount of the unrecharacterized overall 
domestic losses for years prior to such succeeding taxable 
year; and (2) 50 percent of the taxpayer's U.S.-source income 
for such succeeding taxable year.
    The provision defines an overall domestic loss for this 
purpose as any domestic loss to the extent it offsets foreign-
source taxable income for the current taxable year or for any 
preceding taxable year by reason of a loss carryback. For this 
purpose, a domestic loss means the amount by which the U.S.-
source gross income for the taxable year is exceeded by the sum 
of the deductions properly apportioned or allocated thereto, 
determined without regard to any loss carried back from a 
subsequent taxable year. Under the provision, an overall 
domestic loss does not include any loss for any taxable year 
unless the taxpayer elected the use of the foreign tax credit 
for such taxable year.
    Any U.S.-source income recharacterized under the provision 
is allocated among and increases the various foreign tax credit 
separate limitation categories in the same proportion that 
those categories were reduced by the prior overall domestic 
losses, in a manner similar to the recharacterization rules for 
separate limitation losses.
    It is anticipated that situations may arise in which a 
taxpayer generates an overall domestic loss in a year following 
a year in which it had an overall foreign loss, or vice versa. 
In such a case, it would be necessary for ordering and other 
coordination rules to be developed for purposes of computing 
the foreign tax credit limitation in subsequent taxable years. 
The provision grants the Secretary of the Treasury authority to 
prescribe such regulations as may benecessary to coordinate the 
operation of the OFL recapture rules with the operation of the overall 
domestic loss recapture rules added by the provision.

                             EFFECTIVE DATE

    The provision applies to losses incurred in taxable years 
beginning after December 31, 2006.

5. Interest expense allocation rules (sec. 205 of the bill and sec. 864 
        of the Code)

                              PRESENT LAW

In general

    In order to compute the foreign tax credit limitation, a 
taxpayer must determine the amount of its taxable income from 
foreign sources. Thus, the taxpayer must allocate and apportion 
deductions between items of U.S.-source gross income, on the 
one hand, and items of foreign-source gross income, on the 
other.
    In the case of interest expense, the rules generally are 
based on the approach that money is fungible and that interest 
expense is properly attributable to all business activities and 
property of a taxpayer, regardless of any specific purpose for 
incurring an obligation on which interest is paid.\19\ For 
interest allocation purposes, the Code provides that all 
members of an affiliated group of corporations generally are 
treated as a single corporation (the so-called ``one-taxpayer 
rule'') and allocation must be made on the basis of assets 
rather than gross income.
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    \19\ However, exceptions to the fungibility principle are provided 
in particular cases, some of which are described below.
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Affiliated group

            In general
    The term ``affiliated group'' in this context generally is 
defined by reference to the rules for determining whether 
corporations are eligible to file consolidated returns. 
However, some groups of corporations are eligible to file 
consolidated returns yet are not treated as affiliated for 
interest allocation purposes, and other groups of corporations 
are treated as affiliated for interest allocation purposes even 
though they are not eligible to file consolidated returns. 
Thus, under the one-taxpayer rule, the factors affecting the 
allocation of interest expense of one corporation may affect 
the sourcing of taxable income of another, related corporation 
even if the two corporations do not elect to file, or are 
ineligible to file, consolidated returns.
            Definition of affiliated group--consolidated return rules
    For consolidation purposes, the term ``affiliated group'' 
means one or more chains of includible corporations connected 
through stock ownership with a common parent corporation which 
is an includible corporation, but only if: (1) the common 
parent owns directly stock possessing at least 80 percent of 
the total voting power and at least 80 percent of the total 
value of at least one other includible corporation; and (2) 
stock meeting the same voting power and value standards with 
respect to each includible corporation (excluding the common 
parent) is directly owned by one or more other includible 
corporations.
    Generally, the term ``includible corporation'' means any 
domestic corporation except certain corporations exempt from 
tax under section 501 (for example, corporations organized and 
operated exclusively for charitable or educational purposes), 
certain life insurance companies, corporations electing 
application of the possession tax credit, regulated investment 
companies, real estate investment trusts, and domestic 
international sales corporations. A foreign corporation 
generally is not an includible corporation.
            Definition of affiliated group--special interest allocation 
                    rules
    Subject to exceptions, the consolidated return and interest 
allocation definitions of affiliation generally are consistent 
with each other.\20\ For example, both definitions generally 
exclude all foreign corporations from the affiliated group. 
Thus, while debt generally is considered fungible among the 
assets of a group of domestic affiliated corporations, the same 
rules do not apply as between the domestic and foreign members 
of a group with the same degree of common control as the 
domestic affiliated group.
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    \20\ One such exception is that the affiliated group for interest 
allocation purposes includes section 936 corporations that are excluded 
from the consolidated group.
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            Banks, savings institutions, and other financial affiliates
    The affiliated group for interest allocation purposes 
generally excludes what are referred to in the Treasury 
regulations as ``financial corporations'' (Treas. Reg. sec. 
1.861-11T(d)(4)). These include any corporation, otherwise a 
member of the affiliated group for consolidation purposes, that 
is a financial institution (described in section 581 or section 
591), the business of which is predominantly with persons other 
than related persons or their customers, and which is required 
by State or Federal law to be operated separately from any 
other entity which is not a financial institution (sec. 
864(e)(5)(C)). The category of financial corporations also 
includes, to the extent provided in regulations, bank holding 
companies (including financial holding companies), subsidiaries 
of banks and bank holding companies (including financial 
holding companies), and savings institutions predominantly 
engaged in the active conduct of a banking, financing, or 
similar business (sec. 864(e)(5)(D)).
    A financial corporation is not treated as a member of the 
regular affiliated group for purposes of applying the one-
taxpayer rule to other non-financial members of that group. 
Instead, all such financial corporations that would be so 
affiliated are treated as a separate single corporation for 
interest allocation purposes.

                           REASONS FOR CHANGE

    The Committee observes that under present law, a U.S.-based 
multinational corporate group with a significant portion of its 
assets overseas must allocate a significant portion of 
itsinterest expense to foreign-source income, which reduces the foreign 
tax credit limitation and thus the credits allowable, even though the 
interest expense incurred in the United States is not deductible in 
computing the actual tax liability under foreign law. The Committee 
believes that this approach unduly limits such a taxpayer's ability to 
claim foreign tax credits and leaves it excessively exposed to double 
taxation of foreign-source income. The Committee believes that interest 
expense instead should be allocated using an elective ``worldwide 
fungibility'' approach, under which interest expense incurred in the 
United States is allocated against foreign-source income only if the 
debt-to-asset ratio is higher for U.S. than for foreign investments.

                        EXPLANATION OF PROVISION

In general

    The provision modifies the present-law interest expense 
allocation rules (which generally apply for purposes of 
computing the foreign tax credit limitation) by providing a 
one-time election under which the taxable income of the 
domestic members of an affiliated group from sources outside 
the United States generally is determined by allocating and 
apportioning interest expense of the domestic members of a 
worldwide affiliated group on a worldwide-group basis (i.e., as 
if all members of the worldwide group were a single 
corporation). If a group makes this election, the taxable 
income of the domestic members of a worldwide affiliated group 
from sources outside the United States is determined by 
allocating and apportioning the third-party interest expense of 
those domestic members to foreign-source income in an amount 
equal to the excess (if any) of: (1) the worldwide affiliated 
group's worldwide third-party interest expense multiplied by 
the ratio which the foreign assets of the worldwide affiliated 
group bears to the total assets of the worldwide affiliated 
group; \21\ over (2) the third-party interest expense incurred 
by foreign members of the group to the extent such interest 
would be allocated to foreign sources if the provision's 
principles were applied separately to the foreign members of 
the group.\22\
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    \21\ For purposes of determining the assets of the worldwide 
affiliated group, neither stock in corporations within the group nor 
indebtedness (including receivables) between members of the group is 
taken into account. It is anticipated that the Treasury Secretary will 
adopt regulations addressing the allocation and apportionment of 
interest expense on such indebtedness that follow principles analogous 
to those of existing regulations. Income from holding stock or 
indebtedness of another group member is taken into account for all 
purposes under the present-law rules of the Code, including the foreign 
tax credit provisions.
    \22\ Although the interest expense of a foreign subsidiary is taken 
into account for purposes of allocating the interest expense of the 
domestic members of the electing worldwide affiliated group for foreign 
tax credit limitation purposes, the interest expense incurred by a 
foreign subsidiary is not deductible on a U.S. return.
---------------------------------------------------------------------------
    For purposes of the new elective rules based on worldwide 
fungibility, the worldwide affiliated group means all 
corporations in an affiliated group (as that term is defined 
under present law for interest allocation purposes) \23\ as 
well as all controlled foreign corporations that, in the 
aggregate, either directly or indirectly,\24\ would be members 
of such an affiliated group if section 1504(b)(3) did not apply 
(i.e., in which at least 80 percent of the vote and value of 
the stock of such corporations is owned by one or more other 
corporations included in the affiliated group). Thus, if an 
affiliated group makes this election, the taxable income from 
sources outside the United States of domestic group members 
generally is determined by allocating and apportioning interest 
expense of the domestic members of the worldwide affiliated 
group as if all of the interest expense and assets of 80-
percent or greater owned domestic corporations (i.e., 
corporations that are part of the affiliated group under 
present-law section 864(e)(5)(A) as modified to include 
insurance companies) and certain controlled foreign 
corporations were attributable to a single corporation.
---------------------------------------------------------------------------
    \23\ The provision expands the definition of an affiliated group 
for interest expense allocation purposes to include certain insurance 
companies that are generally excluded from an affiliated group under 
section 1504(b)(2) (without regard to whether such companies are 
covered by an election under section 1504(c)(2)).
    \24\ Indirect ownership is determined under the rules of section 
958(a)(2) or through applying rules similar to those of section 
958(a)(2) to stock owned directly or indirectly by domestic 
partnerships, trusts, or estates.
---------------------------------------------------------------------------
    In addition, if an affiliated group elects to apply the new 
elective rules based on worldwide fungibility, the present-law 
rules regarding the treatment of tax-exempt assets and the 
basis of stock in nonaffiliated ten-percent owned corporations 
apply on a worldwide affiliated group basis.
    The common parent of the domestic affiliated group must 
make the worldwide affiliated group election. It must be made 
for the first taxable year beginning after December 31, 2008, 
in which a worldwide affiliated group exists that includes at 
least one foreign corporation that meets the requirements for 
inclusion in a worldwide affiliated group. Once made, the 
election applies to the common parent and all other members of 
the worldwide affiliated group for the taxable year for which 
the election was made and all subsequent taxable years, unless 
revoked with the consent of the Secretary of the Treasury.

Financial institution group election

    The provision allows taxpayers to apply the present-law 
bank group rules to exclude certain financial institutions from 
the affiliated group for interest allocation purposes under the 
worldwide fungibility approach. The provision also provides a 
one-time ``financial institution group'' election that expands 
the present-law bank group. Under the provision, at the 
election of the common parent of the pre-election worldwide 
affiliated group, the interest expense allocation rules are 
applied separately to a subgroup of the worldwide affiliated 
group that consists of: (1) all corporations that are part of 
the present-law bank group; and (2) all ``financial 
corporations.'' For this purpose, a corporation is a financial 
corporation if at least 80 percent of its gross income is 
financial services income (as described in section 
904(d)(2)(C)(i) and the regulations thereunder) that is derived 
from transactions with unrelated persons.\25\ For these 
purposes, items of income or gain from a transaction or series 
of transactions are disregarded if a principal purpose for the 
transaction or transactions is to qualify any corporation as a 
financial corporation.
---------------------------------------------------------------------------
    \25\ See Treas. Reg. sec. 1.904-4(e)(2).
---------------------------------------------------------------------------
    The common parent of the pre-election worldwide affiliated 
group must make the election for the first taxable year 
beginning after December 31, 2008, in which a worldwide 
affiliated group includes a financial corporation. Once made, 
the election applies to the financial institution group for the 
taxable year and all subsequent taxable years. In addition, the 
provision provides anti-abuse rules under which certain 
transfers from one member of a financial institution group to a 
member of the worldwide affiliated group outside of the 
financial institution group are treated as reducing the amount 
of indebtedness of the separate financial institution group. 
The provision provides regulatory authority with respect to the 
election to provide for the direct allocation of interest 
expense in circumstances in which such allocation is 
appropriate to carry out the purposes of the provision, prevent 
assets or interest expense from being taken into account more 
than once, or address changes in members of any group (through 
acquisitions or otherwise) treated as affiliated under this 
provision.

                             EFFECTIVE DATE

    The provision is effective for taxable years beginning 
after December 31, 2008.

6. Determination of foreign personal holding company income with 
        respect to transactions in commodities (sec. 206 of the bill 
        and sec. 954 of the Code)

                              PRESENT LAW

Subpart F foreign personal holding company income

    Under the subpart F rules, U.S. shareholders with a 10-
percent or greater interest in a controlled foreign corporation 
(``U.S. 10-percent shareholders'') are subject to U.S. tax 
currently on certain income earned by the controlled foreign 
corporation, whether or not such income is distributed to the 
shareholders. The income subject to current inclusion under the 
subpart F rules includes, among other things, ``foreign 
personal holding company income.''
    Foreign personal holding company income generally consists 
of the following: dividends, interest, royalties, rents and 
annuities; net gains from sales or exchanges of: (1) property 
that gives rise to the foregoing types of income; (2) property 
that does not give rise to income, and (3) interests in trusts, 
partnerships, and real estate mortgage investment conduits 
(``REMICs''); net gains from commodities transactions; net 
gains from foreign currency transactions; income that is 
equivalent to interest; income from notional principal 
contracts; and payments in lieu of dividends.
    With respect to transactions in commodities, foreign 
personal holding company income does not consist of gains or 
losses which arise out of bona fide hedging transactions that 
are reasonably necessary to the conduct of any business by a 
producer, processor, merchant, or handler of a commodity in the 
manner in which such business is customarily and 
usuallyconducted by others.\26\ In addition, foreign personal holding 
company income does not consist of gains or losses which are comprised 
of active business gains or losses from the sale of commodities, but 
only if substantially all of the controlled foreign corporation's 
business is as an active producer, processor, merchant, or handler of 
commodities.\27\
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    \26\ For hedging transactions entered into on or after January 31, 
2003, Treasury regulations provide that gains or losses from a 
commodities hedging transaction generally are excluded from the 
definition of foreign personal holding company income if the 
transaction is with respect to the controlled foreign corporation's 
business as a producer, processor, merchant or handler of commodities, 
regardless of whether the transaction is a hedge with respect to a sale 
of commodities in the active conduct of a commodities business by the 
controlled foreign corporation. The regulations also provide that, for 
purposes of satisfying the requirements for exclusion from the 
definition of foreign personal holding company income, a producer, 
processor, merchant or handler of commodities includes a controlled 
foreign corporation that regularly uses commodities in a manufacturing, 
construction, utilities, or transportation business (Treas. Reg. sec. 
1.954-2(f)(2)(v)). However, the regulations provide that a controlled 
foreign corporation is not a producer, processor, merchant or handler 
of commodities (and therefore would not satisfy the requirements for 
exclusion) if its business is primarily financial (Treas. Reg. sec. 
1.954-2(f)(2)(v)).
    \27\ Treasury regulations provide that substantially all of a 
controlled foreign corporation's business is as an active producer, 
processor, merchant or handler of commodities if: (1) the sum of its 
gross receipts from all of its active sales of commodities in such 
capacity and its gross receipts from all of its commodities hedging 
transactions that qualify for exclusion from the definition of foreign 
personal holding company income, equals or exceeds (2) 85 percent of 
its total receipts for the taxable year (computed as though the 
controlled foreign corporation was a domestic corporation) (Treas. Reg. 
sec. 1.954-2(f)(2)(iii)(C)).
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Hedging transactions

    Under present law, the term ``capital asset'' does not 
include any hedging transaction which is clearly identified as 
such before the close of the day on which it was acquired, 
originated, or entered into (or such other time as the 
Secretary may by regulations prescribe).\28\ The term ``hedging 
transaction'' means any transaction entered into by the 
taxpayer in the normal course of the taxpayer's trade or 
business primarily: (1) to manage risk of price changes or 
currency fluctuations with respect to ordinary property which 
is held or to be held by the taxpayer; (2) to manage risk of 
interest rate or price changes or currency fluctuations with 
respect to borrowings made or to be made, or ordinary 
obligations incurred or to be incurred, by the taxpayer; or (3) 
to manage such other risks as the Secretary may prescribe in 
regulations.\29\
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    \28\ Sec. 1221(a)(7).
    \29\ Sec. 1221(b)(2)(A).
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The Committee believes that exceptions from subpart F 
foreign personal holding company income for commodities hedging 
transactions and active business sales of commodities should be 
modified to better reflect current active business practices 
and, in the case of hedging transactions, to conform to recent 
tax law changes concerning hedging transactions generally.

                        EXPLANATION OF PROVISION

    The provision modifies the requirements that must be 
satisfied for gains or losses from a commodities hedging 
transaction to qualify for exclusion from the definition of 
subpart F foreign personal holding company income. Under the 
provision, gains or losses from a transaction with respect to a 
commodity are not treated as foreign personal holding company 
income if the transaction satisfies the general definition of a 
hedging transaction under section 1221(b)(2). For purposes of 
this provision, the general definition of a hedging transaction 
under section 1221(b)(2) is modified to include any transaction 
with respect to a commodity entered into by a controlled 
foreign corporation in the normal course of the controlled 
foreign corporation's trade or business primarily: (1) to 
manage risk of price changes or currency fluctuations with 
respect to ordinary property or property described in section 
1231(b) which is held or to be held by the controlled foreign 
corporation; or (2) to manage such other risks as the Secretary 
may prescribe in regulations. Gains or losses from a 
transaction that satisfies the modified definition of a hedging 
transaction are excluded from the definition of foreign 
personal holding company income only if the transaction is 
clearly identified as a hedging transaction in accordance with 
the hedge identification requirements that apply generally to 
hedging transactions under section 1221(b)(2).\30\
---------------------------------------------------------------------------
    \30\ Sec. 1221(a)(7) and (b)(2)(B).
---------------------------------------------------------------------------
    The provision also changes the requirements that must be 
satisfied for active business gains or losses from the sale of 
commodities to qualify for exclusion from the definition of 
foreign personal holding company income. Under the provision, 
such gains or losses are not treated as foreign personal 
holding company income if substantially all of the controlled 
foreign corporation's commodities are comprised of: (1) stock 
in trade of the controlled foreign corporation or other 
property of a kind which would properly be included in the 
inventory of the controlled foreign corporation if on hand at 
the close of the taxable year, or property held by the 
controlled foreign corporation primarily for sale to customers 
in the ordinary course of the controlled foreign corporation's 
trade or business; (2) property that is used in the trade or 
business of the controlled foreign corporation and is of a 
character which is subject to the allowance for depreciation 
under section 167; or (3) supplies of a type regularly used or 
consumed by the controlled foreign corporation in the ordinary 
course of a trade or business of the controlled foreign 
corporation.\31\
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    \31\ For purposes of determining whether substantially all of the 
controlled foreign corporation's commodities are comprised of such 
property, it is intended that the 85-percent requirement provided in 
the current Treasury regulations (as modified to reflect the changes 
made by the proposal) continue to apply.
---------------------------------------------------------------------------
    For purposes of applying the requirements for active 
business gains or losses from commodities sales to qualify for 
exclusion from the definition of foreign personal holding 
company income, the provision also provides that commodities 
with respect to which gains or losses are not taken into 
account as foreign personal holding company income by a regular 
dealer in commodities (or financial instruments referenced to 
commodities) are not taken into account in determining whether 
substantially all of the dealer's commodities are comprised of 
the property described above.

                             EFFECTIVE DATE

    The provision is effective with respect to transactions 
entered into after December 31, 2004.

                  B. International Tax Simplification


1. Repeal of foreign personal holding company rules and foreign 
        investment company rules (sec. 211 of the bill and secs. 542, 
        551-558, 954, 1246, and 1247 of the Code)

                              PRESENT LAW

    Income earned by a foreign corporation from its foreign 
operations generally is subject to U.S. tax only when such 
income is distributed to any U.S. persons that hold stock in 
such corporation. Accordingly, a U.S. person that conducts 
foreign operations through a foreign corporation generally is 
subject to U.S. tax on the income from those operations when 
the income is repatriated to the United States through a 
dividend distribution to the U.S. person. The income is 
reported on the U.S. person's tax return for the year the 
distribution is received, and the United States imposes tax on 
such income at that time. The foreign tax credit may reduce the 
U.S. tax imposed on such income.
    Several sets of anti-deferral rules impose current U.S. tax 
on certain income earned by a U.S. person through a foreign 
corporation. Detailed rules for coordination among the anti-
deferral rules are provided to prevent the U.S. person from 
being subject to U.S. tax on the same item of income under 
multiple rules.
    The Code sets forth the following anti-deferral rules: the 
controlled foreign corporation rules of subpart F (secs. 951-
964); the passive foreign investment company rules (secs. 1291-
1298); the foreign personal holding company rules (secs. 551-
558); the personal holding company rules (secs. 541-547); the 
accumulated earnings tax rules (secs. 531-537); and the foreign 
investment company rules (secs. 1246-1247).

                           REASONS FOR CHANGE

    The Committee believes that the overlap among the various 
anti-deferral regimes results in significant complexity, 
usually with little or no ultimate tax consequences. These 
overlaps require the Code to provide specific rules of priority 
for income inclusions among the regimes, as well as additional 
coordination provisions pertaining to other operational 
differences among the various regimes.

                        EXPLANATION OF PROVISION

    The provision: (1) eliminates the rules applicable to 
foreign personal holding companies and foreign investment 
companies; (2) excludes foreign corporations from the 
application of the personal holding company rules; and (3) 
includes as subpart F foreign personal holding company income 
personal services contract income that is subject to the 
present-law foreign personal holding company rules.

                             EFFECTIVE DATE

    The provision is effective for taxable years of foreign 
corporations beginning after December 31, 2004, and taxable 
years of U.S. shareholders with or within which such taxable 
years of such foreign corporations end.

2. Expansion of de minimis rule under subpart F (sec. 212 of the bill 
        and sec. 954 of the Code)

                              PRESENT LAW

    Under the rules of subpart F (secs. 951-964), U.S. 10-
percent shareholders of a controlled foreign corporation are 
required to include in income currently for U.S. tax purposes 
certain types of income of the controlled foreign corporation, 
whether or not such income is actually distributed currently to 
the shareholders (referred to as ``subpart F income''). Subpart 
F income includes foreign base company income and certain 
insurance income. Foreign base company income includes five 
categories of income: foreign personal holding company income, 
foreign base company sales income, foreign base company 
services income, foreign base company shipping income, and 
foreign base company oil-related income (sec. 954(a)). Under a 
de minimis rule, if the gross amount of a controlled foreign 
corporation's foreign base company income and insurance income 
for a taxable year is less than the lesser of five percent of 
the controlled foreign corporation's gross income or $1 
million, then no part of the controlled foreign corporation's 
gross income is treated as foreign base company income or 
insurance income (sec. 954(b)(3)(A)).

                           REASONS FOR CHANGE

    The Committee believes that significant simplification can 
be achieved by expanding the subpart F de minimis rule.

                        EXPLANATION OF PROVISION

    The provision expands the subpart F de minimis rule to 
provide that, if the gross amount of a controlled foreign 
corporation's foreign base company income and insurance income 
for a taxable year is less than the lesser of five percent of 
the controlled foreign corporation's gross income or $5 
million, then no part of the controlled foreign corporation's 
gross income is treated as foreign base company income or 
insurance income.

                             EFFECTIVE DATE

    The provision is effective for taxable years of foreign 
corporations beginning after December 31, 2004, and taxable 
years of U.S. shareholders with or within which such taxable 
years of such foreign corporations end.

3. Attribution of stock ownership through partnerships to apply in 
        determining section 902 and 960 credits (sec. 213 of the bill 
        and secs. 901, 902, and 960 of the Code)

                              PRESENT LAW

    Under section 902, a domestic corporation that receives a 
dividend from a foreign corporation in which it owns ten 
percent or more of the voting stock is deemed to have paid a 
portion of the foreign taxes paid by such foreign corporation. 
Thus, such a domestic corporation is eligible to claim a 
foreign tax credit with respect to such deemed-paid taxes. The 
domestic corporation that receives a dividend is deemed to have 
paid a portion of the foreign corporation's post-1986 foreign 
income taxes based on the ratio of the amount of the dividend 
to the foreign corporation's post-1986 undistributed earnings 
and profits.
    Foreign income taxes paid or accrued by lower-tier foreign 
corporations also are eligible for the deemed-paid credit if 
the foreign corporation falls within a qualified group (sec. 
902(b)). A ``qualified group'' includes certain foreign 
corporations within the first six tiers of a chain of foreign 
corporations if, among other things, the product of the 
percentage ownership of voting stock at each level of the chain 
(beginning from the domestic corporation) equals at least five 
percent. In addition, in order to claim indirect credits for 
foreign taxes paid by certain fourth-, fifth-, and sixth-tier 
corporations, such corporations must be controlled foreign 
corporations (within the meaning of sec. 957) and the 
shareholder claiming the indirect credit must be a U.S. 
shareholder (as defined in sec. 951(b)) with respect to the 
controlled foreign corporations. The application of the 
indirect foreign tax credit below the third tier is limited to 
taxes paid in taxable years during which the payor is a 
controlled foreign corporation. Foreign taxes paid below the 
sixth tier of foreign corporations are ineligible for the 
indirect foreign tax credit.
    Section 960 similarly permits a domestic corporation with 
subpart F inclusions from a controlled foreign corporation to 
claim deemed-paid foreign tax credits with respect to foreign 
taxes paid or accrued by the controlled foreign corporation on 
its subpart F income.
    The foreign tax credit provisions in the Code do not 
specifically address whether a domestic corporation owning ten 
percent or more of the voting stock of a foreign corporation 
through a partnership is entitled to a deemed-paid foreign tax 
credit.\32\ In Rev. Rul. 71-141,\33\ the IRS held that a 
foreign corporation's stock held indirectly by two domestic 
corporations through their interests in a domestic general 
partnership is attributed to such domestic corporations for 
purposes of determining the domestic corporations' eligibility 
to claim a deemed-paid foreign tax credit with respect to the 
foreign taxes paid by such foreign corporation. Accordingly, a 
general partner of a domestic general partnership is permitted 
to claim deemed-paid foreign tax credits with respect to a 
dividend distributed from the foreign corporation to the 
partnership.
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    \32\ Under section 901(b)(5), an individual member of a partnership 
or a beneficiary of an estate or trust generally may claim a direct 
foreign tax credit with respect to the amount of his or her 
proportionate share of the foreign taxes paid or accrued by the 
partnership, estate, or trust. This rule does not specifically apply to 
corporations that are either members of a partnership or beneficiaries 
of an estate or trust. However, section 702(a)(6) provides that each 
partner (including individuals or corporations) of a partnership must 
take into account separately its distributive share of the 
partnership's foreign taxes paid or accrued. In addition, under section 
703(b)(3), the election under section 901 (whether to credit the 
foreign taxes) is made by each partner separately.
    \33\ 1971-1 C.B. 211.
---------------------------------------------------------------------------
    However, in 1997, the Treasury Department issued final 
regulations under section 902, and the preamble to the 
regulations states that ``[t]he final regulations do not 
resolve under what circumstances a domestic corporate partner 
may compute an amount of foreign taxes deemed paid with respect 
to dividends received from a foreign corporation by a 
partnership or other pass-through entity.''\34\ In recognition 
of the holding in Rev. Rul. 71-141, the preamble to the final 
regulations under section 902 states that a ``domestic 
shareholder'' for purposes of section 902 is a domestic 
corporation that ``owns'' the requisite voting stock in a 
foreign corporation rather than one that ``owns directly'' the 
voting stock. At the same time, the preamble states that the 
IRS is still considering under what other circumstances Rev. 
Rul. 71-141 should apply. Consequently, when adopting the 1997 
final regulations, the IRS left uncertainty over whether a 
domestic corporation owning ten percent or more of the voting 
stock of a foreign corporation through a partnership is 
entitled to a deemed-paid foreign tax credit (other than 
through a domestic general partnership).
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    \34\ T.D. 8708, 1997-1 C.B. 137.
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                           REASONS FOR CHANGE

    The Committee believes that a clarification is appropriate 
regarding the ability of a domestic corporation owning ten 
percent or more of the voting stock of a foreign corporation 
through a partnership to claim a deemed-paid foreign tax 
credit.

                        EXPLANATION OF PROVISION

    The provision clarifies that a domestic corporation is 
entitled to claim deemed-paid foreign tax credits with respect 
to a foreign corporation that is held indirectly through a 
foreign or domestic partnership, provided that the domestic 
corporation owns (indirectly through the partnership) ten 
percent or more of the foreign corporation's voting stock. The 
provision also clarifies that both individual and corporate 
partners may claim direct foreign tax credits with respect to 
their proportionate shares of taxes paid or accrued by a 
partnership.

                             EFFECTIVE DATE

    The provision applies to taxes of foreign corporations for 
taxable years of such corporations beginning after the date of 
enactment.

4. Application of uniform capitalization rules for foreign persons 
        (sec. 214 of the bill and sec. 263A of the Code)

                              PRESENT LAW

    Taxpayers generally may not currently deduct the costs 
incurred in producing property or acquiring property for 
resale. In general, the uniform capitalization rules require 
that a portion of the direct and indirect costs of producing 
property or acquiring property for resale be capitalized or 
included in the cost of inventory (sec. 263A). Consequently, 
such costs must be recovered through an offset to the sales 
price if the property is produced for sale, or through 
depreciation or amortization if the property is produced for 
the taxpayer's own use in a business or investment activity. 
The purpose of this requirement is to match the costs of 
producing or acquiring goods with the revenues realized from 
their sale or use in the business or investment activity.
    The uniform capitalization rules apply to foreign 
corporations, whether or not engaged in business in the United 
States. In the case of a foreign corporation carrying on a U.S. 
trade or business, for example, the uniform capitalization 
rules apply for purposes of computing the corporation's U.S. 
effectively connected taxable income, as well as computing its 
effectively connected earnings and profits for purposes of the 
branch profits tax.
    When a foreign corporation is not engaged in a trade or 
business in the United States, its taxable income and earnings 
and profits may nonetheless be relevant under the Code. For 
example, the subpart F income of a controlled foreign 
corporation may be currently includible on the return of a U.S. 
shareholder of the controlled foreign corporation. Regardless 
of whether or not a foreign corporation is U.S.-controlled, its 
accumulated earnings and profits must be computed in order to 
determine the amount of taxable dividends and the indirect 
foreign tax credit carried by distributions from the foreign 
corporation to any domestic corporation that owns at least 10 
percent of its voting stock.
    The earnings and profits surplus or deficit of any foreign 
corporation for any taxable year generally is determined 
according to rules substantially similar to those applicable to 
domestic corporations. However, Treas. Prop. Reg. sec. 1.964-
1(c)(1)(ii)(B) provides that, for purposes of computing a 
foreign corporation's earnings and profits, the amount of 
expenses that must be capitalized into inventory under the 
uniform capitalization rules may not exceed the amount 
capitalized in keeping the taxpayer's books and records. For 
this purpose, the taxpayer's books and records must be prepared 
in accordance with U.S. generally accepted accounting 
principles for purposes of reflecting in the financial 
statements of a domestic corporation the operations of its 
foreign affiliates. This proposed regulation applies only for 
purposes of determining a foreign corporation's earnings and 
profits and does not apply for purposes of determining subpart 
F income or income effectively connected with a U.S. trade or 
business of a foreign corporation.

                           REASONS FOR CHANGE

    The Committee believes that significant simplification can 
be achieved by limiting the circumstances in which foreign 
persons are required to apply the U.S. uniform capitalization 
rules.

                        EXPLANATION OF PROVISION

    The provision provides that, in lieu of the uniform 
capitalization rules, costs incurred in producing property or 
acquiring property for resale are capitalized using U.S. 
generally accepted accounting principles (i.e., the method used 
to ascertain income, profit, or loss for purposes of reports or 
statements to shareholders, partners, other proprietors, or 
beneficiaries, or for credit purposes) for purposes of 
determining a U.S.-owned foreign corporation's earnings and 
profits and subpart F income. The uniform capitalization rules 
continue to apply to foreign corporations for purposes of 
determining income effectively connected with a U.S. trade or 
business and the related earnings and profits therefrom. Any 
change in the taxpayer's method of accounting required as a 
result of this provision is treated as a voluntary change 
initiated by the taxpayer and is deemed made with the consent 
of the Secretary of the Treasury (i.e., no application for 
change in method of accounting is required to be filed with the 
Secretary). Any resultant section 481(a) adjustment required to 
be taken into account is to be taken into account in the first 
year.

                             EFFECTIVE DATE

    The provision applies to taxable years beginning after 
December 31, 2004.

5. Repeal of withholding tax on dividends from certain foreign 
        corporations (sec. 215 of the bill and sec. 871 of the Code)

                              PRESENT LAW

    Nonresident individuals who are not U.S. citizens and 
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 
passive income (e.g., 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. 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.
    In general, dividends paid by a domestic corporation are 
treated as being from U.S. sources and dividends paid by a 
foreign corporation are treated as being from foreign sources. 
Thus, dividends paid by foreign corporations to foreign persons 
generally are not subject to withholding tax because such 
income generally is treated as foreign-source income.
    An exception from this general rule applies in the case of 
dividends paid by certain foreign corporations. If a foreign 
corporation derives 25 percent or more of its gross income as 
income effectively connected with a U.S. trade or business for 
the three-year period ending with the close of the taxable year 
preceding the declaration of a dividend, then a portion of any 
dividend paid by the foreign corporation to its shareholders 
will be treated as U.S.-source income and, in the case of 
dividends paid to foreign shareholders, will be subject to the 
30-percent withholding tax (sec. 861(a)(2)(B)). This rule is 
sometimes referred to as the ``secondary withholding tax.'' The 
portion of the dividend treated as U.S.-source income is equal 
to the ratio of the gross income of the foreign corporation 
that was effectively connected with its U.S. tradeor business 
over the total gross income of the foreign corporation during the 
three-year period ending with the close of the preceding taxable year. 
The U.S.-source portion of the dividend paid by the foreign corporation 
to its foreign shareholders is subject to the 30-percent withholding 
tax.
    Under the branch profits tax provisions, the United States 
taxes foreign corporations engaged in a U.S. trade or business 
on amounts of U.S. earnings and profits that are shifted out of 
the U.S. branch of the foreign corporation. The branch profits 
tax is comparable to the second-level taxes imposed on 
dividends paid by a domestic corporation to its foreign 
shareholders. The branch profits tax is 30 percent of the 
foreign corporation's ``dividend equivalent amount,'' which 
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 (secs. 884(a) and (b)).
    If a foreign corporation is subject to the branch profits 
tax, then no secondary withholding tax is imposed on dividends 
paid by the foreign corporation to its shareholders (sec. 
884(e)(3)(A)). If a foreign corporation is a qualified resident 
of a tax treaty country and claims an exemption from the branch 
profits tax pursuant to the treaty, the secondary withholding 
tax could apply with respect to dividends it pays to its 
shareholders. Several tax treaties (including treaties that 
prevent imposition of the branch profits tax), however, exempt 
dividends paid by the foreign corporation from the secondary 
withholding tax.

                           REASONS FOR CHANGE

    The Committee observes that the secondary withholding tax 
with respect to dividends paid by certain foreign corporations 
has been largely superseded by the branch profits tax and 
applicable income tax treaties. Accordingly, the Committee 
believes that the tax should be repealed in the interest of 
simplification.

                        EXPLANATION OF PROVISION

    The provision eliminates the secondary withholding tax with 
respect to dividends paid by certain foreign corporations.

                             EFFECTIVE DATE

    The provision is effective for payments made after December 
31, 2004.

6. Repeal of special capital gains tax on aliens present in the United 
        States for 183 days or more (sec. 216 of the bill and sec. 871 
        of the Code)

                              PRESENT LAW

    In general, resident aliens are taxed in the same manner as 
U.S. citizens. Nonresident aliens are subject to: (1) U.S. tax 
on income from U.S. sources that are effectively connected with 
a U.S. trade or business; and (2) a 30-percent withholding tax 
on the gross amount of certain types of passive income derived 
from U.S. sources, such as interest, dividends, rents, and 
other fixed or determinable annual or periodical income (sec. 
871(a)(1)). Bilateral income tax treaties may modify these tax 
rules.
    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)). Thus, nonresident aliens 
generally are not taxable on capital gains because the gains 
generally are considered to be foreign-source income.\35\
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    \35\ Nonresident individuals are subject to the 30-percent gross 
withholding tax, for example, with respect to gains from the sale or 
exchange of intangible property if the payments are contingent on the 
productivity, use, or disposition of the property. Secs. 871(a)(1)(D) 
and 881(a)(4).
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    Special rules apply in the case of sales of personal 
property by certain foreign persons. In this regard, an 
individual who is otherwise treated as a nonresident is treated 
as a U.S. resident for purposes of sourcing income from the 
sale of personal property if the individual has a tax home in 
the United States (sec. 865(g)(1)(A)(i)(II)). An individual's 
U.S. tax home generally is the place where the individual has 
his or her principal place of business. For example, if a 
nonresident individual with a tax home in the United States 
sells stocks or other securities for a gain, the individual 
will be treated as a U.S. resident with respect to the sale 
such that the gain will be treated as U.S.-source income 
potentially subject to U.S. tax.
    Under the special capital gains tax of section 871(a)(2), a 
nonresident individual who is physically present in the United 
States for 183 days or more during a taxable year is subject to 
a 30-percent tax on the excess of U.S.-source capital gains 
over U.S.-source capital losses. This 30-percent tax is not a 
withholding tax. The tax under section 871(a)(2) does not apply 
to gains and losses subject to the gross 30-percent withholding 
tax under section 871(a)(1) or to gains effectively connected 
with a U.S. trade or business. Capital gains and losses are 
taken into account only to the extent that they would be 
recognized and taken into account if such gains and losses were 
effectively connected with a U.S. trade or business. Capital 
loss carryovers are not taken into account.
    As a practical matter, the special rule under section 
871(a)(2) applies only in a very limited set of cases. In order 
for the rule to apply, two conditions must be satisfied: (1) 
the individual must spend at least 183 days in the United 
States during a taxable year without being treated as a U.S. 
resident; and (2) the individual's capital gains must be from 
U.S. sources. If these conditions are satisfied, then the 30-
percent tax applies to the excess of U.S.-source capital gains 
over U.S.-source capital losses. However, section 871(a)(2) 
generally is not applicable because if the individual spends 
183 days or more in the United States in most cases he or she 
would be treated as a U.S. resident, or if not treated as a 
U.S. resident, would generally not have U.S.-source capital 
gains.
    An individual who is not a citizen and who spends 183 days 
or more in the United States during a calendar year generally 
would be treated as a U.S. resident under the substantial 
presence test of section 7701(b). Thus, in most cases, the 
individual who spends at least 183days in the United States 
would not be subject to section 871(a)(2).\36\ However, under the 
substantial presence test under section 7701(b), certain days of 
physical presence in the United States are not counted for purposes of 
meeting the 183-day rule. This includes days spent in the United States 
in which the individual regularly commutes to employment (or self-
employment) in the United States from Canada or Mexico; the individual 
is in transit between two points outside the United States and is 
physically present in the United States for less than 24 hours; the 
individual is temporarily present in the United States as a regular 
member of the crew of a foreign vessel engaged in transportation 
between the United States and a foreign country or U.S. possession; and 
certain exempt individuals. These exceptions from counting physical 
presence in the United States do not apply, however, for purposes of 
the special rule under section 871(a)(2). Thus, it is possible in 
certain cases for an individual to be present in the United States for 
at least 183 days without being treated as a U.S. resident under the 
substantial presence test of section 7701(b).\37\
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    \36\ See the American Law Institute, Federal Income Tax Project, 
International Aspects of United States Income Taxation, Proposals of 
the American Law Institute on United States Taxation of Foreign Persons 
and of the Foreign Income of United States Persons, at 112-113 (1987) 
(recommending that sec. 871(a)(2) be eliminated and stating ``[u]nder 
Section 7701(b), enacted in 1984, an individual physically present in 
the U.S. for 183 days in a calendar year is considered a resident, 
taxable at net income rates on all of his income; and accordingly the 
justification for Section 871(a)(2) no longer exists.'' [footnotes 
omitted]).
    \37\ It should be noted that there also is a difference with 
respect to the year over which the 183-day rule is measured for 
purposes of the substantial presence test and the rule under sec. 
871(a)(2). The sec. 871(a)(2) tax applies to 183 days or more of 
presence in the United States during the taxable year, while the 
substantial presence test under sec. 7701(b) applies to 183 days or 
more of presence in the United States during the calendar year. In most 
cases, however, a nonresident individual's taxable year is the calendar 
year. Secs. 7701(b)(9) and 871(a)(2).
---------------------------------------------------------------------------
    Even if an individual spends at least 183 days in the 
United States but is not treated as a U.S. resident under 
section 7701(b), the nonresident individual's capital gains 
generally will be treated as foreign-source income and, thus, 
not subject to section 871(a)(2). In this regard, capital gains 
generally are from foreign sources if the individual is a 
nonresident, and from U.S. sources if the individual is a U.S. 
resident. Under a special rule, an individual is treated as a 
U.S. resident for sales of personal property (including sales 
giving rise to capital gains) if the individual has a tax home 
in the United States. This rule applies even if the individual 
is treated as a nonresident for other U.S.-tax purposes. An 
individual's capital gains would be treated as U.S.-source 
income and potentially subject to section 871(a)(2) if the 
individual is treated as a U.S. resident under this special 
rule.\38\
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    \38\ The individual's income also could be treated as U.S.-source 
income under sec. 865(e)(2) if the individual derives income from the 
sale of personal property that is attributable to an office or other 
fixed place of business that the individual maintains in the United 
States. However, sec. 871(a)(2) would not apply if the income is 
effectively connected with a U.S. trade or business, or if the sale 
qualifies for the exception from U.S.-source treatment as a result of a 
material participation in the sale by a foreign office of the taxpayer.
---------------------------------------------------------------------------
    Even in the limited cases in which the special rule under 
section 871(a)(2) could potentially apply, a tax treaty might 
prevent its application.\39\
---------------------------------------------------------------------------
    \39\ Under Article 13(5) of the U.S. model income tax treaty, 
subject to certain exceptions, the capital gains of a nonresident 
individual are exempt from U.S. taxation.
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The Committee observes that the special tax on certain 
capital gains of nonresident aliens applies only under a very 
limited set of circumstances as a practical matter. The 
Committee believes that the special tax creates unnecessary 
complexity and confusion and thus should be repealed.

                        EXPLANATION OF PROVISION

    The provision repeals the special tax on certain capital 
gains of nonresident aliens under section 871(a)(2).

                             EFFECTIVE DATE

    The provision is effective for taxable years beginning 
after December 31, 2003.

               C. Additional International Tax Provisions


1. Subpart F exception for active aircraft and vessel leasing income 
        (sec. 221 of the bill and sec. 954 of the Code)

                              PRESENT LAW

    In general, the subpart F rules (secs. 951-964) require 
U.S. shareholders with a 10-percent or greater interest in a 
controlled foreign corporation to include currently in income 
for U.S.-tax purposes certain income of the controlled foreign 
corporation (referred to as ``subpart F income''), without 
regard to whether the income is distributed to the shareholders 
(sec. 951(a)(1)(A)). In effect, the Code treats the U.S. 10-
percent shareholders of a controlled foreign corporation as 
having received a current distribution of their pro rata shares 
of the controlled foreign corporation's subpart F income. The 
amounts included in income by the controlled foreign 
corporation's U.S. 10-percent shareholders under these rules 
are subject to U.S.-tax currently. The U.S. tax on such amounts 
may be reduced through foreign tax credits.
    Subpart F income includes foreign base company shipping 
income (sec. 954(f)). Foreign base company shipping income 
generally includes income derived from the use (or hiring or 
leasing for use) of an aircraft or vessel in foreign commerce, 
the performance of services directly related to the use of any 
such aircraft or vessel, the sale or other disposition of any 
such aircraft or vessel, and certain space or ocean activities 
(e.g., leasing of satellites for use in space). Foreign 
commerce generally involves the transportation of property or 
passengers between a port (or airport) in the U.S. and a port 
(or airport) in a foreign country, two ports (or airports) 
within the same foreign country, or two ports (or airports) in 
different foreign countries.
    In addition, foreign base company shipping income includes 
dividends and interest that a controlled foreign corporation 
receives from certain foreign corporations and any gains from 
the disposition of stock in certain foreign corporations, to 
the extent the dividends, interest, or gains are attributable 
to foreign base company shipping income. Foreign base company 
shipping income also includes incidental income derived in the 
course of active foreign base company shipping operations 
(e.g., income from temporary investments in or sales of related 
shipping assets), foreign exchange gain or loss attributable to 
foreign base company shipping operations, and a controlled 
foreign corporation's distributive share of gross income of any 
partnership and gross income received from certain trusts to 
the extent that the income would have been foreign base company 
shipping income had it been realized directly by the 
corporation. Under a coordination rule, income that is treated 
as foreign base company shipping income of a corporation is not 
treated as any other type of foreign base company income of 
such corporation for purposes of subpart F.
    Subpart F income also includes foreign personal holding 
company income (sec. 954(c)). For subpart F purposes, foreign 
personal holding company income generally consists of the 
following: (1) dividends, interest, royalties, rents and 
annuities; (2) net gains from the sale or exchange of (a) 
property that gives rise to the preceding types of income, (b) 
property that does not give rise to income, and (c) interests 
in trusts, partnerships, and REMICs; (3) net gains from 
commodities transactions; (4) net gains from foreign currency 
transactions; (5) income that isequivalent to interest; (6) 
income from notional principal contracts; and (7) payments in lieu of 
dividends.
    Subpart F foreign personal holding company income does not 
include rents and royalties received by the controlled foreign 
corporation in the active conduct of a trade or business from 
unrelated persons (sec. 954(c)(2)(A)). Also generally excluded 
are dividends and interest received by the controlled foreign 
corporation from a related corporation organized and operating 
in the same foreign country in which the controlled foreign 
corporation was organized, and rents and royalties received by 
the controlled foreign corporation from a related corporation 
for the use of property within the country in which the 
controlled foreign corporation was organized (sec. 954(c)(3)). 
However, interest, rent, and royalty payments do not qualify 
for this exclusion to the extent that such payments reduce 
subpart F income of the payor.

                           REASONS FOR CHANGE

    The Committee believes that the income earned by a 
controlled foreign corporation in connection with an active 
foreign aircraft or ship leasing business should be excluded 
from the anti-deferral rules of subpart F, provided that the 
controlled foreign corporation conducts substantial activities 
with respect to such business.

                        EXPLANATION OF PROVISION

    The provision provides that ``qualified leasing income'' 
derived from or in connection with the leasing or rental of any 
aircraft or vessel is not treated as foreign personal holding 
company income or foreign base company shipping income of a 
controlled foreign corporation. The provision defines 
``qualified leasing income'' as rents or gains derived in the 
active conduct of a leasing trade or business with respect to 
which the controlled foreign corporation conducts substantial 
activity, provided that the leased property is used by the 
lessee or other end-user in foreign commerce and predominantly 
outside the United States, and such lessee or other end-user is 
not related to the controlled foreign corporation (within the 
meaning of sec. 954(d)(3)).
    In determining whether an aircraft or vessel is used in 
foreign commerce, the Committee intends that foreign commerce 
encompass the use of an aircraft or vessel in the 
transportation of property or passengers: (1) between an 
airport or port in the United States (including for this 
purpose any possession of the United States) and an airport or 
port in a foreign country; (2) between an airport or port in a 
foreign country and another in the same country; or (3) between 
an airport or port in a foreign country and another in a 
different foreign country. The Committee intends that an 
aircraft or vessel be considered as used predominantly outside 
the United States if more than 70 percent of its miles traveled 
during the taxable year are traveled outside the United States, 
or if the aircraft or vessel is located outside the United 
States for more than 70 percent of the time during the taxable 
year.

                             EFFECTIVE DATE

    The provision is effective for taxable years of foreign 
corporations beginning after December 31, 2006, and taxable 
years of U.S. shareholders with or within which such taxable 
years of such foreign corporations end.

2. Look-through treatment of payments between related controlled 
        foreign corporations under foreign personal holding company 
        income rules (sec. 222 of the bill and sec. 954 of the Code)

                              PRESENT LAW

    In general, the rules of subpart F (secs. 951-964) require 
U.S. shareholders with a 10-percent or greater interest in a 
controlled foreign corporation to include certain income of the 
controlled foreign corporation (referred to as ``subpart F 
income'') on a current basis for U.S.-tax purposes, regardless 
of whether the income is distributed to the shareholders.
    Subpart F income includes foreign base company income. One 
category of foreign base company income is foreign personal 
holding company income. For subpart F purposes, foreign 
personal holding company income generally includes dividends, 
interest, rents and royalties, among other types of income. 
However, foreign personal holding company income does not 
include dividends and interest received by a controlled foreign 
corporation from a related corporation organized and operating 
in the same foreign country in which the controlled foreign 
corporation is organized, or rents and royalties received by a 
controlled foreign corporation from a related corporation for 
the use of property within the country in which the controlled 
foreign corporation is organized. Interest, rent, and royalty 
payments do not qualify for this exclusion to the extent that 
such payments reduce the subpart F income of the payor.

                           REASONS FOR CHANGE

    The Committee believes that present law unduly restricts 
the ability of U.S.-based multinational corporations to move 
their active foreign earnings from one controlled foreign 
corporation to another. In many cases, taxpayers are able to 
circumvent these restrictions as a practical matter, although 
at additional transaction cost. The Committee believes that 
taxpayers should be given greater flexibility to move non-
subpart-F earnings among controlled foreign corporations as 
business needs may dictate.

                        EXPLANATION OF PROVISION

    Under the provision, dividends, interest, rents, and 
royalties received by one controlled foreign corporation from a 
related controlled foreign corporation are not treated as 
foreign personal holding company income to the extent 
attributable to non-subpart-F earnings of the payor. For these 
purposes, a related controlled foreign corporation is a 
controlled foreign corporation that controls or is controlled 
by the other controlled foreign corporation, or a controlled 
foreign corporation that is controlled by the same person or 
persons that control the other controlled foreign corporation. 
Ownership of more than 50 percent of the controlled foreign 
corporation's stock (by vote or value) constitutes control for 
these purposes.

                             EFFECTIVE DATE

    The provision is effective for taxable years of foreign 
corporations beginning after December 31, 2004, and taxable 
years of U.S. shareholders with or within which such taxable 
years of such foreign corporations end.

3. Look-through treatment under subpart F for sales of partnership 
        interests (sec. 223 of the bill and sec. 954 of the Code)

                              PRESENT LAW

    In general, the subpart F rules (secs. 951-964) require 
U.S. shareholders with a 10-percent or greater interest in a 
controlled foreign corporation to include in income currently 
for U.S.-tax purposes certain types of income of the controlled 
foreign corporation, whether or not such income is actually 
distributed currently to the shareholders (referred to as 
``subpart F income''). Subpart F income includes foreign 
personal holding company income. Foreign personal holding 
company income generally consists of the following: (1) 
dividends, interest, royalties, rents, and annuities; (2) net 
gains from the sale or exchange of (a) property that gives rise 
to the preceding types of income, (b) property that does not 
give rise to income; and (c) interests in trusts, partnerships, 
and REMICs; (3) net gains from commodities transactions; (4) 
net gains from foreign currency transactions; (5) income that 
is equivalent to interest; (6) income from notional principal 
contracts; and (7) payments in lieu of dividends. Thus, if a 
controlled foreign corporation sells a partnership interest at 
a gain, the gain generally constitutes foreign personal holding 
company income and is included in the income of 10-percent U.S. 
shareholders of the controlled foreign corporation as subpart F 
income.

                           REASONS FOR CHANGE

    The Committee believes that the sale of a partnership 
interest by a controlled foreign corporation that owns a 
significant interest in the partnership should constitute 
subpart F income only to the extent that a proportionate sale 
of the underlying partnership assets attributable to the 
partnership interest would constitute subpart F income.

                        EXPLANATION OF PROVISION

    The provision treats the sale by a controlled foreign 
corporation of a partnership interest as a sale of the 
proportionate share of partnership assets attributable to such 
interest for purposes of determining subpart F foreign personal 
holding company income. This rule applies only to partners 
owning directly, indirectly, or constructively at least 25 
percent of a capital or profits interest in the partnership. 
Thus, the sale of a partnership interest by a controlled 
foreign corporation that meets this ownership threshold 
constitutes subpart F income under the proposal only to the 
extent that a proportionate sale of the underlying partnership 
assets attributable to the partnership interest would 
constitute subpart F income. The Treasury Secretary is directed 
to prescribe such regulations as may be appropriate to prevent 
the abuse of this provision.

                             EFFECTIVE DATE

    The provision is effective for taxable years of foreign 
corporations beginning after December 31, 2004, and taxable 
years of U.S. shareholders with or within which such taxable 
years of such foreign corporations end.

4. Election not to use average exchange rate for foreign tax paid other 
        than in functional currency (sec. 224 of the bill and sec. 986 
        of the Code)

                              PRESENT LAW

    For taxpayers that take foreign income taxes into account 
when accrued, present law provides that the amount of the 
foreign tax credit generally is determined by translating the 
amount of foreign taxes paid in foreign currencies into a U.S.-
dollar amount at the average exchange rate for the taxable year 
to which such taxes relate.\40\ This rule applies to foreign 
taxes paid directly by U.S.-taxpayers, which taxes are 
creditable in the year paid or accrued, and to foreign taxes 
paid by foreign corporations that are deemed paid by a U.S. 
corporation that is a shareholder of the foreign corporation 
and hence creditable in the year that the U.S. corporation 
receives a dividend or has an income inclusion from the foreign 
corporation. This rule does not apply to any foreign income 
tax: (1) that is paid after the date that is two years after 
the close of the taxable year to which such taxes relate; (2) 
of an accrual-basis taxpayer that is actually paid in a taxable 
year prior to the year to which the tax relates; or (3) that is 
denominated in an inflationary currency (as defined by 
regulations).
---------------------------------------------------------------------------
    \40\ Sec. 986(a)(1).
---------------------------------------------------------------------------
    Foreign taxes that are not eligible for translation at the 
average exchange rate generally are translated into U.S.-dollar 
amounts using the exchange rates as of the time such taxes are 
paid. However, the Secretary is authorized to issue regulations 
that would allow foreign tax payments to be translated into 
U.S.-dollar amounts using an average exchange rate for a 
specified period.\41\
---------------------------------------------------------------------------
    \41\ Sec. 986(a)(2).
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The Committee believes that taxpayers generally should be 
permitted to elect whether to translate foreign income tax 
payments using an average exchange rate for the taxable year or 
the exchange rate in effect when the taxes are paid, provided 
such election does not provide opportunities for abuse.

                        EXPLANATION OF PROVISION

    For taxpayers that are required under present law to 
translate foreign income tax payments at the average exchange 
rate, the provision provides an election to translate such 
taxes into U.S.-dollar amounts using the exchange rates as of 
the time such taxes are paid, provided the foreign income taxes 
are denominated in a currency other than the taxpayer's 
functional currency.\42\ Any election under the provision 
applies to the taxable year for which the election is made and 
to all subsequent taxable years unless revoked with the consent 
of the Secretary. The provision authorizes the Secretary to 
issue regulations that apply the election to foreign income 
taxes attributable to a qualified business unit.
---------------------------------------------------------------------------
    \42\ Electing taxpayers translate foreign income tax payments 
pursuant to the same present-law rules that apply to taxpayers that are 
required to translate foreign income taxes using the exchange rates as 
of the time such taxes are paid.
---------------------------------------------------------------------------

                             EFFECTIVE DATE

    The provision is effective with respect to taxable years 
beginning after December 31, 2004.

5. Foreign tax credit treatment of ``base difference'' items (sec. 225 
        of the bill and sec. 904 of the Code)

                              PRESENT LAW

    In order to mitigate the possibility of double taxation of 
cross-border income, the United States provides a credit 
against U.S.-tax liability for foreign income taxes paid, 
subject to a number of limitations. The foreign tax credit 
generally is limited to the U.S.-tax liability on a taxpayer's 
foreign-source income in order to ensure that the credit serves 
its purpose of mitigating double taxation of cross-border 
income without offsetting the U.S. tax on U.S.-source income.
    The foreign tax credit limitation is applied separately to 
the following categories of income: (1) passive income; (2) 
high withholding tax interest; (3) financial services income; 
(4) shipping income; (5) certain dividends received from 
noncontrolled section 902 foreign corporations (``10/50 
companies''); \43\ (6) certain dividends from a domestic 
international sales corporation or former domestic 
international sales corporation; (7) taxable income 
attributable to certain foreign trade income; (8) certain 
distributions from a foreign sales corporation or former 
foreign sales corporation; and (9) any other income not 
described in items (1) through (8) (``general limitation'' 
income).
---------------------------------------------------------------------------
    \43\ Subject to certain exceptions, dividends paid by a 10/50 
company in taxable years beginning after December 31, 2002 are subject 
to either a look-through approach in which the dividend is attributed 
to a particular limitation category based on the underlying earnings 
which gave rise to the dividend (for post-2002 earnings and profits), 
or a single-basket limitation approach for dividends from all 10/50 
companies (for pre-2003 earnings and profits).
---------------------------------------------------------------------------
    Under Treasury regulations, foreign taxes are allocated and 
apportioned to the same limitation categories as the income to 
which they relate.\44\ In cases in which foreign law imposes 
tax on an item of income that does not constitute income under 
U.S.-tax principles (a ``base difference'' item), the tax is 
treated as imposed on income in the general limitation 
category.\45\
---------------------------------------------------------------------------
    \44\ Treas. Reg. sec. 1.904-6.
    \45\ Treas. Reg. sec. 1.904-6(a)(1)(iv).
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The Committee believes that the existing Treasury 
regulation addressing ``base differences'' reaches appropriate 
results with respect to most taxpayers. However, taxpayers in 
the financial services industry may have little or no income in 
the general limitation category because the bulk or all of 
their business income falls within the financial services 
income category. As applied to such taxpayers, the regulation 
has the result of assigning taxes attributable to base 
differences to a limitation category in which the taxpayer may 
earn little or no income, thus rendering it unduly difficult 
for such a taxpayer to claim a credit for such foreign taxes. 
The Committee believes that taxpayers should be allowed to make 
a one-time election to treat taxes on ``base difference'' items 
as being imposed either on general limitation income or on 
financial services income. The Committee further expects that 
the Secretary will reexamine the ``base difference'' regulation 
to determine whether the regulation reaches appropriate results 
in other circumstances.

                        EXPLANATION OF PROVISION

    Under the provision, creditable foreign taxes that are 
imposed on amounts that do not constitute income under U.S.-tax 
principles are treated as imposed either on general limitation 
income or on financial services income, at the taxpayer's 
election. Once made, this election applies to all such taxes 
and is revocable only with the consent of the Secretary.

                             EFFECTIVE DATE

    The provision is effective for taxable years ending after 
date of enactment.

6. Modification of exceptions under subpart F for active financing 
        (sec. 226 of the bill and sec. 954 of the Code)

                              PRESENT LAW

    Under the subpart F rules, U.S. shareholders with a 10-
percent or greater interest in a controlled foreign corporation 
(``CFC'') are subject to U.S.-tax currently on certain income 
earned by the CFC, whether or not such income is distributed to 
the shareholders. The income subject to current inclusion under 
the subpart F rules includes, among other things, foreign 
personal holding company income and insurance income. In 
addition, 10-percent U.S. shareholders of a CFC are subject to 
current inclusion with respect to their shares of the CFC's 
foreign base company services income (i.e., income derived from 
services performed for a related person outside the country in 
which the CFC is organized).
    Foreign personal holding company income generally consists 
of the following: (1) dividends, interest, royalties, rents, 
and annuities; (2) net gains from the sale or exchange of (a) 
property that gives rise to the preceding types of income, (b) 
property that does not give rise to income, and (c) interests 
in trusts, partnerships, and REMICs; (3) net gains from 
commodities transactions; (4) net gains from foreign currency 
transactions; (5) income that is equivalent to interest; (6) 
income from notional principal contracts; and (7) payments in 
lieu of dividends.
    Insurance income subject to current inclusion under the 
subpart F rules includes any income of a CFC attributable to 
the issuing or reinsuring of any insurance or annuity contract 
in connection with risks located in a country other than the 
CFC's country of organization. Subpart F insurance income also 
includes income attributable to an insurance contract in 
connection with risks located within the CFC's country of 
organization, as the result of an arrangement under which 
another corporation receives a substantially equal amount of 
consideration for insurance of other country risks. Investment 
income of a CFC that is allocable to any insurance or annuity 
contract related to risks located outside the CFC's country of 
organization is taxable as subpart F insurance income (Treas. 
Reg. sec. 1.953-1(a)).
    Temporary exceptions from foreign personal holding company 
income, foreign base company services income, and insurance 
income apply for subpart F purposes for certain income that is 
derived in the active conduct of a banking, financing, or 
similar business, or in the conduct of an insurance business 
(so-called ``active financing income'').\46\
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    \46\ Temporary exceptions from the subpart F provisions for certain 
active financing income applied only for taxable years beginning in 
1998. Those exceptions were modified and extended for one year, 
applicable only for taxable years beginning in 1999. The Tax Relief 
Extension Act of 1999 (P.L. No. 106-170) clarified and extended the 
temporary exceptions for two years, applicable only for taxable years 
beginning after 1999 and before 2002. The Job Creation and Worker 
Assistance Act of 2002 (P.L. No. 107-147) extended the temporary 
exceptions for five years, applicable only for taxable years beginning 
after 2001 and before 2007, with a modification relating to insurance 
reserves.
---------------------------------------------------------------------------
    With respect to income derived in the active conduct of a 
banking, financing, or similar business, a CFC is required to 
be predominantly engaged in such business and to conduct 
substantial activity with respect to such business in order to 
qualify for the exceptions. In addition, certain nexus 
requirements apply, which provide that income derived by a CFC 
or a qualified business unit (``QBU'') of a CFC from 
transactions with customers is eligible for the exceptions if, 
among other things, substantially all of the activities in 
connection with such transactions are conducted directly by the 
CFC or QBU in its home country, and such income is treated as 
earned by the CFC or QBU in its home country for purposes of 
such country's tax laws. Moreover, the exceptions apply to 
income derived from certain cross border transactions, provided 
that certain requirements are met. Additional exceptions from 
foreign personal holding company income apply for certain 
income derived by a securities dealer within the meaning of 
section 475 and for gain from the sale of active financing 
assets.
    In the case of insurance, in addition to temporary 
exceptions from insurance income and from foreign personal 
holding company income for certain income of a qualifying 
insurance company with respect to risks located within the 
CFC's country of creation or organization, temporary exceptions 
from insurance income and from foreign personal holding company 
income apply for certain income of a qualifying branch of a 
qualifying insurance company with respect to risks located 
within the home country of the branch, provided certain 
requirements are met under each of the exceptions. Further, 
additional temporary exceptions from insurance income and from 
foreign personal holding company income apply for certain 
income of certainCFCs or branches with respect to risks located 
in a country other than the United States, provided that the 
requirements for these exceptions are met.

                           REASONS FOR CHANGE

    The Committee understands that banking and financial 
regulatory requirements in many foreign countries require 
different financial services activities to be conducted in 
separate entities, and that the interaction of these 
requirements with the present-law rules regarding active 
financing income often require financial services firms to 
operate inefficiently. The Committee believes that the rules 
for determining whether a CFC or QBU is eligible to earn active 
financing income should be more consistent with the rules for 
determining whether income earned by an eligible CFC or QBU is 
active financing income. In particular, the Committee believes 
that activities performed by employees of certain affiliates of 
a CFC or QBU should be taken into account in determining 
whether income of the CFC or QBU is active financing income in 
a manner similar to the present-law rules for determining 
whether the CFC or QBU is eligible to earn active financing 
income.

                        EXPLANATION OF PROVISION

    The provision modifies the present-law temporary exceptions 
from subpart F foreign personal holding company income and 
foreign base company services income for income derived in the 
active conduct of a banking, financing, or similar business. 
For purposes of determining whether a CFC or QBU has conducted 
directly in its home country substantially all of the 
activities in connection with transactions with customers, the 
provision provides that an activity is treated as conducted 
directly by the CFC or QBU in its home country if the activity 
is performed by employees of a related person and: (1) the 
related person is itself an eligible CFC the home country of 
which is the same as that of the CFC or QBU; (2) the activity 
is performed in the home country of the related person; and (3) 
the related person is compensated on an arm's length basis for 
the performance of the activity by its employees and such 
compensation is treated as earned by such person in its home 
country for purposes of the tax laws of such country. For 
purposes of determining whether a CFC or QBU is eligible to 
earn active financing income, such activity may not be taken 
into account by any CFC or QBU (including the employer of the 
employees performing the activity) other than the CFC or QBU 
for which the activities are performed.

                             EFFECTIVE DATE

    The provision is effective for taxable years of foreign 
corporations beginning after December 31, 2004, and taxable 
years of U.S. shareholders with or within which such taxable 
years of such foreign corporations end.

7. United States property not to include certain assets of controlled 
        foreign corporation (sec. 227 of the bill and sec. 956 of the 
        Code)

                              PRESENT LAW

    In general, the subpart F rules \47\ require U.S. 
shareholders with a 10-percent or greater interest in a 
controlled foreign corporation (``U.S. 10-percent 
shareholders'') to include in taxable income their pro rata 
shares of certain income of the controlled foreign corporation 
(referred to as ``subpart F income'') when such income is 
earned, whether or not the earnings are distributed currently 
to the shareholders. In addition, the U.S. 10-percent 
shareholders of a controlled foreign corporation are subject to 
U.S. tax on their pro rata shares of the controlled foreign 
corporation's earnings to the extent invested by the controlled 
foreign corporation in certain U.S. property in a taxable 
year.\48\
---------------------------------------------------------------------------
    \47\ Secs. 951-964.
    \48\ Sec. 951(a)(1)(B).
---------------------------------------------------------------------------
    A shareholder's income inclusion with respect to a 
controlled foreign corporation's investment in U.S. property 
for a taxable year is based on the controlled foreign 
corporation's average investment in U.S. property for such 
year. For this purpose, the U.S. property held (directly or 
indirectly) by the controlled foreign corporation must be 
measured as of the close of each quarter in the taxable 
year.\49\ The amount taken into account with respect to any 
property is the property's adjusted basis as determined for 
purposes of reporting the controlled foreign corporation's 
earnings and profits, reduced by any liability to which the 
property is subject. The amount determined for inclusion in 
each taxable year is the shareholder's pro rata share of an 
amount equal to the lesser of: (1) the controlled foreign 
corporation's average investment in U.S. property as of the end 
of each quarter of such taxable year, to the extent that such 
investment exceeds the foreign corporation's earnings and 
profits that were previously taxed on that basis; or (2) the 
controlled foreign corporation's current or accumulated 
earnings and profits (but not including a deficit), reduced by 
distributions during the year and by earnings that have been 
taxed previously as earnings invested in U.S. property.\50\ An 
income inclusion is required only to the extent that the amount 
so calculated exceeds the amount of the controlled foreign 
corporation's earnings that have been previously taxed as 
subpart F income.\51\
---------------------------------------------------------------------------
    \49\ Sec. 956(a).
    \50\ Secs. 956 and 959.
    \51\ Secs. 951(a)(1)(B) and 959.
---------------------------------------------------------------------------
    For purposes of section 956, U.S. property generally is 
defined to include tangible property located in the United 
States, stock of a U.S. corporation, an obligation of a U.S. 
person, and certain intangible assets including a patent or 
copyright, an invention, model or design, asecret formula or 
process or similar property right which is acquired or developed by the 
controlled foreign corporation for use in the United States.\52\
---------------------------------------------------------------------------
    \52\ Sec. 956(c)(1).
---------------------------------------------------------------------------
    Specified exceptions from the definition of U.S. property 
are provided for: (1) obligations of the United States, money, 
or deposits with persons carrying on the banking business; (2) 
certain export property; (3) certain trade or business 
obligations; (4) aircraft, railroad rolling stock, vessels, 
motor vehicles or containers used in transportation in foreign 
commerce and used predominantly outside of the United States; 
(5) certain insurance company reserves and unearned premiums 
related to insurance of foreign risks; (6) stock or debt of 
certain unrelated U.S. corporations; (7) moveable property 
(other than a vessel or aircraft) used for the purpose of 
exploring, developing, or certain other activities in 
connection with the ocean waters of the U.S. Continental Shelf; 
(8) an amount of assets equal to the controlled foreign 
corporation's accumulated earnings and profits attributable to 
income effectively connected with a U.S. trade or business; (9) 
property (to the extent provided in regulations) held by a 
foreign sales corporation and related to its export activities; 
(10) certain deposits or receipts of collateral or margin by a 
securities or commodities dealer, if such deposit is made or 
received on commercial terms in the ordinary course of the 
dealer's business as a securities or commodities dealer; and 
(11) certain repurchase and reverse repurchase agreement 
transactions entered into by or with a dealer in securities or 
commodities in the ordinary course of its business as a 
securities or commodities dealer.\53\
---------------------------------------------------------------------------
    \53\ Sec. 956(c)(2).
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The Committee believes that the acquisition of securities 
by a controlled foreign corporation in the ordinary course of 
its business as a securities dealer generally should not give 
rise to an income inclusion as an investment in U.S. property 
under the provisions of subpart F. Similarly, the Committee 
believes that the acquisition by a controlled foreign 
corporation of obligations issued by unrelated U.S. 
noncorporate persons generally should not give rise to an 
income inclusion as an investment in U.S. property.

                        EXPLANATION OF PROVISION

    The provision adds two new exceptions from the definition 
of U.S. property for determining current income inclusion by a 
U.S. 10-percent shareholder with respect to an investment in 
U.S. property by a controlled foreign corporation.
    The first exception generally applies to securities 
acquired and held by a controlled foreign corporation in the 
ordinary course of its trade or business as a dealer in 
securities. The exception applies only if the controlled 
foreign corporation dealer: (1) accounts for the securities as 
securities held primarily for sale to customers in the ordinary 
course of business; and (2) disposes of such securities (or 
such securities mature while being held by the dealer) within a 
period consistent with the holding of securities for sale to 
customers in the ordinary course of business.
    The second exception generally applies to the acquisition 
by a controlled foreign corporation of obligations issued by a 
U.S. person that is not a domestic corporation and that is not: 
(1) a U.S. 10-percent shareholder of the controlled foreign 
corporation; or (2) a partnership, estate or trust in which the 
controlled foreign corporation or any related person is a 
partner, beneficiary or trustee immediately after the 
acquisition by the controlled foreign corporation of such 
obligation.

                             EFFECTIVE DATE

    The provision is effective for taxable years of foreign 
corporations beginning after December 31, 2004, and for taxable 
years of United States shareholders with or within which such 
taxable years of such foreign corporations end.

8. Provide equal treatment for interest paid by foreign partnerships 
        and foreign corporations (sec. 228 of the bill and sec. 861 of 
        the Code)

                              PRESENT LAW

    In general, interest income from bonds, notes or other 
interest-bearing obligations of noncorporate U.S. residents or 
domestic corporations is treated as U.S.-source income.\54\ 
Other interest (e.g., interest on obligations of foreign 
corporations and foreign partnerships) generally is treated as 
foreign-source income. However, Treasury regulations provide 
that a foreign partnership is a U.S. resident for purposes of 
this rule if at any time during its taxable year it is engaged 
in a trade or business in the United States.\55\ Therefore, any 
interest received from such a foreign partnership is U.S.-
source income.
---------------------------------------------------------------------------
    \54\ Sec. 861(a)(1).
    \55\ Treas. Reg. sec. 1.861-2(a)(2).
---------------------------------------------------------------------------
    Notwithstanding the general rule described above, in the 
case of a foreign corporation engaged in a U.S. trade or 
business (or having gross income that is treated as effectively 
connected with the conduct of a U.S. trade or business), 
interest paid by such U.S. trade or business is treated as if 
it were paid by a domestic corporation (i.e., such interest is 
treated as U.S.-source income).\56\
---------------------------------------------------------------------------
    \56\ Sec. 884(f)(1).
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The Committee believes that the source of interest income 
received from a foreign partnership or foreign corporation 
should be consistent. The Committee believes that interest 
payments from a foreign partnership engaged in a trade or 
business in the United States should be sourced in the same 
manner as interest payments from a foreign corporation engaged 
in a trade or business in the United States.

                        EXPLANATION OF PROVISION

    The provision treats interest paid by foreign partnerships 
in a manner similar to the treatment of interest paid by 
foreign corporations. Thus, interest paid by a foreign 
partnership is treated as U.S.-source income only if the 
interest is paid by a U.S. trade or business conducted by the 
partnership or is allocable to income that is treated as 
effectively connected with the conduct of a U.S. trade or 
business. The provision applies only to foreign partnerships 
that are principally owned by foreign persons. For this 
purpose, a foreign partnership is principally owned by foreign 
persons if, in the aggregate, U.S. citizens and residents do 
not own, directly or indirectly, 20 percent or more of the 
capital or profits interests in the partnership.

                             EFFECTIVE DATE

    This provision is effective for taxable years beginning 
after December 31, 2003.

9. Foreign tax credit treatment of deemed payments under section 367(d) 
        (sec. 229 of the bill and sec. 367 of the Code)

                              PRESENT LAW

    In the case of transfers of intangible property to foreign 
corporations by means of contributions and certain other 
nonrecognition transactions, special rules apply that are 
designed to mitigate the tax avoidance that may arise from 
shifting the income attributable to intangible property 
offshore. Under section 367(d), the outbound transfer of 
intangible property is treated as a sale of the intangible for 
a stream of contingent payments. The amounts of these deemed 
payments must be commensurate with the income attributable to 
the intangible. The deemed payments are included in gross 
income of the U.S. transferor as ordinary income, and the 
earnings and profits of the foreign corporation to which the 
intangible was transferred are reduced by such amounts.
    The Taxpayer Relief Act of 1997 (the ``1997 Act'') repealed 
a rule that treated all such deemed payments as giving rise to 
U.S.-source income. Because the foreign tax credit is generally 
limited to the U.S. tax imposed on foreign-source income, the 
prior-law rule reduced the taxpayer's ability to claim foreign 
tax credits. As a result of the repeal of the rule, the source 
of payments deemed received under section 367(d) is determined 
under general sourcing rules. These rules treat income from 
sales of intangible property for contingent payments the same 
as royalties, with the result that the deemed payments may give 
rise to foreign-source income.\57\
---------------------------------------------------------------------------
    \57\ Secs. 865(d), 862(a).
---------------------------------------------------------------------------
    The 1997 Act did not address the characterization of the 
deemed payments for purposes of applying the foreign tax credit 
separate limitation categories.\58\ If the deemed payments are 
treated like proceeds of a sale, then they could fall into the 
passive category; if the deemed payments are treated like 
royalties, then in many cases they could fall into the general 
category (under look-through rules applicable to payments of 
dividends, interest, rents, and royalties received from 
controlled foreign corporations).\59\
---------------------------------------------------------------------------
    \58\ Sec. 904(d).
    \59\ Sec. 904(d)(3).
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                           REASONS FOR CHANGE

    The Committee believes that it is appropriate to 
characterize deemed payments under section 367(d) as royalties 
for purposes of applying the separate limitation categories of 
the foreign tax credit, and that this treatment should be 
effective for all transactions subject to the underlying 
provision of the 1997 Act.

                        EXPLANATION OF PROVISION

    The provision specifies that deemed payments under section 
367(d) are treated as royalties for purposes of applying the 
separate limitation categories of the foreign tax credit.

                             EFFECTIVE DATE

    The provision is effective for amounts treated as received 
on or after August 5, 1997 (the effective date of the relevant 
provision of the 1997 Act).

10. Modify FIRPTA rules for real estate investment trusts (sec. 230 of 
        the bill and secs. 857 and 897 of the Code)

                              PRESENT LAW

    A real estate investment trust (``REIT'') is a U.S. entity 
that derives most of its income from passive real-estate-
related investments. A REIT must satisfy a number of tests on 
an annual basis that relate to the entity's organizational 
structure, the source of its income, and the nature of its 
assets. If an electing entity meets the requirements for REIT 
status, the portion of its income that is distributed to its 
investors each year generally is treated as a dividend 
deductible by the REIT, and includible in income by its 
investors. In this manner, the distributed income of the REIT 
is not taxed at the entity level. The distributed income is 
taxed only at the investor level. A REIT generally is required 
to distribute 90 percent of its income to its investors before 
the end of its taxable year.
    Special U.S.-tax rules apply to gains of foreign persons 
attributable to dispositions of interests in U.S.-real 
property, including certain transactions involving REITs. The 
rules governing the imposition and collection of tax on such 
dispositions are contained in a series of provisions that were 
enacted in 1980 and that are collectively referred to as the 
Foreign Investment in Real Property Tax Act (``FIRPTA'').
    In general, FIRPTA provides that gain or loss of a foreign 
person from the disposition of a U.S.-real property interest is 
taken into account for U.S.-tax purposes as if such gain or 
loss were effectively connected with a U.S. trade or business 
during the taxable year. Accordingly, foreign persons generally 
are subject to U.S. tax on any gain from a disposition of a 
U.S. realproperty interest at the same rates that apply to 
similar income received by U.S. persons. For these purposes, the 
receipt of a distribution from a REIT is treated as a disposition of a 
U.S.-real property interest by the recipient to the extent that it is 
attributable to a sale or exchange of a U.S.-real property interest by 
the REIT. These capital gains distributions from REITs generally are 
subject to withholding tax at a rate of 35 percent (or a lower treaty 
rate). In addition, the recipients of these capital gains distributions 
are required to file Federal income tax returns in the United States, 
since the recipients are treated as earning income effectively 
connected with a U.S. trade or business.
    In addition, foreign corporations that have effectively 
connected income generally are subject to the branch profits 
tax at a 30-percent rate (or a lower treaty rate).

                           REASONS FOR CHANGE

    The Committee believes that it is appropriate to provide 
greater conformity in the tax consequences of REIT 
distributions and other corporate stock distributions.

                        EXPLANATION OF PROVISION

    The provision removes from treatment as effectively 
connected income for a foreign investor a capital gain 
distribution from a REIT, provided that: (1) the distribution 
is received with respect to a class of stock that is regularly 
traded on an established securities market located in the 
United States; and (2) the foreign investor does not own more 
than 5 percent of the class of stock at any time during the 
taxable year within which the distribution is received.
    Thus, a foreign investor is not required to file a U.S. 
Federal income tax return by reason of receiving such a 
distribution. The distribution is to be treated as a REIT 
dividend to that investor, taxed as a REIT dividend that is not 
a capital gain. Also, the branch profits tax no longer applies 
to such a distribution.

                             EFFECTIVE DATE

    The provision applies to taxable years beginning after the 
date of enactment.

11. Temporary rate reduction for certain dividends received from 
        controlled foreign corporations (sec. 231 of the bill and new 
        sec. 965 of the Code)

                              PRESENT LAW

    The United States employs a ``worldwide'' tax system, under 
which domestic corporations generally are taxed on all income, 
whether derived in the United States or abroad. Income earned 
by a domestic parent corporation from foreign operations 
conducted by foreign corporate subsidiaries generally is 
subject to U.S. tax when the income is distributed as a 
dividend to the domestic corporation. Until such repatriation, 
the U.S. tax on such income generally is deferred. However, 
certain anti-deferral regimes may cause the domestic parent 
corporation to be taxed on a current basis in the United States 
with respect to certain categories of passive or highly mobile 
income earned by its foreign subsidiaries, regardless of 
whether the income has been distributed as a dividend to the 
domestic parent corporation. The main anti-deferral regimes in 
this context are the controlled foreign corporation rules of 
subpart F \60\ and the passive foreign investment company 
rules.\61\ A foreign tax credit generally is available to 
offset, in whole or in part, the U.S. tax owed on foreign-
source income, whether earned directly by the domestic 
corporation, repatriated as an actual dividend, or included 
under one of the anti-deferral regimes.\62\
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    \60\ Secs. 951-964.
    \61\ Secs. 1291-1298.
    \62\ Secs. 901, 902, 960, 1291(g).
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The Committee observes that the residual U.S. tax imposed 
on the repatriation of lower-tax foreign earnings serves as a 
disincentive to repatriate such earnings. The Committee does 
not believe that this disincentive is objectionable as a 
general matter, as it is inherent in the design of the U.S. 
deferral-based tax system, under which U.S.-based multinational 
corporations enjoy a significant timing benefit with respect to 
most active foreign earnings relative to comparable domestic 
earnings. Nevertheless, the Committee believes that a temporary 
reduction in the U.S. tax on repatriated dividends will 
stimulate the U.S. domestic economy by triggering the 
repatriation of foreign earnings that otherwise would have 
remained offshore. The Committee emphasizes that this is a 
temporary economic stimulus measure. The Committee does not 
intend to make this measure permanent, or to ``extend'' or 
enact it again in the future.

                        EXPLANATION OF PROVISION

    Under the provision, certain actual and deemed dividends 
received by a U.S. corporation from a controlled foreign 
corporation are subject to tax at a reduced rate of 5.25 
percent. For corporations taxed at the top corporate income tax 
rate of 35 percent, this rate reduction is equivalent to an 85-
percent dividends-received deduction. This rate reduction is 
available only for the first taxable year of an electing 
taxpayer ending 120 days or more after the date of enactment of 
the provision.
    The reduced rate applies only to repatriations in excess of 
the taxpayer's average repatriation level over 3 of the 5 most 
recent taxable years ending on or before December 31, 2002, 
determined by disregarding the highest-repatriation year and 
the lowest-repatriation year among such 5 years.\63\ The 
taxpayer may designate which of its dividends are treated as 
meeting the base-period average level and which of its 
dividends are treated as comprising the excess.
---------------------------------------------------------------------------
    \63\ If the taxpayer has fewer than 5 taxable years ending on or 
before December 31, 2002, then the base period consists of all such 
taxable years, with none disregarded.
---------------------------------------------------------------------------
    In order to qualify for the reduced rate, dividends must be 
described in a ``domestic reinvestment plan'' approved by the 
taxpayer's senior management and board of directors. This plan 
must provide for the reinvestment of the repatriated dividends 
in the United States, ``including as a source for the funding 
of worker hiring and training; infrastructure; research 
anddevelopment; capital investments; or the financial stabilization of 
the corporation for the purposes of job retention or creation.''
    The provision disallows 85 percent of the foreign tax 
credits attributable to dividends subject to the reduced rate 
and removes 85 percent of the underlying income from the 
taxpayer's foreign tax credit limitation fraction under section 
904. In addition, any expenses, losses, or deductions of the 
taxpayer may not be used to reduce the tax on dividends 
qualifying for the benefits of the provision.
    In the case of an affiliated group, an election under the 
provision is made by the common parent on a group-wide basis, 
and all members of the group are treated as a single taxpayer. 
The election applies to all controlled foreign corporations 
with respect to which an electing taxpayer is a United States 
shareholder.

                             EFFECTIVE DATE

    The provision is effective for the first taxable year of an 
electing taxpayer ending 120 days or more after the provision's 
date of enactment.

12. Exclusion of certain horse-racing and dog-racing gambling winnings 
        from the income of nonresident alien individuals (sec. 232 of 
        the bill and sec. 872 of the Code)

                              PRESENT LAW

    Under section 871, certain items of gross income received 
by a nonresident alien from sources within the United States 
are subject to a flat 30-percent withholding tax. Gambling 
winnings received by a nonresident alien from wagers placed in 
the United States are U.S.-source and thus generally are 
subject to this withholding tax, unless exempted by treaty. 
Currently, several U.S. income tax treaties exempt U.S.-source 
gambling winnings of residents of the other treaty country from 
U.S. withholding tax. In addition, no withholding tax is 
imposed under section 871 on the non-business gambling income 
of a nonresident alien from wagers on the following games 
(except to the extent that the Secretary determines that 
collection of the tax would be administratively feasible): 
blackjack, baccarat, craps, roulette, and big-6 wheel. Various 
other (non-gambling-related) items of income of a nonresident 
alien are excluded from gross income under section 872(b) and 
are thereby exempt from the 30-percent withholding tax, without 
any authority for the Secretary to impose the tax by 
regulation. In cases in which a withholding tax on gambling 
winnings applies, section 1441(a) of the Code requires the 
party making the winning payout to withhold the appropriate 
amount and makes that party responsible for amounts not 
withheld.
    With respect to gambling winnings of a nonresident alien 
resulting from a wager initiated outside the United States on a 
pari-mutuel \64\ event taking place within the United States, 
the source of the winnings, and thus the applicability of the 
30-percent U.S. withholding tax, depends on the type of 
wagering pool from which the winnings are paid. If the payout 
is made from a separate foreign pool, maintained completely in 
a foreign jurisdiction (e.g., a pool maintained by a racetrack 
or off-track betting parlor that is showing in a foreign 
country a simulcast of a horse race taking place in the United 
States), then the winnings paid to a nonresident alien 
generally would not be subject to withholding tax, because the 
amounts received generally would not be from sources within the 
United States. However, if the payout is made from a ``merged'' 
or ``commingled'' pool, in which betting pools in the United 
States and the foreign country are combined for a particular 
event, then the portion of the payout attributable to wagers 
placed in the United States could be subject to withholding 
tax. The party making the payment, in this case a racetrack or 
off-track betting parlor in a foreign country, would be 
responsible for withholding the tax.
---------------------------------------------------------------------------
    \64\ In pari-mutuel wagering (common in horse racing), odds and 
payouts are determined by the aggregate bets placed. The money wagered 
is placed into a pool, the party maintaining the pool takes a 
percentage of the total, and the bettors effectively bet against each 
other. Pari-mutuel wagering may be contrasted with fixed-odds wagering 
(common in sports wagering), in which odds (or perhaps a point spread) 
are agreed to by the bettor and the party taking the bet and are not 
affected by the bets placed by other bettors.
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The Committee believes that nonresident aliens should be 
able to wager outside the United States in pari-mutuel pools on 
live horse or dog races taking place within the United States 
without any resulting winnings being subjected to U.S. income 
tax, regardless of whether the foreign pool is merged with a 
U.S. pool.

                        EXPLANATION OF PROVISION

    The provision provides an exclusion from gross income under 
section 872(b) for winnings paid to a nonresident alien 
resulting from a legal wager initiated outside the United 
States in a pari-mutuel pool on a live horse or dog race in the 
United States, regardless of whether the pool is a separate 
foreign pool or a merged U.S.-foreign pool.

                             EFFECTIVE DATE

    The provision is effective for wagers made after the date 
of enactment of the provision.

13. Limitation of withholding on U.S.-source dividends paid to Puerto 
        Rico corporation (sec. 233 of the bill and secs. 881 and 1442 
        of the Code)

                              PRESENT LAW

    In general, dividends paid by corporations organized in the 
United States \65\ to corporations organized outside of the 
United States and its possessions are subject to U.S. income 
tax withholding at the flat rate of 30-percent. The rate may be 
reduced or eliminated under a tax treaty. Dividends paid by 
U.S. corporations to corporations organized in certain U.S. 
possessions are subject to different rules.\66\ Corporations 
organized in the U.S. possessions of the Virgin Islands, Guam, 
American Samoa or the Northern Mariana Islands are not subject 
to withholding tax on dividends from corporations organized in 
the United States, provided that certain local ownership and 
activity requirements are met. Each of those possessions have 
adopted local internal revenue codes that provide a zero rate 
of withholding tax on dividends paid by corporations organized 
in the possession to corporations organized in the United 
States.
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    \65\ The team ``United States'' does not include its possessions. 
Sec. 7701(a)(9).
    \66\ The usual method of effecting a mitigation of the flat 30 
percent rate--an income tax treaty providing for a lower rate--is not 
possible in the case of a possession. See S. Rep. No. 1707, 89th Cong., 
2d Sess. 34 (1966).
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    Under the tax laws of Puerto Rico, which is also a U.S. 
possession, a 10-percent withholding tax is imposed on 
dividends paid by Puerto Rico corporations to non-Puerto Rico 
corporations.\67\ Dividends paid by corporations organized in 
the United States to Puerto Rico corporations are subject to 
U.S. withholding tax at a 30-percent rate. Under Puerto Rico 
law, Puerto Rico corporations may elect to credit their U.S. 
income taxes against their Puerto Rico income taxes. Creditable 
income taxes include the 30-percent dividend withholding tax 
and the underlying U.S. corporate tax attributable to the 
dividends. However, a Puerto Rico corporation's tax credit for 
U.S. income taxes may be limited because the sum of the U.S. 
withholding tax and the underlying U.S. corporate tax generally 
exceeds the amount of Puerto Rico corporate income tax imposed 
on the dividend. Consequently, Puerto Rico corporations with 
subsidiaries organized in the United States may be subject to 
some degree of double taxation on their U.S. subsidiaries' 
earnings.
---------------------------------------------------------------------------
    \67\ The 10-percent withholding rate may be subject to exemption or 
elimination if the dividend is paid out of income that is subject to 
certain tax incentives offered by Puerto Rico. These tax incentives may 
also reduce the rate of underlying Puerto Rico corporate tax to a flat 
rate of between two and seven percent.
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The 30-percent withholding tax rate on U.S.-source 
dividends to Puerto Rico corporations places such companies at 
an economic disadvantage relative to corporations organized in 
foreign countries with which the United States has a tax 
treaty, and relative to corporations organized in other 
possessions. The Committee believes that creating and 
maintaining parity between U.S. and Puerto Rico dividend 
withholding tax rates would place Puerto Rico corporations on a 
more level playing field with corporations organized in treaty 
countries and other possessions.

                        EXPLANATION OF PROVISION

    The provision lowers the withholding income tax rate on 
U.S. source dividends paid to a corporation created or 
organized in Puerto Rico from 30 percent to 10 percent, to 
create parity with the 10-percent withholding tax imposed by 
Puerto Rico on dividends paid to non-Puerto Rico corporations. 
The lower rate applies only if the same local ownership and 
activity requirements are met that are applicable to 
corporations organized in other possessions receiving dividends 
from corporations organized in the United States. The Committee 
believes that it isdesirable that the U.S. and Puerto Rico 
corporate dividend withholding tax rates should remain in parity in the 
future. Accordingly, the Committee intends to revisit the U.S. dividend 
withholding tax rate should there be a change to the relevant Puerto 
Rico rate.

                             EFFECTIVE DATE

    The provision is effective for dividends paid after date of 
enactment.

14. Require Commerce Department report on adverse decisions of the 
        World Trade Organization (sec. 234 of the bill)

                              PRESENT LAW

    The Secretary of Commerce does not have an obligation to 
transmit any future report to the Senate Committee on Finance 
and the House of Representatives Committee on Ways and Means, 
in consultation with the United States Trade Representative, 
regarding whether dispute settlement panels or the Appellate 
Body of the World Trade Organization have: (1) added to or 
diminished the rights of the United States by imposing 
obligations and restrictions on the use of antidumping, 
countervailing, or safeguard measures not agreed to under the 
World Trade Organization Antidumping Agreement, the Agreement 
on Subsidies and Countervailing Measures, or the Agreement on 
Safeguards; (2) appropriately applied the standard of review 
contained in Article 17.6 of the Antidumping Agreement; or (3) 
exceeded its authority or terms of reference.

                           REASONS FOR CHANGE

    The Committee believes it is important to be informed of 
decisions by dispute settlement panels and the Appellate Body 
of the World Trade Organization.

                        EXPLANATION OF PROVISION

    The provision requires that by no later than March 31, 
2004, the Secretary of Commerce, in consultation with the 
United States Trade Representative, shall transmit a report to 
the Senate Committee on Finance and the House of 
Representatives Committee on Ways and Means regarding whether 
dispute settlement panels or the Appellate Body of the World 
Trade Organization have: (1) added to or diminished the rights 
of the United States by imposing obligations and restrictions 
on the use of antidumping, countervailing, or safeguard 
measures not agreed to under the World Trade Organization 
Antidumping Agreement, the Agreement on Subsidies and 
Countervailing Measures, or the Agreement on Safeguards; (2) 
appropriately applied the standard of review contained in 
Article 17.6 of the Antidumping Agreement; or (3) exceeded its 
authority or terms of reference.

                             EFFECTIVE DATE

    The provision is effective on the date of enactment.

15. Study of impact of international tax law on taxpayers other than 
        large corporations (sec. 235 of the bill)

                              PRESENT LAW

    The United States employs a ``worldwide'' tax system, under 
which U.S. persons (including domestic corporations) generally 
are taxed on all income, whether derived in the United States 
or abroad. In contrast, foreign persons (including foreign 
corporations) are subject to U.S. tax only on U.S.-source 
income and income that has a sufficient nexus to the United 
States. The United States generally provides a credit to U.S. 
persons for foreign income taxes paid or accrued.\68\ The 
foreign tax credit generally is limited to the U.S.-tax 
liability on a taxpayer's foreign-source income, in order to 
ensure that the credit serves its purpose of mitigating double 
taxation of foreign-source income without offsetting the U.S. 
tax on U.S.-source income.\69\
---------------------------------------------------------------------------
    \68\ Sec. 901.
    \69\ Secs. 901, 904.
---------------------------------------------------------------------------
    Within this basic framework, there are a variety of rules 
that affect the U.S. taxation of cross-border transactions. 
Detailed rules govern the determination of the source of income 
and the allocation and apportionment of expenses between 
foreign-source and U.S.-source income. Such rules are relevant 
not only for purposes of determining the U.S. taxation of 
foreign persons (because foreign persons are subject to U.S. 
tax only on income that is from U.S. sources or otherwise has 
sufficient U.S. nexus), but also for purposes of determining 
the U.S. taxation of U.S. persons (because the U.S. tax on a 
U.S. person's foreign-source income may be reduced or 
eliminated by foreign tax credits). Authority is provided for 
the reallocation of items of income and deductions between 
related persons in order to ensure the clear reflection of the 
income of each person and to prevent the avoidance of tax. 
Although U.S. tax generally is not imposed on a foreign 
corporation that operates abroad, several anti-deferral regimes 
apply to impose current U.S. tax on certain income from foreign 
operations of certain U.S.-owned foreign corporations.
    A cross-border transaction potentially gives rise to tax 
consequences in two (or more) countries. The tax treatment in 
each country generally is determined under the tax laws of the 
respective country. However, an income tax treaty between the 
two countries may operate to coordinate the two tax regimes and 
mitigate the double taxation of the transaction. In this 
regard, the United States' network of bilateral income tax 
treaties includes provisions affecting both U.S. and foreign 
taxation of both U.S. persons with foreign income and foreign 
persons with U.S. income.

                           REASONS FOR CHANGE

    The Committee understands that the international tax rules 
may create disproportionate compliance costs for taxpayers that 
are not large corporations. The Committee believes that the 
Treasury Secretary (or his delegate) should study these 
taxpayers' compliance burden in this regard and provide 
recommendations to reduce this burden.

                        EXPLANATION OF PROVISION

    The provision requires the Secretary of the Treasury or the 
Secretary's delegate to conduct a study of the impact of 
Federal international tax rules on taxpayers other than large 
corporations, including the burdens placed on such taxpayers in 
complying with such rules. In addition, not later than 180 days 
after the date of the enactment of this provision, the 
Secretary shall report to the Committee on Finance of the 
Senate and the Committee on Ways and Means of the House of 
Representatives the results of the study conducted as a result 
of this provision, including any recommendations for 
legislative or administrative changes to reduce the compliance 
burden on taxpayers other than large corporations and for such 
other purposes as the Secretary determines appropriate.

                             EFFECTIVE DATE

    The provision is effective on the date of enactment.

16. Consultative role for Senate Committee on Finance in connection 
        with the review of proposed tax treaties (sec. 236 of the bill)

                              PRESENT LAW

    The United States maintains a network of bilateral tax 
treaties that limit the amount of tax that may be imposed by 
one treaty country on residents of the other treaty country. 
Most of these treaties are income tax treaties designed to 
reduce or eliminate the double taxation of income earned by 
residents of either country from sources within the other 
country, and to prevent the avoidance or evasion of the taxes 
of the two countries.
    Under the Constitution, treaties become effective only upon 
the advice and consent of the Senate. After a proposed tax 
treaty is signed and formally transmitted by the President to 
the Senate, the Senate Committee on Foreign Relations reviews 
the proposed treaty, conducts ratification hearings, and 
reports to the Senate with a recommendation as to ratification 
of the proposed treaty. The Senate Committee on Finance has no 
formal role in the process.

                           REASON FOR CHANGE

    The Committee believes that the Senate Committee on Finance 
should have a consultative role with respect to proposed tax 
treaties received and reported by the Senate Committee on 
Foreign Relations.

                        EXPLANATION OF PROVISION

    Under the provision, the Senate Committee on Foreign 
Relations would be required to consult with the Senate 
Committee on Finance with respect to proposed tax treaties 
prior to reporting any such treaty to the Senate. The Senate 
Committee on Finance would be required to respond in writing 
within 120 days of receipt of a request for consultation from 
the Senate Committee on Foreign Relations. If the Senate 
Committee on Finance does not respond within this time period, 
the Committee will be considered to have waived the right to 
consult with respect to the provisions of the tax treaty.
    The Senate Committee on Foreign Relations would be required 
to consider the views of the Senate Committee on Finance when 
reporting a tax treaty to the Senate and would be required to 
include the views of the Senate Committee on Finance in its 
report to the Senate.

                             EFFECTIVE DATE

    The provision would be effective on the date of enactment.

       TITLE III--DOMESTIC MANUFACTURING AND BUSINESS PROVISIONS


           A. Domestic Manufacturing and Business Provisions


1. Expansion of qualified small-issue bond program (sec. 301 of the 
        bill and sec. 144 of the Code)

                              PRESENT LAW

    Qualified small-issue bonds are tax-exempt State and local 
government bonds used to finance private business manufacturing 
facilities (including certain directly related and ancillary 
facilities) or the acquisition of land and equipment by certain 
farmers. In both instances, these bonds are subject to limits 
on the amount of financing that may be provided, both for a 
single borrowing and in the aggregate. In general, no more than 
$1 million of small-issue bond financing may be outstanding at 
any time for property of a business (including related parties) 
located in the same municipality or county. Generally, this $1 
million limit may be increased to $10 million if all other 
capital expenditures of the business in the same municipality 
or county over a six-year period are counted toward the limit. 
Outstanding aggregate borrowing is limited to $40 million per 
borrower (including related parties) regardless of where the 
property is located. No more than $250,000 per borrower 
($62,500 for used property) may be used to finance eligible 
farm property.
    Property and businesses eligible for this financing are 
specified. For example, only depreciable property (and related 
real property) used in the production of tangible personal 
property is eligible for financing as a manufacturing facility. 
Storage and distribution of products generally is not treated 
as production under this provision. Agricultural land and 
equipment may only be financed for first-time farmers, defined 
as individuals who have not at any prior time owned farmland in 
excess of: (1) 30 percent of the median size of a farm in the 
same county; or (2) $125,000 in value.
    Before 1987, qualified small-issue bonds also could be used 
to finance commercial facilities. In addition to general 
prohibitions on the tax-exempt private activity bond financing 
of certain facilities, Federal law precludes the use of 
qualified small-issue bonds to finance a broader list of 
facilities. For example, no more than 25 percent of a bond 
issue can be used to finance restaurants, bars, automobile 
sales and service facilities, or entertainment facilities. No 
portion of these bond proceeds can be used to finance golf 
courses, country clubs, massage parlors, tennis clubs or other 
racquet sport facilities, skating facilities, hot tub 
facilities, or racetracks.

                           REASONS FOR CHANGE

    The Committee believes that the class of facilities 
eligible for qualified small-issue bond financing should be 
expanded to include otherwise eligible facilities with total 
capital expenditures of less than $20 million. The present-law 
capital expenditures limit of $10 million has not been adjusted 
in many years.

                        EXPLANATION OF PROVISION

    The bill increases the maximum allowable amount of total 
capital expenditures by an eligible business in the same 
municipality or county during the six-year period from $10 
million to $20 million. As under present-law, no more than $10 
million of bond financing may be outstanding at any time for 
property of an eligible business (including related parties) 
located in the same municipality or county. Other present-law 
limits (e.g., the $40 million per borrower limit) continue to 
apply.

                             EFFECTIVE DATE

    The provision is effective for bonds issued after the date 
of enactment.

2. Expensing of investment in broadband equipment (sec. 302 of the bill 
        and new sec. 191 of the Code)

                              PRESENT LAW

    Under present law, a taxpayer generally must capitalize the 
cost of property used in a trade or business and recover such 
cost over time through annual deductions for depreciation or 
amortization. Tangible property generally is depreciated under 
the Modified Accelerated Cost Recovery System (MACRS) of 
section 168, which determines depreciation by applying specific 
recovery periods, placed-in-service conventions, and 
depreciation methods to the cost of various types of 
depreciable property.
    Personal property is classified under MACRS based on the 
property's ``class life'' unless a different classification is 
specifically provided in section 168. The class life applicable 
for personal property is the asset guideline period (midpoint 
class life as of January 1, 1986). Based on the property's 
classification, a recovery period is prescribed under MACRS. In 
general, there are six classes of recovery periods to which 
personal property can be assigned. For example, personal 
property that has a class life of four years or less has a 
recovery period of three years, whereas personal property with 
a class life greater than four years but less than 10 years has 
a recovery period of five years. The class lives and recovery 
periods for most property are contained in Rev. Proc. 87-56, 
1987-2 C.B. 674 (as clarified and modified by Rev. Proc. 88-22, 
1988-1 C.B. 785).

                           REASONS FOR CHANGE

    The Committee believes it is important to continue to build 
the nation's internet infrastructure as these technologies, and 
the network they create, provide the basis of future income and 
job growth. In particular, development of this infrastructure 
in underserved and rural areas is critical to future job and 
income growth in these areas. In addition, the Committee 
believes that the economy's current recovery can be enhanced by 
providing a short-term stimulus to such investments.

                        EXPLANATION OF PROVISION

    The bill provides that the taxpayer may elect to treat 
qualified broadband expenditures paid or incurred after 
December 31, 2003, and before January 1, 2005, as a deduction 
in the taxable year in which the equipment is placed in 
service.
    Qualified expenditures are expenditures incurred with 
respect to equipment with which the taxpayer offers current 
generation broadband services to qualified subscribers. In 
addition, qualified expenditures include qualified expenditures 
incurred by the taxpayer with respect to qualified equipment 
with which the taxpayer offers next generation broadband 
services to qualified subscribers. Current generation broadband 
services are defined as the transmission of signals at a rate 
of at least 1 million bits per second to the subscriber and at 
a rate of at least 128,000 bits per second from the subscriber. 
Next generation broadband services are defined as the 
transmission of signals at a rate of at least 22 million bits 
per second to the subscriber and at a rate of at least 5 
million bits per second from the subscriber.
    Qualified subscribers for the purposes of the current 
generation broadband deduction include nonresidential 
subscribers in rural or underserved areas, and residential 
subscribers in rural or underserved areas that are not in a 
saturated market. A saturated market is defined as a census 
tract in which current generation broadband services have been 
provided by a single provider to 85 percent or more of the 
total number of potential residential subscribers residing 
within such census tracts. For the purposes of the next 
generation broadband deduction, qualified subscribers include 
nonresidential subscribers in rural or underserved areas or any 
residential subscriber. In the case of a taxpayer who incurs 
expenditures for equipment capable of serving both subscribers 
in qualifying areas and other areas, qualifying expenditures 
are determined by multiplying otherwise qualifying expenditures 
by the ratio of the number of potential qualifying subscribers 
to all potential subscribers the qualifying equipment would be 
capable of serving.
    Qualifying equipment must be capable of providing broadband 
services a majority of the time during periods of maximum 
demand. Qualifying equipment is that equipment that extends 
from the last point of switching to the outside of the building 
in which the subscriber is located, equipment that extends from 
the customer side of a mobile telephone switching office to a 
transmission/reception antenna (including the antenna) of the 
subscriber, equipment that extends from the customer side of 
the headend to the outside of the building in which the 
subscriber is located, or equipment that extends from a 
transmission/reception antenna to a transmission/reception 
antenna on the outside of the building used by the subscriber. 
Any packet switching equipment deployed in connection with 
other qualifying equipment is qualifying equipment, regardless 
of location, provided that it is the last such equipment in a 
series as part of transmission of a signal to a subscriber or 
the first in a series in the transmission of a signal from a 
subscriber. Also, multiplexing and demultiplexing equipment are 
qualified equipment.
    A rural area is any census tract which is not within 10 
miles of any incorporated or census designated place with a 
population of more than 25,000 and which is not within a county 
with a population density of more than 500 people per square 
mile. An underserved area is any census tract which is located 
in an empowerment zone or enterprise community or any census 
tract in which the poverty level is greater than or equal to 30 
percent and in which the medianfamily income or Statewide 
median family income. A residential subscriber is any individual who 
purchases broadband service to be delivered to his or her dwelling.

                             EFFECTIVE DATE

    The proposal is effective for expenditures incurred after 
December 31, 2003.

3. Exemption for natural aging process from interest capitalization 
        (sec. 303 of the bill and sec. 263(A) of the Code)

                              PRESENT LAW

    Section 263A provides uniform rules for capitalization of 
certain costs. In general, 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 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.
    Special rules apply for the allocation of interest expense 
to property produced by the taxpayer.\70\ In general, interest 
paid or incurred during the production period of certain types 
of property that is allocable to the production of the property 
must be capitalized. Property subject to the interest 
capitalization requirement includes property produced by the 
taxpayer for use in its trade or business or in an activity for 
profit, but only if it: (1) is real property; (2) has an 
estimated production period exceeding two years (one year if 
the cost of the property exceeds $1 million); or (3) has a 
class life of 20 years or more (as defined under section 168). 
The production period of property for this purpose begins when 
construction or production is commenced and ends when the 
property is ready to be placed in service or is ready to be 
held for sale. For example, in the case of property such as 
tobacco, wine, or whiskey that is aged before it is sold, the 
production period includes the aging period. Activities such as 
planning or design generally do not cause the production period 
to begin.
---------------------------------------------------------------------------
    \70\ Sec. 263A(f).
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The Committee is concerned about an inequity in the Code 
that results in capitalization of a portion of a taxpayer's 
interest expense for certain distilled spirits merely due to 
the natural aging process of such product (e.g., fine bourbon). 
The requirement to capitalize such costs results in a 
competitive disadvantage for such distillers compared to other 
distilled products in which natural aging is not required 
(e.g., vodka). This provision removes this inequity and will 
aid many small distilleries located in the United States by not 
forcing them to carry additional inventory costs over long 
periods of time.

                        EXPLANATION OF PROVISION

    The provision provides that for purposes of determining the 
production period for purposes of capitalization of interest 
expense under section 263A(f) that the production period for 
distilled spirits shall be determined without regard to any 
period allocated to the natural aging process.\71\
---------------------------------------------------------------------------
    \71\ It is intended that for purposes of the provision, that the 
natural aging process begin when the distilled spirits are placed in 
charred barrels to lie for an extended period of time to allow such 
product to obtain its color, much of its distinctive flavor, and to 
mellow. The natural aging process concludes when the distilled spirits 
are removed from the barrel.
---------------------------------------------------------------------------

                             EFFECTIVE DATE

    The provision applies to production periods beginning after 
the date of enactment.

4. Section 355 ``active business test'' applied to chains of affiliated 
        corporations (sec. 304 of the bill and sec. 355 of the Code)

                              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 applies if the 
distribution of the stock of a controlled corporation satisfies 
the requirements of section 355 of the Code. To qualify for 
tax-free treatment under section 355, both the distributing 
corporation and the controlled corporation must be engaged 
immediately after the distribution in the active conduct of a 
trade or business that has been conducted for at least five 
years and was not acquired in a taxable transaction during that 
period.\72\ 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) the corporation is not directly 
engaged in an active business, but 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.\73\
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    \72\ Section 355(b).
    \73\ Section 355(b)(2)(A).
---------------------------------------------------------------------------
    In determining whether a corporation satisfies the active 
trade or business requirement, the IRS position for advance 
ruling purposes is that the value of the gross assets of the 
trade or business being relied on must ordinarily constitute at 
least 5 percent of the total fair market value of the gross 
assets of the corporation directly conducting the trade or 
business.\74\ However, if the corporation is not directly 
engaged in an active trade or business, then the IRS takes the 
position that the ``substantially all'' test requires that at 
least 90 percent of the fair market 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.\75\
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    \74\ Rev. Proc. 2003-3, sec. 4.01(30), 2003-1 I.R.B. 113.
    \75\ Rev. Proc. 96-30, sec. 4.03(5), 1996-1 C.B. 696; Rev. Proc. 
77-37, sec. 304, 1977-2 C.B. 568.
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    Prior to a spin-off under section 355 of the Code, 
corporate groups that have conducted business in separate 
corporate entities often must undergo elaborate restructurings 
to place active businesses in the proper entities to satisfy 
the 5-year active business requirement. If the top-tier 
corporation of a chain that is being spun off or retained is a 
holding company, then the requirements regarding the activities 
of its subsidiaries are more stringent than if the top-tier 
corporation itself engaged in some active business.
    The Committee believes that it is appropriate to simplify 
planning for corporate groups that use a holding company 
structure to engage in distributions that qualify for tax-free 
treatment under section 355.

                        EXPLANATION OF PROVISION

    Under the bill, the active business test is determined by 
reference to the relevant affiliated group. For the 
distributing corporation, the relevant affiliated group 
consists of the distributing corporation as the common parent 
and all corporations affiliated with the distributing 
corporation through stock ownership described in section 
1504(a)(1)(B) (regardless of whether the corporations are 
includible corporations under section 1504(b)), immediately 
after the distribution. The relevant affiliated group for a 
controlled corporation is determined in a similar manner (with 
the controlled corporation as the common parent).

                             EFFECTIVE DATE

    The bill applies to distributions after the date of 
enactment, with three exceptions. The bill does not apply to 
distributions: (1) made pursuant to an agreement which is 
binding on the date of enactment and at all times thereafter; 
(2) described in a ruling request submitted to the IRS on or 
before the date of enactment; or (3) described on or before the 
date of enactment in a public announcement or in a filing with 
the Securities and Exchange Commission. The distributing 
corporation may irrevocably elect not to have the exceptions 
described above apply.
    The bill also applies to any distribution prior to the date 
of enactment, but solely for the purpose of determining 
whether, after the date of enactment, the taxpayer continues to 
satisfy the requirements of section 355(b)(2)(A).\76\
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    \76\ For example, a holding company taxpayer that had distributed a 
controlled corporation in a spin-off prior to the date of enactment, in 
which spin-off the taxpayer satisfied the ``substantially all'' active 
business stock test of present law section 355(b)(2)(A) immediately 
after the distribution, would not be deemed to have failed to satisfy 
any requirement that it continue that same qualified structure for any 
period of time after the distribution, solely because of a 
restructuring that occurs after the date of enactment and that would 
satisfy the requirements of new section 355(b)(2)(A).
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5. Exclusion of certain indebtedness of small business investment 
        companies from acquisition indebtedness (sec. 305 of the bill 
        and sec. 514 of the Code)

                              PRESENT LAW

    In general, an organization that is otherwise exempt from 
Federal income tax is taxed on income from a trade or business 
that is unrelated to the organization's exempt purposes. 
Certain types of income, such as rents, royalties, dividends, 
and interest, generally are excluded from unrelated business 
taxable income except when such income is derived from ``debt-
financed property.'' Debt-financed property generally means any 
property that is held to produce income and with respect to 
which there is acquisition indebtedness at any time during the 
taxable year.
    In general, income of a tax-exempt organization that is 
produced by debt-financed property is treated as unrelated 
business income in proportion to the acquisition indebtedness 
on the income-producing property. Acquisition indebtedness 
generally means the amount of unpaid indebtedness incurred by 
an organization to acquire or improve the property and 
indebtedness that would not have been incurred but for the 
acquisition or improvement of the property.\77\ Acquisition 
indebtedness does not include, however: (1) certain 
indebtedness incurred in the performance or exercise of a 
purpose or function constituting the basis of the 
organization's exemption; (2) obligations to pay certain types 
of annuities; (3) an obligation, to the extent it is insured by 
the Federal Housing Administration, to finance the purchase, 
rehabilitation, or construction of housing for low and moderate 
income persons; or (4) indebtedness incurred by certain 
qualified organizations to acquire or improve real property. An 
extension, renewal, or refinancing of an obligation evidencing 
a pre-existing indebtedness is not treated as the creation of a 
new indebtedness.
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    \77\ Special rules apply in the case of an exempt organization that 
owns a partnership interest in a partnership that holds debt-financed 
income-producing property. An exempt organization's share of 
partnership income that is derived from such debt-financed property 
generally is taxed as debt-financed income unless an exception provides 
otherwise.
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                           REASONS FOR CHANGE

    Small business investment companies obtain financial 
assistance from the Small Business Administration in the form 
of equity or by incurring indebtedness that is held or 
guaranteed by the Small Business Administration pursuant to the 
Small Business Investment Act of 1958. Tax-exempt organizations 
that invest in small business investment companies who are 
treated as partnerships and who incur indebtedness that is held 
or guaranteed by the Small Business Administration may be 
subject to unrelated business income tax on their distributive 
shares of income from the small business investment company. 
The Committee believes that the imposition of unrelated 
business income tax in such cases creates a disincentive for 
tax-exempt organizations to invest in small business investment 
companies, thereby reducing the amount ofinvestment capital 
that may be provided by small business investment companies to the 
nation's small businesses.

                        EXPLANATION OF PROVISION

    The provision modifies the debt-financed property 
provisions by excluding from the definition of acquisition 
indebtedness any indebtedness incurred by a small business 
investment company licensed under the Small Business Investment 
Act of 1958 that is evidenced by a debenture: (1) issued by 
such company under section 303(a) of said Act; and (2) held or 
guaranteed by the Small Business Administration.

                             EFFECTIVE DATE

    The provision is effective for debt incurred by a small 
business investment company after December 31, 2003, with 
respect to property it acquires after such date.

6. Modified taxation of imported archery products (sec. 306 of the bill 
        and sec. 4161 of the Code)

                              PRESENT LAW

    The Code imposes an excise tax of 11 percent on the sale by 
a manufacturer, producer or importer of any bow with a draw 
weight of 10 pounds or more.\78\ An excise tax of 12.4 percent 
is imposed on the sale by a manufacturer or importer of any 
shaft, point, nock, or vane designed for use as part of an 
arrow which after its assembly: (1) is over 18 inches long; or 
(2) is designed for use with a taxable bow (if shorter than 18 
inches).\79\ No tax is imposed on finished arrows. An 11-
percent excise tax also is imposed on any part of an accessory 
for taxable bows and on quivers for use with arrows: (1) over 
18 inches long; or (2) designed for use with a taxable bow (if 
shorter than 18 inches).\80\
---------------------------------------------------------------------------
    \78\ Sec. 4161(b)(1)(A).
    \79\ Sec. 4161(b)(2).
    \80\ Sec. 4161(b)(1)(B).
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                           REASONS FOR CHANGE

    Under present law, foreign manufacturers and importers of 
arrows avoid the 12.4-percent excise tax paid by domestic 
manufacturers because the tax is placed on arrow components 
rather than finished arrows. As a result, arrows assembled 
outside of the United States have a price advantage over 
domestically manufactured arrows. The Committee believes it is 
appropriate to close this loophole. The Committee also believes 
that adjusting the minimum draw weight for taxable bows from 10 
pounds to 30 pounds will better target the excise tax to actual 
hunting use by eliminating the excise tax on instructional 
(``youth'') bows.

                        EXPLANATION OF PROVISION

    The bill increases the draw weight for a taxable bow from 
10 pounds or more to a peak draw weight of 30 pounds or 
more.\81\ The bill also imposes an excise tax of 12 percent on 
arrows generally. An arrow for this purpose is defined as a 
taxable arrow shaft to which additional components are 
attached. The present law 12.4-percent excise tax on certain 
arrow components is unchanged by the bill. In the case of any 
arrow comprised of a shaft or any other component upon which 
tax has been imposed, the amount of the arrow tax is equal to 
the excess of: (1) the arrow tax that would have been imposed 
but for this exception; over (2) the amount of tax paid with 
respect to such components. Finally, the bill subjects certain 
broadheads (a type of arrow point) to an excise tax equal to 11 
percent of the sales price instead of 12.4 percent.
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    \81\ Draw weight is the maximum force required to bring the 
bowstring to a full-draw position not less than 26\1/4\-inches, 
measured from the pressure point of the hand grip to the nocking 
position on the bowstring.
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                             EFFECTIVE DATE

    The provision is effective for articles sold by the 
manufacturer, producer, or importer after December 31, 2003.

7. Modification to cooperative marketing rules to include value added 
        processing involving animals (sec. 307 of the bill and sec. 
        1388 of the Code)

                              PRESENT LAW

    Under present law, cooperatives generally are treated 
similarly to pass-through entities in that the cooperative is 
not subject to corporate income tax to the extent the 
cooperative timely pays patronage dividends. Farmers' 
cooperatives are tax-exempt and include cooperatives of 
farmers, fruit growers, and like organizations that are 
organized and operated on a cooperative basis for the purpose 
of marketing the products of members or other producers and 
remitting the proceeds of sales, less necessary marketing 
expenses, on the basis of either the quantity or the value of 
products furnished by them (sec. 521). Farmers' cooperatives 
may claim a limited amount of additional deductions for 
dividends on capital stock and patronage-based distributions of 
nonpatronage income.
    In determining whether a cooperative qualifies as a tax-
exempt farmers' cooperative, the IRS has apparently taken the 
position that a cooperative is not marketing certain products 
of members or other producers if the cooperative adds value 
through the use of animals (e.g., farmers sell corn to a 
cooperative which is fed to chickens that produce eggs sold by 
the cooperative).

                           REASONS FOR CHANGE

    The Committee disagrees with the apparent IRS position 
concerning the marketing of certain products by cooperatives 
after the cooperative has added value to the products 
throughthe use of animals. Therefore, the Committee believes that the 
tax rules should be modified to clarify that cooperatives are permitted 
to market such products.

                        EXPLANATION OF PROVISION

    The provision provides that marketing products of members 
or other producers includes feeding products of members or 
other producers to cattle, hogs, fish, chickens, or other 
animals and selling the resulting animals or animal products.

                             EFFECTIVE DATE

    The provision is effective for taxable years beginning 
after the date of enactment.

8. Extension of declaratory judgment procedures to farmers' cooperative 
        organizations (sec. 308 of the bill and sec. 7428 of the Code)

                              PRESENT LAW

    In limited circumstances, the Code provide declaratory 
judgment procedures, which generally permit a taxpayer to seek 
judicial review of an IRS determination prior to the issuance 
of a notice of deficiency and prior to payment of tax. Examples 
of declaratory judgment procedures that are available include 
disputes involving the initial or continuing classification of 
a tax-exempt organization described in section 501(c)(3), a 
private foundation described in section 509(a), or a private 
operating foundation described in section 4942(j)(3), the 
qualification of retirement plans, the value of gifts, the 
status of certain governmental obligations, or eligibility of 
an estate to pay tax in installments under section 6166.\82\ In 
such cases, taxpayers may challenge adverse determinations by 
commencing a declaratory judgment action. For example, 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 
exempt status.
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    \82\ For disputes involving the initial or continuing qualification 
of an organization described in sections 501(c)(3), 509(a), or 
4942(j)(3), declaratory judgment actions may be brought in the U.S. Tax 
Court, a U.S. district court, or the U.S. Court of Federal Claims. For 
all other Federal tax declaratory judgment actions, proceedings may be 
brought only in the U.S. Tax Court.
---------------------------------------------------------------------------
    Declaratory judgment procedures are not available under 
present law to a cooperative with respect to an IRS 
determination regarding its status as a farmers' cooperative 
under section 521.

                           REASONS FOR CHANGE

    The Committee believes that declaratory judgment procedures 
currently available to other organizations and in other 
situations also should be available to farmers' cooperative 
organizations with respect to an IRS determination regarding 
the status of an organization as a farmers' cooperative under 
section 521.

                        EXPLANATION OF PROVISION

    The provision extends the declaratory judgment procedures 
to cooperatives. Such a case may be commenced in the U.S. Tax 
Court, a U.S. district court, or the U.S. Court of Federal 
Claims, and such court would have jurisdiction to determine a 
cooperative's initial or continuing qualification as a farmers' 
cooperative described in section 521.

                             EFFECTIVE DATE

    The provision is effective for pleadings filed after the 
date of enactment.

9. Temporary suspension of personal holding company tax (sec. 309 of 
        the bill and sec. 541 of the Code)

                              PRESENT LAW

    Under present law, a tax is imposed on the taxable income 
of corporations. The rates are as follows:

          TABLE 1.--MARGINAL FEDERAL CORPORATE INCOME TAX RATES
------------------------------------------------------------------------
      If taxable income is:             Then the income tax rate is:
------------------------------------------------------------------------
$0-$50,000.......................  15 percent of taxable income.
$50,001-$75,000..................  25 percent of taxable income.
$75,001-$10,000,000..............  34 percent of taxable income.
Over $10,000,000.................  35 percent of taxable income.
------------------------------------------------------------------------

    The first two graduated rates described above are phased 
out by a five-percent surcharge for corporations with taxable 
income between $100,000 and $335,000. Also, the application of 
the 34-percent rate is phased out by a three-percent surcharge 
for corporations with taxable income between $15 million and 
$18,333,333.
    When a corporation distributes its after-tax earnings to 
individual shareholders as dividends, a tax is imposed on the 
shareholders at rates up to 15 percent.\83\ If a corporation 
receives a dividend from another corporation, the recipient 
corporation is entitled to a dividends-received deduction that 
excludes a significant part of the dividend from the 
recipient's income. The percentage of a dividend received that 
is deducted varies from 70 percent to 100 percent, depending on 
the level of ownership of the recipient corporation in the 
distributing corporation.\84\ Thus, with a 70-percent dividends 
received deduction, the tax rate imposed on a dividend received 
by a corporation in the 35-percent tax bracket is 10.5 
percent.\85\ For corporations at lower rate brackets, the tax 
rates on these dividends are lower.
---------------------------------------------------------------------------
    \83\ The 15-percent rate applies to dividends received in taxable 
years beginning before January 1, 2009. Dividends received on or after 
that date are scheduled to be taxed at the rates applicable to ordinary 
income, which range up to 35 percent (39.6 percent for taxable years 
beginning after December 31, 2010).
    \84\ If the recipient corporation owns less than 20 percent of the 
distributing corporation, the dividends-received deduction is 70 
percent. If the recipient corporation owns less than 80 percent but at 
least 20 percent of the distributing corporation, the dividends-
received deduction is 80 percent. If the recipient corporation owns 80 
percent or more of the distributing corporation, the dividends received 
deduction is generally 100 percent.
    \85\ This is the 35 percent tax rate, applied to the 30 percent of 
the dividend that is taxable after a 70 percent dividends-received 
deduction.
---------------------------------------------------------------------------
    In addition to the regular corporate income tax, a 
corporate level penalty tax, the ``personal holding company 
tax'' is currently imposed at 15 percent \86\ on certain 
corporate earnings of personal holding companies that are not 
distributed to shareholders. The personal holding company tax 
was originally enacted to prevent so-called ``incorporated 
pocketbooks'' that could be formed by individuals to hold 
assets that could have been held directly by the individuals, 
such as passive investment assets, and retain the income at 
corporate rates that were then significantly lower than 
individual tax rates.
---------------------------------------------------------------------------
    \86\ This rate is scheduled to return to the highest individual tax 
rate when the lower dividend tax rate expires.
---------------------------------------------------------------------------
    Corporations are personal holding companies only if they 
are closely held and have substantial passive income. A 
corporation is closely held if, at any time during the last 
half of the taxable year, more than 50 percent of the value of 
the stock of the corporation is owned, directly or indirectly, 
by five or fewer individuals (determined with the application 
of specified attribution rules). A corporation has substantial 
passive income if at least 60 percent of the corporation's 
adjusted ordinary gross income (as defined for this purpose) is 
``personal holding company income,'' generally, income from 
interest, dividends, rents, royalties, compensation for use of 
corporate property by certain shareholders, and income under 
contracts giving someone other than the corporation the right 
to designate the individual service provider. Numerous 
adjustments apply in specified situations where there are 
specified indicia that the income is active rather than 
passive.
    A corporation that otherwise would be subject to personal 
holding company tax can distribute, or can agree to be deemed 
to have distributed, its modified taxable income and avoid the 
tax. A corporation may make such an actual dividend 
distribution during its taxable year or, up to a specified 
limited amount, until the 15th day of the third month following 
the close of its taxable year. In addition, if an election is 
filed with its return for the year, its shareholders may agree 
to include a deemed amount in their income as if a dividend had 
been paid (``consent dividend''). A corporation may also make a 
``deficiency dividend'' distribution within 90 days following a 
determination by the IRS or a court that personal holding 
company tax liability isdue. That distribution can eliminate 
the personal holding company tax itself, though interest (and 
penalties, if any) with respect to such tax would still be owed to the 
IRS.\87\
---------------------------------------------------------------------------
    \87\ Section 547.
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The personal holding company tax was enacted in 1934 to 
prevent individual shareholders from avoiding the steeply 
graduated income tax rates imposed on individuals at a time 
when the corporate tax rate was relatively low.
    The Committee believes that today there is little incentive 
for taxpayers to use personal holding companies to avoid the 
individual income tax rates because the individual income tax 
rates are generally similar to, or lower than, the corporate 
income tax rates.
    The Committee recognizes that, due to the dividends-
received deduction, income from dividend paying stock is taxed 
more lightly when the dividend paying stock is held in a C 
corporation than when it is held by an individual. However, the 
differential between the maximum 10.5-percent rate on dividends 
received by a corporation and the maximum 15-percent rate on 
dividends received by individuals is relatively small. The 
committee does not expect that this differential will produce a 
significant incentive for individuals to hold such stocks in 
corporate entities.
    Accordingly, the Committee believes that simplification can 
be achieved during the period that individual dividends are 
taxed at a maximum 15-percent rate, by repealing the personal 
holding company tax.

                        EXPLANATION OF PROVISION

    The provision repeals the personal holding company tax 
until 2009, the period of time the 15-percent rate on dividends 
received by individuals is scheduled to be in effect.

                             EFFECTIVE DATE

    The provision is effective for taxable years beginning 
after December 31, 2003.
    The provision would be treated, for purposes of section 303 
of the Jobs and Growth Tax Relief Reconciliation Act of 2003 as 
enacted by Title III of that Act (relating to lower rates on 
capital gains and dividends), so that the provision terminates 
when those provisions terminate (currently scheduled to be for 
taxable years beginning after December 31, 2008).

10. Increase section 179 expensing (sec. 310 of the bill and sec. 179 
        of the Code)

                              PRESENT LAW

    Present law provides that, in lieu of depreciation, a 
taxpayer with a sufficiently small amount of annual investment 
may elect to deduct such costs. The Jobs and Growth Tax Relief 
Reconciliation Act (JGTRRA) of 2003 \88\ increased the amount a 
taxpayer may deduct, for taxable years beginning in 2003 
through 2005, to $100,000 of the cost of qualifying property 
placed in service for the taxable year.\89\ In general, 
qualifying property is defined as depreciable tangible personal 
property (and certain computer software) that is purchased for 
use in the active conduct of a trade or business. The $100,000 
amount is reduced (but not below zero) by the amount by which 
the cost of qualifying property placed in service during the 
taxable year exceeds $400,000.
---------------------------------------------------------------------------
    \88\ Pub. Law No. 108-27, sec. 202 (2003).
    \89\ Additional section 179 incentives are provided with respect to 
a qualified property used by a business in the New York Liberty Zone 
(sec. 1400L(f)), an empowerment zone (sec. 1397A), or a renewal 
community (sec. 1400J).
---------------------------------------------------------------------------
    Prior to the enactment of JGTRRA (and for taxable years 
beginning in 2006 and thereafter) a taxpayer with a 
sufficiently small amount of annual investment may elect to 
deduct up to $25,000 of the cost of qualifying property placed 
in service for the taxable year. The $25,000 amount is reduced 
(but not below zero) by the amount by which the cost of 
qualifying property placed in service during the taxable year 
exceeds $200,000. In general, qualifying property is defined as 
depreciable tangible personal property that is purchased for 
use in the active conduct of a trade or business.
    The amount eligible to be expensed for a taxable year may 
not exceed the taxable income for a taxable year that is 
derived from the active conduct of a trade or business 
(determined without regard to this provision). Any amount that 
is not allowed as a deduction because of the taxable income 
limitation may be carried forward to succeeding taxable years 
(subject to similar limitations). No general business credit 
under section 38 is allowed with respect to any amount for 
which a deduction is allowed under section 179.

                           REASONS FOR CHANGE

    The Committee believes that section 179 expensing provides 
two important benefits for small business. First, it lowers the 
cost of capital for qualifying property used in a trade or 
business. With a lower cost of capital, the Committee believes 
small business will invest in more equipment and employ more 
workers. Second, it eliminates depreciation recordkeeping 
requirements with respect to expensed property. In order to 
increase the value of these benefits and to increase the number 
of eligible taxpayers, the Committee bill increases the capital 
investment allowed to be purchased under section 179 prior to 
the benefits being phased out.

                        EXPLANATION OF PROVISION

    The provision provides that the $100,000 amount ($25,000 
for taxable years beginning in 2006 and thereafter) is reduced 
(but not below zero) by only one half of the amount by which 
thecost of qualifying property placed in service during the 
taxable year exceeds $400,000 ($200,000 for taxable years beginning 
2006 and thereafter).\90\
---------------------------------------------------------------------------
    \90\ As a result of the reduced phase-out percentage, the 
deductible amount in the New York Liberty Zone, an enterprise zone or a 
renewal community is correspondingly increased. See sec. 1400L(f), sec. 
1397A and sec. 1400J.
---------------------------------------------------------------------------
    For example, under the provision, if in 2004 an eligible 
taxpayer places in service qualifying property costing 
$500,000, the $100,000 amount is reduced by $50,000 (i.e., one 
half the amount by which the $500,000 cost of qualifying 
property placed in service during the taxable year exceeds 
$400,000). Thus, the maximum amount eligible for section 179 
expensing by this taxpayer for 2004 is $50,000.

                             EFFECTIVE DATE

    The provision is effective for taxable years beginning 
after December 31, 2002.

11. Three-year carryback of net operating losses (sec. 311 of the bill 
        and sec. 172 of the Code)

                              PRESENT LAW

    A net operating loss (``NOL'') is, generally, the amount by 
which a taxpayer's allowable deductions exceed the taxpayer's 
gross income. A carryback of an NOL generally results in the 
refund of Federal income tax for the carryback year. A 
carryforward of an NOL reduces Federal income tax for the 
carryforward year.
    In general, an NOL may be carried back two years and 
carried forward 20 years to offset taxable income in such 
years.\91\ Different rules apply with respect to NOLs arising 
in certain circumstances. For example, a three-year carryback 
applies with respect to NOLs: (1) arising from casualty or 
theft losses of individuals; or (2) attributable to 
Presidentially declared disasters for taxpayers engaged in a 
farming business or a small business. A five-year carryback 
period applies to NOLs from a farming loss (regardless of 
whether the loss was incurred in a Presidentially declared 
disaster area). Special rules also apply to real estate 
investment trusts (no carryback), specified liability losses 
(10-year carryback), and excess interest losses (no carryback 
to any year preceding a corporate equity reduction 
transaction).
---------------------------------------------------------------------------
    \91\ Sec. 172.
---------------------------------------------------------------------------
    The alternative minimum tax rules provide that a taxpayer's 
NOL deduction cannot reduce the taxpayer's alternative minimum 
taxable income (``AMTI'') by more than 90 percent of the AMTI 
(determined without regard to the NOL deduction).
    Section 202 of the Job Creation and Worker Assistance Act 
of 2002 \92\ (``JCWAA'') provided a temporary extension of the 
general NOL carryback period to five years (from two years) for 
NOLs arising in taxable years ending in 2001 and 2002. In 
addition, the five-year carryback period applies to NOLs from 
these years that qualify under present law for a three-year 
carryback period (i.e., NOLs arising from casualty or theft 
losses of individuals or attributable to certain Presidentially 
declared disaster areas).
---------------------------------------------------------------------------
    \92\ Pub. Law No. 107-147.
---------------------------------------------------------------------------
    A taxpayer can elect to forgo the five-year carryback 
period. The election to forgo the five-year carryback period is 
made in the manner prescribed by the Secretary of the Treasury 
and must be made by the due date of the return (including 
extensions) for the year of the loss. The election is 
irrevocable. If a taxpayer elects to forgo the five-year 
carryback period, then the losses are subject to the rules that 
otherwise would apply under section 172 absent the 
provision.\93\
---------------------------------------------------------------------------
    \93\ Because JCWAA was enacted after some taxpayers had filed tax 
returns for years affected by the provision, a technical correction is 
needed to provide for a period of time in which prior decisions 
regarding the NOL carryback may be reviewed. Similarly, a technical 
correction is needed to modify the carryback adjustment procedures of 
sec. 6411 for NOLs arising in 2001 and 2002. These issues were 
addressed in a letter dated April 15, 2002, sent by the Chairmen and 
Ranking Members of the House Ways and Means Committee and Senate 
Finance Committee, as well as in guidance issued by the IRS pursuant to 
the Congressional letter (Rev. Proc. 2002-40, 2002-23 I.R.B. 1096, June 
10, 2002).
---------------------------------------------------------------------------
    JCWAA also provided that an NOL deduction attributable to 
NOL carrybacks arising in taxable years ending in 2001 and 
2002, as well as NOL carryforwards to these taxable years, may 
offset 100 percent of a taxpayer's AMTI.

                           REASONS FOR CHANGE

    The NOL carryback and carryover rules are designed to allow 
taxpayers to smooth out swings in business income (and Federal 
income taxes thereon) that result from business cycle 
fluctuations and unexpected financial losses. The uncertain 
economic conditions that resulted in the enactment of the 
extended carryback of NOLs as part of the JCWAA have continued. 
As a consequence, many taxpayers continue to incur unexpected 
financial losses. Thus, the Committee believes a three-year NOL 
carryback period provides taxpayers in all sectors of the 
economy who are experiencing such losses the ability to 
increase their cash flow through the refund of income taxes 
paid in prior years, which can be used for capital investment 
or other expenses that will provide stimulus to the economy.

                        EXPLANATION OF PROVISION

    The provision provides for a three-year carryback of NOLs 
for NOLs arising in taxable years ending in 2003.\94\
---------------------------------------------------------------------------
    \94\ Because certain taxpayers may have already filed tax returns 
(or be in the process of filing tax returns) for taxable years ending 
in 2003, the proposal contains special rules allowing taxpayers until 
April 15, 2004 to review prior decisions regarding an NOL carryback.
---------------------------------------------------------------------------
    The provision also allows an NOL deduction attributable to 
NOL carrybacks arising in taxable years ending in 2003 as well 
as NOL carryforwards to these taxable years, to offset 100 
percent of a taxpayer's AMTI.

                             EFFECTIVE DATE

    The three-year carryback provision is effective for net 
operating losses generated in taxable years ending in 2003. The 
provision relating to AMTI is effective for NOL carrybacks 
arising in, and NOL carryforwards to, taxable years ending in 
2003.

                   B. Manufacturing Relating to Films


1. Special rules for certain film and television production (sec. 321 
        of the bill and new sec. 181 of the Code)

                              PRESENT LAW

    The modified Accelerated Cost Recovery System (``MACRS'') 
does not apply to certain property, including any motion 
picture film, video tape, or sound recording, or to any other 
property if the taxpayer elects to exclude such property from 
MACRS and the taxpayer properly applies a unit-of-production 
method or other method of depreciation not expressed in a term 
of years. Section 197 does not apply to certain intangible 
property, including property produced by the taxpayer or any 
interest in a film, sound recording, video tape, book or 
similar property not acquired in a transaction (or a series of 
related transactions) involving the acquisition of assets 
constituting a trade or business or substantial portion 
thereof. Thus, the recovery of the cost of a film, video tape, 
or similar property that is produced by the taxpayer or is 
acquired on a ``stand-alone'' basis by the taxpayer may not be 
determined under either the MACRS depreciation provisions or 
under the section 197 amortization provisions. The cost 
recovery of such property may be determined under section 167, 
which allows a depreciation deduction for the reasonable 
allowance for the exhaustion, wear and tear, or obsolescence of 
the property. A taxpayer is allowed to recover, through annual 
depreciation deductions, the cost of certain property used in a 
trade or business or for the production of income. Section 
167(g) provides that the cost of motion picture films, sound 
recordings, copyrights, books, and patents are eligible to be 
recovered using the income forecast method of depreciation.

                           REASONS FOR CHANGE

    The Committee understands that over the past decade, 
production of American film projects has moved to foreign 
locations. Specifically, in recent years, a number of foreign 
governments have offered tax and other incentives designed to 
entice production of U.S. motion pictures and television 
programs to their countries. These governments have recognized 
that the benefits of hosting such productions do not flow only 
to the film and television industry. These productions create 
broader economic effects, with revenues and jobs generated in a 
variety of other local businesses. Hotels, restaurants, 
catering companies, equipment rental facilities, transportation 
vendors, and many others benefit from these productions.
    This has become a significant trend affecting the film and 
television industry as well as the small businesses that they 
support. The Committee understands that a recent report by the 
U.S. Department of Commerce estimated that runaway production 
drains as much as $10 billion per year from the U.S. economy. 
These losses have been most pronounced in made-for-television 
movies and miniseries productions. According to the report, out 
of the 308 U.S.-developed television movies produced in 1998, 
139 were produced abroad. This is a significant increase from 
the 30 produced abroad in 1990.
    The Committee believes the report makes a compelling case 
that runaway film and television production has eroded 
important segments of a vital American industry. According to 
official labor statistics, more than 270,000 jobs in the U.S. 
are directly involved in film production. By industry 
estimates, 70 to 80 percent of these workers are hired at the 
location where the production is filmed.
    The Committee believes this legislation will encourage 
producers to bring feature film and television production 
projects to cities and towns across the United States, thereby 
decreasing the runaway production problem.

                        EXPLANATION OF PROVISION

    The provision permits qualifying film and television 
productions to elect to deduct certain production expenditures 
in the year the expenditure is incurred in lieu of capitalizing 
the cost and recovering it through depreciation allowances.\95\
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    \95\ An election to deduct such costs shall be made in such manner 
as prescribed by the Secretary and by the due date (including 
extensions of time) for filing the taxpayer's return of tax for the 
taxable year in which production costs of such property are first 
incurred. An election may not be revoked without the consent of the 
Secretary. The Committee intends that, in the absence of specific 
guidance by the Secretary, deducting qualifying costs on the 
appropriate tax return shall constitute a valid election.
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    The provision limits the amount of production expenditures 
that may be expensed to $15 million for each qualifying 
production.\96\ An additional $5 million of production 
expenditures may be deducted (up to $20 million in total) if a 
significant amount of the production expenditures are incurred 
in areas eligible for designation as a low-income community or 
eligible for designation by the Delta Regional Authority as a 
distressed county or isolated area of distress. Expenditures in 
excess of $15 million ($20 million in distressed areas) are 
required to be recovered over a three-year period using the 
straight-line method beginning in the month such property is 
placed in service.
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    \96\ Thus, a qualifying film that is co-produced is limited to $15 
million of deduction. The benefits of this provision shall be allocated 
among the owners of a film in a manner that reasonably reflects each 
owner's proportionate investment in and economic interest in the film.
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    The provision defines a qualified film or television 
production as any production of a motion picture (whether 
released theatrically or directly to video cassette or any 
other format); miniseries; scripted, dramatic television 
episode; or movie of the week if at least 75 percent of the 
total compensation expended on the production are for services 
performed in the United States.\97\ With respect to property 
which is one or more episodes in a television series, only the 
first 44 episodes qualify under the proposal. Qualified 
property does not include sexually explicit productions as 
defined by section 2257 of title 18 of the U.S. Code.
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    \97\ The term compensation does not include participations and 
residuals.
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    The provision also requires the Commerce Department to 
report on whether the provision materially aided in retaining 
film production in the U.S. The report is required to be 
submitted to the Senate Committee on Finance and the House 
Committee on Ways and Means no later than December 31, 2006.

                             EFFECTIVE DATE

    The provision is effective for qualifying productions 
started after the date of enactment and sunsets for qualifying 
productions commencing after December 31, 2008.

2. Modification of application of income forecast method of 
        depreciation (sec. 322 of the bill and sec. 167 of the Code)

                              PRESENT LAW

Depreciation

    The modified Accelerated Cost Recovery System (``MACRS'') 
does not apply to certain property, including any motion 
picture film, video tape, or sound recording, or to any other 
property if the taxpayer elects to exclude such property from 
MACRS and the taxpayer properly applies a unit-of-production 
method or other method of depreciation not expressed in a term 
of years. Section 197 does not apply to certain intangible 
property, including property produced by the taxpayer or any 
interest in a film, sound recording, video tape, book or 
similar property not acquired in a transaction (or a series of 
related transactions) involving the acquisition of assets 
constituting a trade or business or substantial portion 
thereof. Thus, the recovery of the cost of a film, video tape, 
or similar property that is produced by the taxpayer or is 
acquired on a ``stand-alone'' basis by the taxpayer may not be 
determined under either the MACRS depreciation provisions or 
under the section 197 amortization provisions. The cost 
recovery of such property may be determined under section 167, 
which allows a depreciation deduction for the reasonable 
allowance for the exhaustion, wear and tear, or obsolescence of 
the property. A taxpayer is allowed to recover, through annual 
depreciation deductions, the cost of certain property used in a 
trade or business or for the production of income. Section 
167(g) provides that the cost of motion picture films, sound 
recordings, copyrights, books, and patents are eligible to be 
recovered using the income forecast method of depreciation.

Income forecast method of depreciation

    Under the income forecast method, a property's depreciation 
deduction for a taxable year is determined by multiplying the 
adjusted basis of the property by a fraction, the numerator of 
which is the income generated by the property during the year 
and the denominator of which is the total forecasted or 
estimated income expected to be generated prior to the close of 
the tenth taxable year after the year the property was placed 
in service. Any costs that are not recovered by the end of the 
tenth taxable year after the property was placed in service may 
be taken into account as depreciation in such year.
    The adjusted basis of property that may be taken into 
account under the income forecast method only includes amounts 
that satisfy the economic performance standard of section 
461(h). In addition, taxpayers that claim depreciation 
deductions under the income forecast method are required to pay 
(or receive) interest based on a recalculation of depreciation 
under a ``look-back'' method.
    The ``look-back'' method is applied in any ``recomputation 
year'' by: (1) comparing depreciation deductions that had been 
claimed in prior periods to depreciation deductions that would 
have been claimed had the taxpayer used actual, rather than 
estimated, total income from the property; (2) determining the 
hypothetical overpayment or underpayment of tax based on this 
recalculated depreciation; and (3) applying the overpayment 
rate of section 6621 of the Code. Except as provided in 
Treasury regulations, a ``recomputation year'' is the third and 
tenth taxable year after the taxable year the property was 
placed in service, unless the actual income from the property 
for each taxable year ending with or before the close of such 
years was within 10-percent of the estimated income from the 
property for such years.

                           REASONS FOR CHANGE

    The Committee is aware that taxpayers and the IRS have 
expended significant resources in auditing and litigating 
disputes regarding the proper treatment of participations and 
residuals for purposes of computing depreciation under the 
income forecast method of depreciation. The Committee 
understands that these issues relate solely to the timing of 
deductions and not to whether such costs are valid deductions. 
In addition, the Committee is aware of other disagreements 
between taxpayers and the Treasury Department regarding the 
mechanics of the income forecast formula. The Committee 
believes expending taxpayer and government resources disputing 
these items is an unproductive use of economic resources. As 
such, the provision addresses the issues and eliminates any 
uncertainty as to the proper tax treatment of these items.

                        EXPLANATION OF PROVISION

    The provision clarifies that, solely for purposes of 
computing the allowable deduction for property under the income 
forecast method of depreciation, participations and residuals 
may be included in the adjusted basis of the property beginning 
in the year such property is placed in service, but only if 
such participations and residuals relate to income to be 
derived from the property before the close of the tenth taxable 
year following the year the property is placed in service (as 
defined in section 167(g)(1)(A)). For purposes of the 
provision, participations and residuals are defined as costs 
the amount of which, by contract, varies with the amount of 
income earned in connection with such property. The provision 
also clarifies that the income from the property to be taken 
into account under the income forecast method is the gross 
income from such property.
    The provision also grants authority to the Treasury 
Department to prescribe appropriate adjustments to the basis of 
property (and the look-back method) to reflect the treatment of 
participations and residuals under the provision.
    In addition, the provision clarifies that, in the case of 
property eligible for the income forecast method that the 
holding in the Associated Patentees \98\ decision will continue 
to constitute a valid method. Thus, rather than accounting for 
participations and residuals as a cost of the property under 
the income forecast method of depreciation, the taxpayer may 
deduct those payments as they are paid as under the Associated 
Patentees decision. This may be done on a property-by-property 
basis and shall be applied consistently with respect to a given 
property thereafter. The provision also clarifies that 
distribution costs are not taken into account for purposes of 
determining the taxpayer's current and total forecasted income 
with respect to a property.
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    \98\ Associated Patentees, Inc. v. Commissioner, 4 T.C. 979 (1945).
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                             EFFECTIVE DATE

    The provision applies to property placed in service after 
date of enactment. No inference is intended as to the 
appropriate treatment under present law. It is intended that 
the Treasury Department and the IRS expedite the resolution of 
open cases. In resolving these cases in an expedited and 
balanced manner, the Treasury Department and IRS are encouraged 
to take into account the principles of the provision.

                  C. Manufacturing Relating to Timber


1. Expensing of reforestation expenses (sec. 331 of the bill and sec. 
        194 of the Code)

                              PRESENT LAW

Amortization of reforestation costs (sec. 194)

    A taxpayer may elect to amortize up to $10,000 ($5,000 in 
the case of a separate return by a married individual) of 
qualifying reforestation expenditures incurred during the 
taxable year with respect to qualifying timber property. 
Amortization is taken over 84 months (seven years) and is 
subject to a mandatory half-year convention. In the case of an 
individual, the amortization deduction is allowed in 
determining adjusted gross income (i.e., an ``above-the-line 
deduction'') rather than as an itemized deduction.
    Qualifying reforestation expenditures are the direct costs 
a taxpayer incurs in connection with the forestation or 
reforestation of a site by planting or seeding, and include 
costs for the preparation of the site, the cost of the seed or 
seedlings, and the cost of the labor and tools (including 
depreciation of long lived assets such as tractors and other 
machines) used in the reforestation activity. Qualifying 
reforestation expenditures do not include expenditures that 
would otherwise be deductible and do not include costs for 
which the taxpayer has been reimbursed under a governmental 
cost sharing program, unless the amount of the reimbursement is 
also included in the taxpayer's gross income.
    The amount amortized is reduced by one half of the amount 
of reforestation credit claimed under section 48(b) (see 
below). Reforestation amortization is subject to recapture as 
ordinary income on sale of qualifying timber property within 10 
years of the year in which the qualifying reforestation 
expenditures were incurred.

Reforestation tax credit (sec. 48(b))

    A tax credit is allowed equal to 10 percent of the 
reforestation expenditures incurred during the year that are 
properly elected to be amortized. An amount allowed as a credit 
is subject to recapture if the qualifying timber property to 
which the expenditure relates is disposed of within five years.

                           REASONS FOR CHANGE

    The Committee believes it is important to encourage 
taxpayers to make investments in reforestation. The Committee 
believes that by shortening the recovery period of such outlays 
taxpayers will find a greater investment return to investments 
in reforestation. In addition, the Committee observes that 
elimination of the overlapping amortization and credit 
provisions of present law will simplify tax computation, record 
keeping, and tax return filing for taxpayers.\99\
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    \99\ The Committee notes that the staff of the Joint Committee on 
Taxation identified the overlap of amortization of reforestation 
expenses and the credit for reforestation expenses as an area of 
complexity and recommended that the overlapping provisions be replaced 
with expensing of qualifying expenses. Joint Committee on Taxation, 
Study of the Overall State of the Federal Tax System and 
Recommendations for Simplification, Pursuant to Section 8022(3)(B) of 
the Internal Revenue Code of 1986 (JCS-3-01), April 2001, Volume II, p. 
463.
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                        EXPLANATION OF PROVISION

    The bill permits taxpayers to elect to deduct (i.e., 
expense) up to $10,000 ($5,000 in the case of a separate return 
by a married individual) of qualifying reforestation 
expenditures incurred during the taxable year with respect to 
qualifying timber property. Any expenses above $10,000 ($5,000) 
would be amortized over a seven-year period.
    The provision replaces the credit provisions of present 
law.

                             EFFECTIVE DATE

    The provision is effective for expenditures paid or 
incurred after date of enactment.

2. Election to treat cutting of timber as a sale or exchange (sec. 332 
        of the bill and sec. 631(a) of the Code)

                              PRESENT LAW

    Under present law, a taxpayer may elect to treat the 
cutting of timber as a sale or exchange of the timber. If an 
election is made, the gain or loss is recognized in an amount 
equal to the difference between the fair market value of the 
timber and the basis of the timber. An election, once made, is 
effective for the taxable year and all subsequent taxable 
years, unless the IRS, upon a showing of undue hardship by the 
taxpayer, permits the revocation of the election. If an 
election is revoked, a new election may be made only with the 
consent of the IRS.

                           REASONS FOR CHANGE

    The Committee believes that changes made in the tax law 
should allow a taxpayer to revoke its election to treat the 
cutting of timber as a sale or exchange.

                        EXPLANATION OF PROVISION

    Under the provision, an election made for a taxable year 
ending on or before the date of enactment, to treat the cutting 
of timber as a sale or exchange, may be revoked by the taxpayer 
without the consent of the IRS for any taxable year ending 
after that date. The prior election (and revocation) is 
disregarded for purposes of making a subsequent election.\100\
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    \100\ The present-law rules of section 631(a) apply to any 
subsequent election.
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                             EFFECTIVE DATE

    The provision is effective on date of enactment.

3. Capital gains treatment to apply to outright sales of timber by 
        landowner (sec. 333 of the bill and sec. 631(b) of the Code)

                              PRESENT LAW

    Under present law, a taxpayer disposing of timber held for 
more than one year is eligible for capital gains treatment in 
three situations. First, if the taxpayer sells or exchanges 
timber that is a capital asset (sec. 1221) or property used in 
the trade or business (sec. 1231), the gain generally is long-
term capital gain; however, if the timber is held for sale to 
customers in the taxpayer's business, the gain will be ordinary 
income. Second, if the taxpayer disposes of the timber with a 
retained economic interest, the gain is eligible for capital 
gain treatment (sec. 631(b)). Third, if the taxpayer cuts 
standing timber, the taxpayer may elect to treat the cutting as 
a sale or exchange eligible for capital gains treatment (sec. 
631(a)).

                           REASONS FOR CHANGE

    The Committee believes that the requirement that the owner 
of timber retain an economic interest in the timber in order to 
obtain capital gain treatment under section 631(b) results in 
poor timber management. Under present law, the buyer, when 
cutting and removing timber, has no incentive to protect young 
or other uncut trees because the buyer only pays for the timber 
that is cut and removed. Therefore, the Committee bill 
eliminates this requirement and provides for capital gain 
treatment under section 631(b) in the case of outright sales of 
timber.

                        EXPLANATION OF PROVISION

    Under the provision, in the case of a sale of timber by the 
owner of the land from which the timber is cut, the requirement 
that a taxpayer retain an economic interest in the timber in 
order to treat gains as capital gain under section 631(b) does 
not apply. Outright sales of timber by the landowner will 
qualify for capital gains treatment in the same manner as sales 
with a retained economic interest qualify under present law, 
except that the usual tax rules relating to the timing of the 
income from the sale of the timber will apply (rather than the 
special rule of section 631(b) treating the disposal as 
occurring on the date the timber is cut).

                             EFFECTIVE DATE

    The provision is effective for sales of timber after the 
date of enactment.

4. Modified safe harbor rules for timber REITs (sec. 334 of the bill 
        and sec. 857 of the Code)

                              PRESENT LAW

In general

    Under present law, real estate investment trusts 
(``REITs'') are subject to a special taxation regime. Under 
this regime, a REIT is allowed a deduction for dividends paid 
to its shareholders. As a result, REITs generally do not pay 
tax on distributed income. REITs are generally restricted to 
earning certain types of passive income, primarily rents from 
real property and interests on mortgages secured by real 
property.
    To qualify as a REIT, a corporation must satisfy a number 
of requirements, among which are four tests: organizational 
structure, source of income, nature of assets, and distribution 
of income.

Income or loss from prohibited transactions

    A 100-percent tax is imposed on the net income of a REIT 
from ``prohibited transactions''. A prohibited transaction is 
the sale or other disposition of property held for sale in the 
ordinary course of a trade or business,\101\ other than 
foreclosure property.\102\ A safe harbor is provided for 
certain sales of rent producing real property. To qualify for 
the safe harbor, three criteria generally must be met. First, 
the REIT must have held the property for at least four years 
for rental purposes. Second, the aggregate expenditures made by 
the REIT during the four-year period prior to the date of the 
sale must not exceed 30 percent of the net selling price of the 
property. Third, either (i) the REIT must make 7 or fewer sales 
of property during the taxable year or (ii) the aggregate 
adjusted basis of the property sold must not exceed 10 percent 
of the aggregate bases of all the REIT's assets at the 
beginning of the REIT's taxable year. In the latter case, 
substantially all of the marketing and development expenditures 
with respect to the property must be made through an 
independent contractor.
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    \101\ Sec. 1221(a)(l).
    \102\ Thus, the 100-percent tax on prohibited transactions helps to 
ensure that the REIT is a passive entity and may not engage in ordinary 
retailing activities such as sales to customers of condominium units or 
subdivided lots in a development project.
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Certain timber income

    Some REITs have been formed to hold land on which trees are 
grown. Upon maturity of the trees, the standing trees are sold 
by the REIT. The Internal Revenue Service has issued private 
letter rulings in particular instances stating that the income 
from the sale of the trees can qualify as REIT real property 
income because the uncut timber and the timberland on which the 
timber grew is considered real property and the sale of uncut 
trees can qualify as capital gain derived from the sale of real 
property.\103\
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    \103\ See, e.g., PLR 200052021, PLR 199945055, PLR 19927021, PLR 
8838016. A private letter ruling may be relied upon only by the 
taxpayer to which the ruling is issued. However, such rulings provide 
an indication of administrative practice.
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Limitation on investment in other entities

    A REIT is limited in the amount that it can own in other 
corporations. Specifically, a REIT cannot own securities (other 
than Government securities and certain real estate assets) in 
an amount greater than 25 percent of the value of REIT assets. 
In addition, it cannot own such securities of any one issuer 
representing more than five percent of the total value of REIT 
assetsor more than 10 percent of the voting securities or 10 
percent of the value of the outstanding securities of any one issuer. 
Securities for purposes of these rules are defined by reference to the 
Investment Company Act of 1940.\104\
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    \104\ Certain securities that are within a safe-harbor definition 
of ``straight debt'' are not taken into account for purposes of the 
limitation to no more than 10 percent of the value of an issuer's 
outstanding securities.
---------------------------------------------------------------------------
            Special rules for Taxable REIT subsidiaries
    Under an exception to the general rule limiting REIT 
securities ownership of other entities, a REIT can own stock of 
a taxable REIT subsidiary (``TRS''), generally, a corporation 
other than a REIT \105\ with which the REIT makes a joint 
election to be subject to special rules. A TRS can engage in 
active business operations that would produce income that would 
not be qualified income for purposes of the 95-percent or 75-
percent income tests for a REIT, and that income is not 
attributed to the REIT. Transactions between a TRS and a REIT 
are subject to a number of specified rules that are intended to 
prevent the TRS (taxable as a separate corporate entity) from 
shifting taxable income from its activities to the pass through 
entity REIT or from absorbing more than its share of expenses. 
Under one rule, a 100-percent excise tax is imposed on rents, 
deductions, or interest paid by the TRS to the REIT to the 
extent such items would exceed an arm's length amount as 
determined under section 482.\106\
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    \105\ Certain corporations are not eligible to be a TRS, such as a 
corporation which directly or indirectly operates or manages a lodging 
facility or a health care facility or directly or indirectly provides 
to any other person rights to a brand name under which any lodging 
facility or health care facility is operated. Sec. 856(l)(3).
    \106\ If the excise tax applies, the item is not also reallocated 
back to the TRS under section 482.
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                           REASONS FOR CHANGE

    The Committee believes it is appropriate to provide a safe 
harbor from the prohibited transactions rules, to permit a REIT 
that holds timberland to make sales of timber property, 
provided there is not significant development of the property. 
A similar provision already exists for rental properties.

                        EXPLANATION OF PROVISION

    Under the provision, a sale of a real estate asset by a 
REIT will not be a prohibited transaction if the following six 
requirements are met:
          (1) The asset must have been held for at least four 
        years in the trade or business of producing timber;
          (2) The aggregate expenditures made by the REIT (or a 
        partner of the REIT) during the four-year period 
        preceding the date of sale that are includible in the 
        basis of the property (other than timberland 
        acquisition expenditures \107\) and that are directly 
        related to the operation of the property for the 
        production of timber or for the preservation of the 
        property for use as timberland must not exceed 30 
        percent of the net selling price of the property;
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    \107\ The timberland acquisition expenditures that are excluded for 
this purpose are those expenditures that are related to timberland 
other than the specific timberland that is being sold under the safe 
harbor, but costs of which may be combined with costs of such property 
in the same ``management block'' under Treasury regulations section 
1.611-3(d). Any specific timberland being sold must meet the 
requirement that it has been held for at least four years by the REIT 
in order to qualify for the safe harbor.
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          (3) The aggregate expenditures made by the REIT (or a 
        partner of the REIT) during the four-year period 
        preceding the date of sale that are includible in the 
        basis of the property and that are not directly related 
        to the operation of the property for the production of 
        timber or the preservation of the property for use as 
        timberland must not exceed five percent of the net 
        selling price of the property;
          (4) The REIT either (a) does not make more than seven 
        sales of property (other than sales of foreclosure 
        property or sales to which 1033 applies) or (b) the 
        aggregate adjusted bases (as determined for purposes of 
        computing earnings and profits) of property sold during 
        the year (other than sales of foreclosure property or 
        sales to which 1033 applies) does not exceed 10 percent 
        of the aggregate bases (as determined for purposes of 
        computing earnings and profits) of property of all 
        assets of the REIT as of the beginning of the year;
          (5) Substantially all of the marketing expenditures 
        with respect to the property are made by persons who 
        are independent contractors (as defined by section 
        856(d)(3)) with respect to the REIT and from whom the 
        REIT does not derive any income; and
          (6) The sales price on the sale of the property 
        cannot be based in whole or in part on income or 
        profits of any person, including income or profits 
        derived from the sale of such properties.
    Capital expenditures counted towards the 30-percent limit 
are those expenditures that are includible in the basis of the 
property (other than timberland acquisition expenditures), and 
that are directly related to operation of the property for the 
production of timber, or for the preservation of the property 
for use as timberland. These capital expenditures are those 
incurred directly in the operation of raising timber (i.e., 
silviculture), as opposed to capital expenditures incurred in 
the ownership of undeveloped land. In general, these capital 
expenditures incurred directly in the operation of raising 
timber include capital expenditures incurred by the REIT to 
create an established stand of growing trees. A stand of trees 
is considered established when a target stand exhibits the 
expected growing rate and is free of non-target competition 
(e.g., hardwoods, grasses, brush, etc.) that may significantly 
inhibit or threaten the target stand survival. The costs 
commonly incurred during stand establishment are: (1) site 
preparation including manual or mechanical scarification, 
manual or mechanical cutting, disking, bedding, shearing, 
raking, piling, broadcast and windrow/pile burning (including 
slash disposal costs as required for stand establishment); (2) 
site regeneration including manual or mechanical hardwood 
coppice; (3) chemical application via aerial or ground to 
eliminate or reduce vegetation; (4) nursery operating costs 
including personnel salaries and benefits, facilities costs, 
cone collection and seed extraction, and other costs directly 
attributable to the nursery operations (to the extent such 
costs are allocable to seedlings used by the REIT); (5) 
seedlings including storage, transportation and handling 
equipment; (6) direct planting of seedlings; and (7) initial 
stand fertilization, up through stand establishment. Other 
examples of capital expenditures incurred directly in the 
operation of raising timber include construction cost of road 
to be used for managing the timber land (including for removal 
of logs or fire protection), environmental costs (i.e., habitat 
conservation plans), and any other post stand establishment 
capital costs (e.g., ``mid-term fertilization costs).''
    Capital expenditures counted towards the 5-percent limit 
are those capital expenditures incurred in the ownership of 
undeveloped land that are not incurred in the direct operation 
of raising timber (i.e., silviculture). This category of 
capital expenditures includes: (1) expenditures to separate the 
REIT's holdings of land into separate parcels; (2) costs of 
granting leases or easements to cable, cellular or similar 
companies; (3) costs in determining the presence or quality of 
minerals located on the land; (4) costs incurred to defend 
changes in law that would limit future use of the land by the 
REIT or a purchaser from the REIT; (5) costs incurred to 
determine alternative uses of the land (e.g., recreational 
use); and (6) development costs of the property incurred by the 
REIT (e.g., engineering, surveying, legal, permit, consulting, 
road construction, utilities, and other development costs for 
use other than to grow timber).
    Costs that are not includible in the basis of the property 
are not counted towards either the 30-percent or five-percent 
requirements.

                             EFFECTIVE DATE

    The provision is effective for taxable years beginning 
after the date of enactment.

                    TITLE IV--ADDITIONAL PROVISIONS


             A. Provisions Designed to Curtail Tax Shelters


1. Clarification of the economic substance doctrine (sec. 401 of the 
        bill and sec. 7701 of the Code)

                              PRESENT LAW

In general

    The Code provides specific rules regarding the computation 
of taxable income, including the amount, timing, source, and 
character of items of income, gain, loss and deduction. These 
rules are designed to provide for the computation of taxable 
income in a manner that provides for a degree of specificity to 
both taxpayers and the government. Taxpayers generally may plan 
their transactions in reliance on these rules to determine the 
Federal income tax consequences arising from the transactions.
    In addition to the statutory provisions, courts have 
developed several doctrines that can be applied to deny the tax 
benefits of tax motivated transactions, notwithstanding that 
the transaction may satisfy the literal requirements of a 
specific tax provision. The common-law doctrines are not 
entirely distinguishable, and their application to a given set 
of facts is often blurred by the courts and the IRS. Although 
these doctrines serve an important role in the administration 
of the tax system, invocation of these doctrines can be seen as 
at odds with an objective, ``rule-based'' system of taxation. 
Nonetheless, courts have applied the doctrines to deny tax 
benefits arising from certain transactions.\108\
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    \108\ See, e.g., ACM Partnership v. Commissioner, 157 F.3d 231 (3d 
Cir. 1998), aff'g 73 T.C.M. (CCH) 2189 (1997), cert. denied 526 U.S. 
1017 (1999).
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    A common-law doctrine applied with increasing frequency is 
the ``economic substance'' doctrine. In general, this doctrine 
denies tax benefits arising from transactions that do not 
result in a meaningful change to the taxpayer's economic 
position other than a purported reduction in Federal income 
tax.\109\
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    \109\ Closely related doctrines also applied by the courts 
(sometimes interchangeable with the economic substance doctrine) 
include the ``sham transaction doctrine'' and the ``business purpose 
doctrine''. See, e.g., Knetsch v. United States, 364 U.S. 361 (1960) 
(denying interest deductions on a ``sham transaction'' whose only 
purpose was to create the deductions).
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            Economic substance doctrine
    Courts generally deny claimed tax benefits if the 
transaction that gives rise to those benefits lacks economic 
substance independent of tax considerations--notwithstanding 
that the purported activity actually occurred. The tax court 
has described the doctrine as follows:

          The tax law * * * requires that the intended 
        transactions have economic substance separate and 
        distinct from economic benefit achieved solely by tax 
        reduction. The doctrine of economic substance becomes 
        applicable, and a judicial remedy is warranted, where a 
        taxpayer seeks to claim tax benefits, unintended by 
        Congress, by means of transactions that serve no 
        economic purpose other than tax savings.\110\
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    \110\ ACM Partnership v. Commissioner, 73 T.C.M. at 2215.
---------------------------------------------------------------------------
            Business purpose doctrine
    Another common law doctrine that overlays and is often 
considered together with (if not part and parcel of) the 
economic substance doctrine is the business purpose doctrine. 
The business purpose test is a subjective inquiry into the 
motives of the taxpayer--that is, whether the taxpayer intended 
the transaction to serve some useful non-tax purpose. In making 
this determination, some courts have bifurcated a transaction 
in which independent activities with non-tax objectives have 
been combined with an unrelated item having only tax-avoidance 
objectives in order to disallow the tax benefits of the overall 
transaction.\111\
---------------------------------------------------------------------------
    \111\ ACM Partnership v. Commissioner, 157 F.3d at 256 n.48.
---------------------------------------------------------------------------

Application by the courts

            Elements of the doctrine
    There is a lack of uniformity regarding the proper 
application of the economic substance doctrine.\112\ Some 
courts apply a conjunctive test that requires a taxpayer to 
establish the presence of both economic substance (i.e., the 
objective component) and business purpose (i.e., the subjective 
component) in order for the transaction to survive judicial 
scrutiny.\113\ A narrower approach used by some courts is to 
conclude that either a business purpose or economic substance 
is sufficient to respect the transaction).\114\ A third 
approach regards economic substance and business purpose as 
``simply more precise factors to consider'' in determining 
whether a transaction has any practical economic effects other 
than the creation of tax benefits.\115\
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    \112\ ``The casebooks are glutted with [economic substance] tests. 
Many such tests proliferate because they give the comforting illusion 
of consistency and precision. They often obscure rather than clarify.'' 
Collins v. Commissioner, 857 F.2d 1383, 1386 (9th Cir. 1988).
    \113\ See, e.g., Pasternak v. Commissioner, 990 F.2d 893, 898 (6th 
Cir. 1993) (``The threshold question is whether the transaction has 
economic substance. If the answer is yes, the question becomes whether 
the taxpayer was motivated by profit to participate in the 
transaction.'')
    \114\ See, e.g., Rice's Toyota World v. Commissioner, 752 F.2d 89, 
91-92 (4th Cir. 1985) (``To treat a transaction as a sham, the court 
must find that the taxpayer was motivated by no business purposes other 
than obtaining tax benefits in entering the transaction, and, second, 
that the transaction has no economic substance because no reasonable 
possibility of a profit exists.''); IES Industries v. United States, 
253 F.3d 350, 358 (8th Cir. 2001) (``In determining whether a 
transaction is a sham for tax purposes [under the Eighth Circuit test], 
a transaction will be characterized as a sham if it is not motivated by 
any economic purpose out of tax considerations (the business purpose 
test), and if it is without economic substance because no real 
potential for profit exists'' (the economic substance test).'') As 
noted earlier, the economic substance doctrine and the sham transaction 
doctrine are similar and sometimes are applied interchangeably. For a 
more detailed discussion of the sham transaction doctrine, see, e.g., 
Joint Committee on Taxation, Study of Present-Law Penalty and Interest 
Provisions as Required by Section 3801 of the Internal Revenue Service 
Restructuring and Reform Act of 1998 (including Provisions Relating to 
Corporate Tax Shelters) (JCS-3-99) at 182.
    \115\ See, e.g., ACM Partnership v. Commissioner, 157 F.3d at 247; 
James v. Commissioner, 899 F.2d 905, 908 (10th Cir. 1995); Sacks v. 
Commissioner, 69 F.3d 982, 985 (9th Cir. 1995) (``Instead, the 
consideration of business purpose and economic substance are simply 
more precise factors to consider. * * * We have repeatedly and 
carefully noted that this formulation cannot be used as a 'rigid two-
step analysis'.'').
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            Profit potential
    There also is a lack of uniformity regarding the necessity 
and level of profit potential necessary to establish economic 
substance. Since the time of Gregory v. Helvering,\116\ several 
courts have denied tax benefits on the grounds that the subject 
transactions lacked profit potential.\117\ In addition, some 
courts have applied the economic substance doctrine to disallow 
tax benefits in transactions in which a taxpayer was exposed to 
risk and the transaction had a profit potential, but the court 
concluded that the economic risks and profit potential were 
insignificant when compared to the tax benefits.\118\ Under 
this analysis, the taxpayer's profit potential must be more 
than nominal. Conversely, other courts view the application of 
the economic substance doctrine as requiring an objective 
determination of whether a ``reasonable possibility of profit'' 
from the transaction existed apart from the tax benefits.\119\ 
In these cases, in assessing whether a reasonable possibility 
of profit exists, it is sufficient if there is a nominal amount 
of pre-tax profit as measured against expected net tax 
benefits.
---------------------------------------------------------------------------
    \116\ 293 U.S. 465 (1935).
    \117\ See, e.g., Knetsch, 364 U.S. at 361; Goldstein v. 
Commissioner, 364 F.2d 734 (2d Cir. 1966) (holding that an 
unprofitable, leveraged acquisition of Treasury bills, and accompanying 
prepaid interest deduction, lacked economic substance); Ginsburg v. 
Commissioner, 35 T.C.M. (CCH) 860 (1976) (holding that a leveraged 
cattle-breeding program lacked economic substance).
    \118\ See, e.g., Goldstein v. Commissioner, 364 F.2d at 739-40 
(disallowing deduction even though taxpayer had a possibility of small 
gain or loss by owning Treasury bills); Sheldon v. Commissioner, 94 
T.C. 738, 768 (1990) (stating, ``potential for gain * * * is 
infinitesimally nominal and vastly insignificant when considered in 
comparison with the claimed deductions'').
    \119\ See, e.g., Rice's Toyota World v. Commissioner, 752 F.2d at 
94 (the economic substance inquiry requires an objective determination 
of whether a reasonable possibility of profit from the transaction 
existed apart from tax benefits); Compaq Computer Corp. v. 
Commissioner, 277 F.3d at 781 (applied the same test, citing Rice's 
Toyota World); IES Industries v. United States, 253 F.3d at 354 (the 
application of the objective economic substance test involves 
determining whether there was a ``reasonable possibility of profit * * 
* apart from tax benefits.'').
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                           REASONS FOR CHANGE

    The Committee is concerned that many taxpayers are engaging 
in tax avoidance transactions that rely on the interaction of 
highly technical tax law provisions.\120\ These transactions 
usually produce surprising results that were not contemplated 
by Congress. Whether these transactions are respected usually 
hinges on whether the transaction had sufficient economic 
substance. The Committee is concerned that in addressing these 
transactions the courts, in some cases, are reaching 
conclusions inconsistent with Congressional intent. In 
addition, the Committee is concerned that in determining 
whether a transaction has economic substance, taxpayers are 
subject to different legal standards based on the circuit in 
which the taxpayer is located. Thus, the Committee believes it 
is appropriate to clarify for the courts the appropriate 
standards to use in determining whether a transaction has 
economic substance.
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    \120\ The Committee agrees with the famous statement of Judge Hand 
that ``[a]nyone may so arrange his affairs that his taxes shall be as 
low as possible * * *.'' Helvering v. Gregory, 69 F.2d 809, 810 (2d 
Cir. 1934). However, the Committee also agrees with the more recent 
statement of the court in Saviano v. Commissioner, 765 F.2d 643, 654 
(7th Cir. 1985), which said:

        We have no quarrel with [Judge Hand's statement]; 
      however, a caveat must be considered in conjunction with 
      it. The freedom to arrange one's affairs to minimize taxes 
      does not include the right to engage in financial fantasies 
      with the expectation that the Internal Revenue Service and 
      the courts will play along. The Commissioner and the courts 
      are empowered, and in fact duty-bound, to look beyond the 
      contrived forms of transactions to their economic substance 
      and to apply the tax laws accordingly. That is what we have 
      done in this case and that is what taxpayers should expect 
      in the future.

                        EXPLANATION OF PROVISION

In general

    The provision clarifies and enhances the application of the 
economic substance doctrine. The provision provides that, in a 
case in which a court determines that the economic substance 
doctrine is relevant to a transaction (or a series of 
transactions), such transaction (or series of transactions) has 
economic substance (and thus satisfies the economic substance 
doctrine) only if the taxpayer establishes that: (1) the 
transaction changes in a meaningful way (apart from Federal 
income tax consequences) the taxpayer's economic position; and 
(2) the taxpayer has a substantial non-tax purpose for entering 
into such transaction and the transaction is a reasonable means 
of accomplishing such purpose.\121\
---------------------------------------------------------------------------
    \121\ If the tax benefits are clearly contemplated and expected by 
the language and purpose of the relevant authority, it is not intended 
that such tax benefits be disallowed if the only reason for such 
disallowance is that the transaction fails the economic substance 
doctrine as defined in this provision.
---------------------------------------------------------------------------
    The provision does not change current law standards used by 
courts in determining when to utilize an economic substance 
analysis.\122\ Also, the provision does not alter the court's 
ability to aggregate, disaggregate or otherwise recharacterize 
a transaction when applying the doctrine.\123\ The provision 
provides a uniform definition of economic substance, but does 
not alter the flexibility of the courts in other respects.
---------------------------------------------------------------------------
    \122\ See, e.g., Treas. Reg. 1.269-2, stating that characteristic 
of circumstances in which a deduction otherwise allowed will be 
disallowed are those in which the effect of the deduction, credit, or 
other allowance would be to distort the liability of the particular 
taxpayer when the essential nature of the transaction or situation is 
examined in the light of the basic purpose or plan which the deduction, 
credit, or other allowance was designed by the Congress to effectuate.
    \123\ See, e.g., Minnesota Tea Co. v. Helvering, 302 U.S. 609, 613 
(1938) (``A given result at the end of a straight path is not made a 
different result because reached by following a devious path.'').
---------------------------------------------------------------------------

Conjunctive analysis

    The provision clarifies that the economic substance 
doctrine involves a conjunctive analysis--there must be an 
objective inquiry regarding the effects of the transaction on 
the taxpayer's economic position, as well as a subjective 
inquiry regarding the taxpayer's motives for engaging in the 
transaction. Under the provision, a transaction must satisfy 
both tests--i.e., it must change in a meaningful way (apart 
from Federal income tax consequences) the taxpayer's economic 
position, and the taxpayer must have a substantial non-tax 
purpose for entering into such transaction (and the transaction 
is a reasonable means of accomplishing such purpose)--in order 
to satisfy the economic substance doctrine. This clarification 
eliminates the disparity that exists among the circuits 
regarding the application of the doctrine, and modifies its 
application in those circuits in which either a change in 
economic position or a non-tax business purpose (without having 
both) is sufficient to satisfy the economic substance doctrine.

Non-tax business purpose

    The provision provides that a taxpayer's non-tax purpose 
for entering into a transaction (the second prong in the 
analysis) must be ``substantial,'' and that the transaction 
must be ``a reasonable means'' of accomplishing such purpose. 
Under this formulation, the non-tax purpose for the transaction 
must bear a reasonable relationship to the taxpayer's normal 
business operations or investment activities.\124\
---------------------------------------------------------------------------
    \124\ See, e.g., Treas. reg. sec. 1.269-2(b) (stating that a 
distortion of tax liability indicating the principal purpose of tax 
evasion or avoidance might be evidenced by the fact that ``the 
transaction was not undertaken for reasons germane to the conduct of 
the business of the taxpayer''). Similarly, in ACM Partnership v. 
Commissioner, 73 T.C.M. (CCH) 2189 (1997), the court stated:

        Key to [the determination of whether a transaction has 
      economic substance] is that the transaction must be 
      rationally related to a useful nontax purpose that is 
      plausible in light of the taxpayer's conduct and useful in 
      light of the taxpayer's economic situation and intentions. 
      Both the utility of the stated purpose and the rationality 
      of the means chosen to effectuate it must be evaluated in 
      accordance with commercial practices in the relevant 
      industry. A rational relationship between purpose and means 
      ordinarily will not be found unless there was a reasonable 
      expectation that the nontax benefits would be at least 
      commensurate with the transaction costs. [citations 
---------------------------------------------------------------------------
      omitted]

    See also Martin McMahon Jr., Economic Substance, Purposive 
Activity, and Corporate Tax Shelters, 94 Tax Notes 1017, 1023 (Feb. 25, 
2002) (advocates ``confining the most rigorous application of business 
purpose, economic substance, and purposive activity tests to 
transactions outside the ordinary course of the taxpayer's business--
those transactions that do not appear to contribute to any business 
activity or objective that the taxpayer may have had apart from tax 
planning but are merely loss generators.''); Mark P. Gergen, The Common 
Knowledge of Tax Abuse, 54 SMU L. Rev. 131, 140 (Winter 2001) (``The 
message is that you can pick up tax gold if you find it in the street 
while going about your business, but you cannot go hunting for it.'').
---------------------------------------------------------------------------
    In determining whether a taxpayer has a substantial non-tax 
business purpose, an objective of achieving a favorable 
accounting treatment for financial reporting purposes will not 
be treated as having a substantial non-tax purpose.\125\ 
Furthermore, a transaction that is expected to increase 
financial accounting income as a result of generating tax 
deductions or losses without a corresponding financial 
accounting charge (i.e., a permanent book-tax difference) \126\ 
should not be considered to have a substantial non-tax purpose 
unless a substantial non-tax purpose exists apart from the 
financial accounting benefits.\127\
---------------------------------------------------------------------------
    \125\ However, if the tax benefits are clearly contemplated and 
expected by the language and purpose of the relevant authority, such 
tax benefits should not be disallowed solely because the transaction 
results in a favorable accounting treatment. An example is the repealed 
foreign sales corporation rules.
    \126\ This includes tax deductions or losses that are anticipated 
to be recognized in a period subsequent to the period the financial 
accounting benefit is recognized. For example, FAS 109 in some cases 
permits the recognition of financial accounting benefits prior to the 
period in which the tax benefits are recognized for income tax 
purposes.
    \127\ Claiming that a financial accounting benefit constitutes a 
substantial non-tax purpose fails to consider the origin of the 
accounting benefit (i.e., reduction of taxes) and significantly 
diminishes the purpose for having a substantial non-tax purpose 
requirement. See, e.g., American Electric Power, Inc. v. U.S., 136 F. 
Supp. 2d 762, 791-92 (S.D. Ohio, 2001) (``AEP's intended use of the 
cash flows generated by the [corporate-owned life insurance] plan is 
irrelevant to the subjective prong of the economic substance analysis. 
If a legitimate business purpose for the use of the tax savings `were 
sufficient to breathe substance into a transaction whose only purpose 
was to reduce taxes, [then] every sham tax-shelter device might 
succeed,' '' citing Winn-Dixie v. Commissioner, 113 T.C. 254, 287 
(1999)).
---------------------------------------------------------------------------
    By requiring that a transaction be a ``reasonable means'' 
of accomplishing its non-tax purpose, the provision reiterates 
the present-law ability of the courts to bifurcate a 
transaction in which independent activities with non-tax 
objectives are combined with an unrelated item having only tax-
avoidance objectives in order to disallow the tax benefits of 
the overall transaction.\128\
---------------------------------------------------------------------------
    \128\ See, e.g., ACM Partnership v. Commissioner, 157 F.3d at 256 
n.48.
---------------------------------------------------------------------------
Profit potential
    Under the provision, a taxpayer may rely on factors other 
than profit potential to demonstrate that a transaction results 
in a meaningful change in the taxpayer's economic position; the 
provision merely sets forth a minimum threshold of profit 
potential if that test is relied on to demonstrate a meaningful 
change in economic position. If a taxpayer relies on a profit 
potential, however, the present value of the reasonably 
expected pre-tax profit must be substantial in relation to the 
present value of the expected net tax benefits that would be 
allowed if the transaction were respected.\129\ Moreover, the 
profit potential must exceed a risk-free rate of return. In 
addition, in determining pre-tax profit, fees and other 
transaction expenses and foreign taxes are treated as expenses.
---------------------------------------------------------------------------
    \129\ Thus, a ``reasonable possibility of profit'' will not be 
sufficient to establish that a transaction has economic substance.
---------------------------------------------------------------------------
    In applying the profit potential test to a lessor of 
tangible property, depreciation, applicable tax credits (such 
as the rehabilitation tax credit and the low income housing tax 
credit), and any other deduction as provided in guidance by the 
Secretary are not taken into account in measuring tax benefits.
Transactions with tax-indifferent parties
    The provision also provides special rules for transactions 
with tax-indifferent parties. For this purpose, a tax-
indifferent party means any person or entity not subject to 
Federal income tax, or any person to whom an item would have no 
substantial impact on its income tax liability. Under these 
rules, the form of a financing transaction will not be 
respected if the present value of the tax deductions to be 
claimed is substantially in excess of the present value of the 
anticipatedeconomic returns to the lender. Also, the form of a 
transaction with a tax-indifferent party will not be respected if it 
results in an allocation of income or gain to the tax-indifferent party 
in excess of the tax-indifferent party's economic gain or income or if 
the transaction results in the shifting of basis on account of 
overstating the income or gain of the tax-indifferent party.

Other rules

    The Secretary may prescribe regulations which provide: (1) 
exemptions from the application of this provision; and (2) 
other rules as may be necessary or appropriate to carry out the 
purposes of the provision.
    No inference is intended as to the proper application of 
the economic substance doctrine under present law. In addition, 
except with respect to the economic substance doctrine, the 
provision shall not be construed as altering or supplanting any 
other common law doctrine (including the sham transaction 
doctrine), and this provision shall be construed as being 
additive to any such other doctrine.

                             EFFECTIVE DATE

    The provision applies to transactions entered into after 
the date of enactment.

2. Penalty for failing to disclose reportable transaction (sec. 402 of 
        the bill and sec. 6707A of the Code)

                              PRESENT LAW

    Regulations under section 6011 require a taxpayer to 
disclose with its tax return certain information with respect 
to each ``reportable transaction'' in which the taxpayer 
participates.\130\
---------------------------------------------------------------------------
    \130\ On February 27, 2003, the Treasury Department and the IRS 
released final regulations regarding the disclosure of reportable 
transactions. In general, the regulations are effective for 
transactions entered into on or after February 28, 2003.
    The discussion of present law refers to the new regulations. The 
rules that apply with respect to transactions entered into on or before 
February 28, 2003, are contained in Treas. Reg. sec. 1.6011-4T in 
effect on the date the transaction was entered into.
---------------------------------------------------------------------------
    There are six categories of reportable transactions. The 
first category is any transaction that is the same as (or 
substantially similar to) \131\ a transaction that is specified 
by the Treasury Department as a tax avoidance transaction whose 
tax benefits are subject to disallowance under present law 
(referred to as a ``listed transaction'').\132\
---------------------------------------------------------------------------
    \131\ The regulations clarify that the term ``substantially 
similar'' includes any transaction that is expected to obtain the same 
or similar types of tax consequences and that is either factually 
similar or based on the same or similar tax strategy. Further, the term 
must be broadly construed in favor of disclosure. Treas. Reg. sec. 
1.6011-4(c)(4).
    \132\ Treas. Reg. sec. 1.6011-4(b)(2).
---------------------------------------------------------------------------
    The second category is any transaction that is offered 
under conditions of confidentiality. In general, if a 
taxpayer's disclosure of the structure or tax aspects of the 
transaction is limited in any way by an express or implied 
understanding or agreement with or for the benefit of any 
person who makes or provides a statement, oral or written, as 
to the potential tax consequences that may result from the 
transaction, it is considered offered under conditions of 
confidentiality (whether or not the understanding is legally 
binding).\133\
---------------------------------------------------------------------------
    \133\ Treas. Reg. sec. 1.6011-4(b)(3).
---------------------------------------------------------------------------
    The third category of reportable transactions is any 
transaction for which: (1) the taxpayer has the right to a full 
or partial refund of fees if the intended tax consequences from 
the transaction are not sustained, or; (2) the fees are 
contingent on the intended tax consequences from the 
transaction being sustained.\134\
---------------------------------------------------------------------------
    \134\ Treas. Reg. sec. 1.6011-4(b)(4).
---------------------------------------------------------------------------
    The fourth category of reportable transactions relates to 
any transaction resulting in a taxpayer claiming a loss (under 
section 165) of at least: (1) $10 million in any single year or 
$20 million in any combination of years by a corporate taxpayer 
or a partnership with only corporate partners; (2) $2 million 
in any single year or $4 million in any combination of years by 
all other partnerships, S corporations, trusts, and 
individuals; or (3) $50,000 in any single year for individuals 
or trusts if the loss arises with respect to foreign currency 
translation losses.\135\
---------------------------------------------------------------------------
    \135\ Treas. Reg. sec. 1.6011-4(b)(5). IRS Rev. Proc. 2003-24, 
2003-11 I.R.B. 599, exempts certain types of losses from this 
reportable transaction category.
---------------------------------------------------------------------------
    The fifth category of reportable transactions refers to any 
transaction done by certain taxpayers \136\ in which the tax 
treatment of the transaction differs (or is expected to differ) 
by more than $10 million from its treatment for book purposes 
(using generally accepted accounting principles) in any 
year.\137\
---------------------------------------------------------------------------
    \136\ The significant book-tax category applies only to taxpayers 
that are reporting companies under the Securities Exchange Act of 1934 
or business entities that have $250 million or more in gross assets.
    \137\ Treas. Reg. sec. 1.6011-4(b)(6). IRS Rev. Proc. 2003-25, 
2003-11 I.R.B. 601, exempts certain types of transactions from this 
reportable transaction category.
---------------------------------------------------------------------------
    The final category of reportable transactions is any 
transaction that results in a tax credit exceeding $250,000 
(including a foreign tax credit) if the taxpayer holds the 
underlying asset for less than 45 days.\138\
---------------------------------------------------------------------------
    \138\ Treas. Reg. sec. 1.6011-4(b)(7).
---------------------------------------------------------------------------
    Under present law, there is no specific penalty for failing 
to disclose a reportable transaction; however, such a failure 
may jeopardize a taxpayer's ability to claim that any income 
tax understatement attributable to such undisclosed transaction 
is due to reasonable cause, and that the taxpayer acted in good 
faith.\139\
---------------------------------------------------------------------------
    \139\ Section 6664(c) provides that a taxpayer can avoid the 
imposition of a section 6662 accuracy-related penalty in cases where 
the taxpayer can demonstrate that there was reasonable cause for the 
underpayment and that the taxpayer acted in good faith. On December 31, 
2002, the Treasury Department and IRS issued proposed regulations under 
sections 6662 and 6664 (REG-126016-01) that limit the defenses 
available to the imposition of an accuracy-related penalty in 
connection with a reportable transaction when the transaction is not 
disclosed.
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The Committee is aware that individuals and corporations 
are increasingly using sophisticated transactions to avoid or 
evade Federal income tax.\140\ Such a phenomenon could pose a 
serious threat to the efficacy of the tax system because of 
both the potential loss of revenue and the potential threat to 
the integrity of the self-assessment system.
---------------------------------------------------------------------------
    \140\ In this regard, the Committee has concerns with the outcomes 
and rationales used by courts in some recent decisions involving tax-
motivated transactions. For a more detailed discussion of recent court 
decisions and other developments regarding tax shelters, see Joint 
Committee on Taxation, Background and Present Law Relating to Tax 
Shelters (JCX 19-02), March 19, 2002.
---------------------------------------------------------------------------
    The Committee over three years ago began working on 
legislation to address this significant compliance problem. In 
addition, the Treasury Department, using the tools available, 
issued regulations requiring disclosure of certain transactions 
and requiring organizers and promoters of tax-engineered 
transactions to maintain customer lists and make these lists 
available to the IRS. Nevertheless, the Committee believes that 
additional legislation is needed to provide the Treasury 
Department with additional tools to assist its efforts to 
curtail abusive transactions. Moreover, the Committee believes 
that a penalty for failing to make the required disclosures, 
when the imposition of such penalty is not dependent on the tax 
treatment of the underlying transaction ultimately being 
sustained, will provide an additional incentive for taxpayers 
to satisfy their reporting obligations under the new disclosure 
provisions.

                        EXPLANATION OF PROVISION

In general

    The provision creates a new penalty for any person who 
fails to include with any return or statement any required 
information with respect to a reportable transaction. The new 
penalty applies without regard to whether the transaction 
ultimately results in an understatement of tax, and applies in 
addition to any accuracy-related penalty that may be imposed.

Transactions to be disclosed

    The provision does not define the terms ``listed 
transaction'' \141\ or ``reportable transaction,'' nor does the 
provision explain the type of information that must be 
disclosed in order to avoid the imposition of a penalty. 
Rather, the provision authorizes the Treasury Department to 
define a ``listed transaction'' and a ``reportable 
transaction'' under section 6011.
---------------------------------------------------------------------------
    \141\ The provision states that, except as provided in regulations, 
a listed transaction means a reportable transaction, which is the same 
as, or substantially similar to, a transaction specifically identified 
by the Secretary as a tax avoidance transaction for purposes of section 
6011. For this purpose, it is expected that the definition of 
``substantially similar'' will be the definition used in Treas. Reg. 
sec. 1.6011-4(c)(4). However, the Secretary may modify this definition 
(as well as the definitions of ``listed transaction'' and ``reportable 
transactions'') as appropriate.
---------------------------------------------------------------------------

Penalty rate

    The penalty for failing to disclose a reportable 
transaction is $50,000. The amount is increased to $100,000 if 
the failure is with respect to a listed transaction. For large 
entities and high net worth individuals, the penalty amount is 
doubled (i.e., $100,000 for a reportable transaction and 
$200,000 for a listed transaction). The penalty cannot be 
waived with respect to a listed transaction. As to reportable 
transactions, the penalty can be rescinded (or abated) only if: 
(1) the taxpayer on whom the penalty is imposed has a history 
of complying with the Federal tax laws; (2) it is shown that 
the violation is due to an unintentional mistake of fact; (3) 
imposing the penalty would be against equity and good 
conscience, and (4) rescinding the penalty would promote 
compliance with the tax laws and effective tax administration. 
The authority to rescind the penalty can only be exercised by 
the IRS Commissioner personally or the head of the Office of 
Tax Shelter Analysis. Thus, the penalty cannot be rescinded by 
a revenue agent, an Appeals officer, or any other IRS 
personnel. The decision to rescind a penalty must be 
accompanied by a record describing the facts and reasons for 
the action and the amount rescinded. There will be no taxpayer 
right to appeal a refusal to rescind a penalty. The IRS also is 
required to submit an annual report to Congress summarizing the 
application of the disclosure penalties and providing a 
description of each penalty rescinded under this provision and 
the reasons for the rescission.
    A ``large entity'' is defined as any entity with gross 
receipts in excess of $10 million in the year of the 
transaction or in the preceding year. A ``high net worth 
individual'' is defined as any individual whose net worth 
exceeds $2 million, based on the fair market value of the 
individual's assets and liabilities immediately before entering 
into the transaction.
    A public entity that is required to pay a penalty for 
failing to disclose a listed transaction (or is subject to an 
understatement penalty attributable to a non-disclosed listed 
transaction, a non-disclosed reportable avoidance 
transaction,\142\ or a transaction that lacks economic 
substance) must disclose the imposition of the penalty in 
reports to the Securities and Exchange Commission for such 
period as the Secretary shall specify. The provision applies 
without regard to whether the taxpayer determines the amount of 
the penalty to be material to the reports in which the penalty 
must appear, and treats any failure to disclose a transaction 
in such reports as a failure to disclose a listed transaction. 
A taxpayer must disclose a penalty in reports to the Securities 
and Exchange Commission once the taxpayer has exhausted its 
administrative and judicial remedies with respect to the 
penalty (or if earlier, when paid).
---------------------------------------------------------------------------
    \142\ A reportable avoidance transaction is a reportable 
transaction with a significant tax avoidance purpose.
---------------------------------------------------------------------------

                             EFFECTIVE DATE

    The provision is effective for returns and statements the 
due date for which is after the date of enactment.

3. Accuracy-related penalty for listed transactions and other 
        reportable transactions having a significant tax avoidance 
        purpose (sec. 403 of the bill and sec. 6662A of the Code)

                              PRESENT LAW

    The accuracy-related penalty 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. If the correct income tax liability 
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 
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.\143\ The amount of 
any understatement generally is reduced by any portion 
attributable to an item if: (1) the treatment of the item is or 
was supported by substantial authority; or (2) facts relevant 
to the tax treatment of the item were adequately disclosed and 
there was a reasonable basis for its tax treatment.\144\
---------------------------------------------------------------------------
    \143\ Sec. 6662.
    \144\ Sec. 6662(d)(2)(B).
---------------------------------------------------------------------------
    Special rules apply with respect to tax shelters.\145\ For 
understatements by non-corporate taxpayers attributable to tax 
shelters, the penalty may be avoided only if the taxpayer 
establishes that, in addition to having substantial authority 
for the position, the taxpayer 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.
---------------------------------------------------------------------------
    \145\ Sec. 6662(d)(2)(C).
---------------------------------------------------------------------------
    The understatement penalty generally is abated (even with 
respect to tax shelters) in cases in which the taxpayer can 
demonstrate that there was ``reasonable cause'' for the 
underpayment and that the taxpayer acted in good faith.\146\ 
The relevant regulations provide that reasonable cause exists 
where the taxpayer ``reasonably relies in good faith on an 
opinion based on a professional tax advisor's analysis of the 
pertinent facts and authorities [that] * * * unambiguously 
concludes that there is a greater than 50-percent likelihood 
that the tax treatment of the item will be upheld if 
challenged'' by the IRS.\147\
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    \146\ Sec. 6664(c).
    \147\ Treas. Reg. sec. 1.6662-4(g)(4)(i)(B); Treas. Reg. sec. 
1.6664-4(c).
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                           REASONS FOR CHANGE

    Because the Treasury shelter initiative emphasizes 
combating abusive tax avoidance transactions by requiring 
increased disclosure of such transactions by all parties 
involved, the Committee believes that taxpayers should be 
subject to a strict liability penalty on an understatement of 
tax that is attributable to non-disclosed listed transactions 
or non-disclosed reportable transactions that have a 
significant purpose of tax avoidance. Furthermore, in order to 
deter taxpayers from entering into tax avoidance transactions, 
the Committee believes that a more meaningful (but less 
stringent) accuracy-related penalty should apply to such 
transactions even when disclosed.

                        EXPLANATION OF PROVISION

In general

    The provision modifies the present-law accuracy related 
penalty by replacing the rules applicable to tax shelters with 
a new accuracy-related penalty that applies to listed 
transactions and reportable transactions with a significant tax 
avoidance purpose (hereinafter referred to as a ``reportable 
avoidance transaction'').\148\ The penalty rate and defenses 
available to avoid the penalty vary depending on whether the 
transaction was adequately disclosed.
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    \148\ The terms ``reportable transaction'' and ``listed 
transaction'' have the same meanings as used for purposes of the 
penalty for failing to disclose reportable transactions.
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            Disclosed transactions
    In general, a 20-percent accuracy-related penalty is 
imposed on any understatement attributable to an adequately 
disclosed listed transaction or reportable avoidance 
transaction. The only exception to the penalty is if the 
taxpayer satisfies a more stringent reasonable cause and good 
faith exception (hereinafter referred to as the ``strengthened 
reasonable cause exception''), which is described below. The 
strengthened reasonable cause exception is available only if 
the relevant facts affecting the tax treatment are adequately 
disclosed, there is or was substantial authority for the 
claimed tax treatment, and the taxpayer reasonably believed 
that the claimed tax treatment was more likely than not the 
proper treatment.
            Undisclosed transactions
    If the taxpayer does not adequately disclose the 
transaction, the strengthened reasonable cause exception is not 
available (i.e., a strict-liability penalty applies), and the 
taxpayer is subject to an increased penalty rate equal to 30-
percent of the understatement.
    In addition, a public entity that is required to pay the 
30-percent penalty must disclose the imposition of the penalty 
in reports to the SEC for such periods as the Secretary shall 
specify. The disclosure to the SEC applies without regard to 
whether the taxpayer determines the amount of the penalty to be 
material to the reports in which the penalty must appear, and 
any failure to disclose such penalty in the reports is treated 
as a failure to disclose a listed transaction. A taxpayer must 
disclose a penalty in reports to the SEC once the taxpayer has 
exhausted its administrative and judicial remedies with respect 
to the penalty (or if earlier, when paid).
    Once the 30-percent penalty has been included in the 
Revenue Agent Report, the penalty cannot be compromised for 
purposes of a settlement without approval of the Commissioner 
personally or the head of the Office of Tax Shelter Analysis. 
Furthermore, the IRS is required to submit an annual report to 
Congress summarizing the application of this penalty and 
providing a description of each penalty compromised under this 
provision and the reasons for the compromise.

Determination of the understatement amount

    The penalty is applied to the amount of any understatement 
attributable to the listed or reportable avoidance transaction 
without regard to other items on the tax return. For purposes 
of this provision, the amount of the understatement is 
determined as the sum of: (1) the product of the highest 
corporate or individual tax rate (as appropriate) and the 
increase in taxable income resulting from the difference 
between the taxpayer's treatment of the item and the proper 
treatment of the item (without regard to other items on the tax 
return); \149\ and (2) the amount of any decrease in the 
aggregate amount of credits which results from a difference 
between the taxpayer's treatment of an item and the proper tax 
treatment of such item.
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    \149\ For this purpose, any reduction in the excess of deductions 
allowed for the taxable year over gross income for such year, and any 
reduction in the amount of capital losses which would (without regard 
to section 1211) be allowed for such year, shall be treated as an 
increase in taxable income.
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    Except as provided in regulations, a taxpayer's treatment 
of an item shall not take into account any amendment or 
supplement to a return if the amendment or supplement is filed 
after the earlier of when the taxpayer is first contacted 
regarding an examination of the return or such other date as 
specified by the Secretary.

Strengthened reasonable cause exception

    A penalty is not imposed under the provision with respect 
to any portion of an understatement if it shown that there was 
reasonable cause for such portion and the taxpayer acted in 
good faith. Such a showing requires: (1) adequate disclosure of 
the facts affecting the transaction in accordance with the 
regulations under section 6011; \150\ (2) that there is or was 
substantial authority for such treatment; and (3) that the 
taxpayer reasonably believed that such treatment was more 
likely than not the proper treatment. For this purpose, a 
taxpayer will be treated as having a reasonable belief with 
respect to the tax treatment of an item only if such belief: 
(1) is based on the facts and law that exist at the time the 
tax return that includes the item is filed; and (2) relates 
solely to the taxpayer's chances of success on the merits and 
does not take into account the possibility that (a) a return 
will not be audited, (b) the treatment will not be raised on 
audit, or (c) the treatment will be resolved through settlement 
if raised.
---------------------------------------------------------------------------
    \150\ See the previous discussion regarding the penalty for failing 
to disclose a reportable transaction.
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    A taxpayer may (but is not required to) rely on an opinion 
of a tax advisor in establishing its reasonable belief with 
respect to the tax treatment of the item. However, a taxpayer 
may not rely on an opinion of a tax advisor for this purpose if 
the opinion: (1) is provided by a ``disqualified tax advisor''; 
or (2) is a ``disqualified opinion.''
            Disqualified tax advisor
    A disqualified tax advisor is any advisor who: (1) is a 
material advisor \151\ and who participates in the 
organization, management, promotion or sale of the transaction 
or is related (within the meaning of section 267(b) or 
707(b)(1)) to any person who so participates; (2) is 
compensated directly or indirectly \152\ by a material advisor 
with respect to the transaction; (3) has a fee arrangement with 
respect to the transaction that is contingent on all or part of 
the intended tax benefits from the transaction being sustained; 
or (4) as determined under regulations prescribed by the 
Secretary, has a disqualifying financial interest with respect 
to the transaction.
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    \151\ The term ``material advisor'' (defined below in connection 
with the new information filing requirements for material advisors) 
means any person who provides any material aid, assistance, or advice 
with respect to organizing, promoting, selling, implementing, or 
carrying out any reportable transaction, and who derives gross income 
in excess of $50,000 in the case of a reportable transaction 
substantially all of the tax benefits from which are provided to 
natural persons ($250,000 in any other case).
    \152\ This situation could arise, for example, when an advisor has 
an arrangement or understanding (oral or written) with an organizer, 
manager, or promoter of a reportable transaction that such party will 
recommend or refer potential participants to the advisor for an opinion 
regarding the tax treatment of the transaction.
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    A material advisor is considered as participating in the 
``organization'' of a transaction if the advisor performs acts 
relating to the development of the transaction. This may 
include, for example, preparing documents: (1) establishing a 
structure used in connection with the transaction (such as a 
partnership agreement); (2) describing the transaction (such as 
an offering memorandum or other statement describing the 
transaction); or (3) relating to the registration ofthe 
transaction with any Federal, state or local government body.\153\ 
Participation in the ``management'' of a transaction means involvement 
in the decision-making process regarding any business activity with 
respect to the transaction. Participation in the ``promotion or sale'' 
of a transaction means involvement in the marketing or solicitation of 
the transaction to others. Thus, an advisor who provides information 
about the transaction to a potential participant is involved in the 
promotion or sale of a transaction, as is any advisor who recommends 
the transaction to a potential participant.
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    \153\ An advisor should not be treated as participating in the 
organization of a transaction if the advisor's only involvement with 
respect to the organization of the transaction is the rendering of an 
opinion regarding the tax consequences of such transaction. However, 
such an advisor may be a ``disqualified tax advisor'' with respect to 
the transaction if the advisor participates in the management, 
promotion or sale of the transaction (or if the advisor is compensated 
by a material advisor, has a fee arrangement that is contingent on the 
tax benefits of the transaction, or as determined by the Secretary, has 
a continuing financial interest with respect to the transaction).
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            Disqualified opinion
    An opinion may not be relied upon if the opinion: (1) is 
based on unreasonable factual or legal assumptions (including 
assumptions as to future events); (2) unreasonably relies upon 
representations, statements, finding or agreements of the 
taxpayer or any other person; (3) does not identify and 
consider all relevant facts; or (4) fails to meet any other 
requirement prescribed by the Secretary.

Coordination with other penalties

    Any understatement upon which a penalty is imposed under 
this provision is not subject to the accuracy-related penalty 
under section 6662. However, such understatement is included 
for purposes of determining whether any understatement (as 
defined in sec. 6662(d)(2)) is a substantial understatement as 
defined under section 6662(d)(1).
    The penalty imposed under this provision shall not apply to 
any portion of an understatement to which a fraud penalty is 
applied under section 6663.

                             EFFECTIVE DATE

    The provision is effective for taxable years ending after 
the date of enactment.

4. Penalty for understatements attributable to transactions lacking 
        economic substance, etc. (sec. 404 of the bill and sec. 6662B 
        of the Code)

                              PRESENT LAW

    An accuracy-related penalty 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. If the correct income tax liability 
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 
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.\154\ The amount of 
any understatement is reduced by any portion attributable to an 
item if: (1) the treatment of the item is supported by 
substantial authority; or (2) facts relevant to the tax 
treatment of the item were adequately disclosed and there was a 
reasonable basis for its tax treatment.
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    \154\ Sec. 6662.
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    Special rules apply with respect to tax shelters.\155\ For 
understatements by non-corporate taxpayers attributable to tax 
shelters, the penalty may be avoided only if the taxpayer 
establishes that, in addition to having substantial authority 
for the position, the taxpayer 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.
---------------------------------------------------------------------------
    \155\ Sec. 6662(d)(2)(C).
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    The penalty generally is abated (even with respect to tax 
shelters) in cases in which the taxpayer can demonstrate that 
there was ``reasonable cause'' for the underpayment and that 
the taxpayer acted in good faith.\156\ The relevant regulations 
provide that reasonable cause exists where the taxpayer 
``reasonably relies in good faith on an opinion based on a 
professional tax advisor's analysis of the pertinent facts and 
authorities [that] * * * unambiguously concludes that there is 
a greater than 50-percent likelihood that the tax treatment of 
the item will be upheld if challenged'' by the IRS.\157\
---------------------------------------------------------------------------
    \156\ Sec. 6664(c).
    \157\ Treas. Reg. sec. 1.6662-4(g)(4)(i)(B); Treas. Reg. sec. 
1.6664-4(c).
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                           REASONS FOR CHANGE

    The Committee is concerned that many taxpayers are engaging 
in tax avoidance transactions that rely on the interaction of 
highly technical tax law provisions. These transactions usually 
produce surprising results that were not contemplated by 
Congress. Whether these transactions are respected usually 
hinges on whether the transaction had sufficient economic 
substance. The Committee believes that the benefits that 
taxpayers potentially obtain from these transactions 
significantly outweigh the potential costs of engaging in such 
transactions. In addition, the Committee believes taxpayers 
will continue to engage in tax avoidance transactions until the 
risk and cost to the taxpayer of engaging in the transactions 
is increased. Thus, the Committee believes that taxpayers 
should be subject to the imposition of a substantial strict 
liability penalty for transactions that are determined not to 
have economic substance.

                        EXPLANATION OF PROVISION

    The provision imposes a penalty for an understatement 
attributable to any transaction that lacks economic substance 
(referred to in the statute as a ``non-economic substance 
transaction understatement'').\158\ The penalty rate is 40 
percent (reduced to 20 percent if the taxpayer adequately 
discloses the relevant facts in accordance with regulations 
prescribed under section 6011). No exceptions (including the 
reasonable cause or rescission rules) to the penalty would be 
available under the provision (i.e., the penalty is a strict-
liability penalty).
---------------------------------------------------------------------------
    \158\ Thus, unlike the new accuracy-related penalty under section 
6662A (which applies only to listed and reportable avoidance 
transactions), the new penalty under this provision applies to any 
transaction that lacks economic substance.
---------------------------------------------------------------------------
    A ``non-economic substance transaction'' means any 
transaction if: (1) the transaction lacks economic substance 
(as defined in the earlier provision regarding the economic 
substance doctrine); \159\ (2) the transaction was not 
respected under the rules relating to transactions with tax-
indifferent parties (as described in the earlier provision 
regarding the economic substance doctrine); \160\ or (3) any 
similar rule of law. For this purpose, a similar rule of law 
would include, for example, an understatement attributable to a 
transaction that is determined to be a sham transaction.
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    \159\ The provision provides that a transaction has economic 
substance only if: (1) the transaction changes in a meaningful way 
(apart from Federal income tax effects) the taxpayer's economic 
position, and (2) the transaction has a substantial non-tax purpose for 
entering into such transaction and is a reasonable means of 
accomplishing such purpose.
    \160\ The provision provides that the form of a transaction that 
involves a tax-indifferent party will not be respected in certain 
circumstances.
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    For purposes of this provision, the calculation of an 
``understatement'' is made in the same manner as in the 
separate provision relating to accuracy-related penalties for 
listed and reportable avoidance transactions (new sec. 6662A). 
Thus, the amount of the understatement under this provision 
would be determined as the sum of: (1) the product of the 
highest corporate or individual tax rate (as appropriate) and 
the increase in taxable income resulting from the difference 
between the taxpayer's treatment of the item and the proper 
treatment of the item (without regard to other items on the tax 
return); \161\ and (2) the amount of any decrease in the 
aggregate amount of credits which results from a difference 
between the taxpayer's treatment of an item and the proper tax 
treatment of such item. In essence, the penalty will apply to 
the amount of any understatement attributable solely to a non-
economic substance transaction.
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    \161\ For this purpose, any reduction in the excess of deductions 
allowed for the taxable year over gross income for such year, and any 
reduction in the amount of capital losses that would (without regard to 
section 1211) be allowed for such year, would be treated as an increase 
in taxable income.
---------------------------------------------------------------------------
    Except as provided in regulations, the taxpayer's treatment 
of an item will not take into account any amendment or 
supplement to a return if the amendment or supplement is filed 
after the earlier of the date the taxpayer is first contacted 
regarding an examination of such return or such other date as 
specified by the Secretary.
    A public entity that is required to pay a penalty under 
this provision (regardless of whether the transaction was 
disclosed) must disclose the imposition of the penalty in 
reports to the SEC for such periods as the Secretary shall 
specify. The disclosure to the SEC applies without regard to 
whether the taxpayer determines the amount of the penalty to be 
material to the reports in which the penalty must appear, and 
any failure to disclose such penalty in the reports is treated 
as a failure to disclose a listed transaction. A taxpayer must 
disclose a penalty in reports to the SEC once the taxpayer has 
exhausted its administrative and judicial remedies with respect 
to the penalty (or if earlier, when paid).
    Prior to this penalty being asserted in the first letter of 
proposed deficiency that allows the taxpayer an opportunity for 
administrative review in the IRS Office of Appeals (e.g., a 
Revenue Agent Report), the IRS Chief Counsel or his delegate at 
the IRS National Office must approve the inclusion in writing. 
Once a penalty (regardless of whether the transaction was 
disclosed) has been included in the Revenue Agent Report, the 
penalty cannot be compromised for purposes of a settlement 
without approval of the Commissioner personally or the head of 
the Office of Tax Shelter Analysis. Furthermore, the IRS is 
required to submit an annual report to Congress summarizing the 
application of this penalty and providing a description of each 
penalty compromised under this provision and the reasons for 
the compromise.
    Any understatement to which a penalty is imposed under this 
provision will not be subject to the accuracy-related penalty 
under section 6662 or under new 6662A (accuracy-related 
penalties for listed and reportable avoidance transactions). 
However, an understatement under this provision would be taken 
into account for purposes of determining whether any 
understatement (as defined in sec. 6662(d)(2)) is a substantial 
understatement as defined under section 6662(d)(1). The penalty 
imposed under this provision will not apply to any portion of 
an understatement to which a fraud penalty is applied under 
section 6663.

                             EFFECTIVE DATE

    The provision applies to transactions entered into after 
the date of enactment.

5. Modifications of substantial understatement penalty for 
        nonreportable transactions (sec. 405 of the bill and sec. 6662 
        of the Code)

                              PRESENT LAW

Definition of substantial understatement

    An accuracy-related penalty equal to 20 percent applies to 
any substantial understatement of tax. A ``substantial 
understatement'' exists if the correct income tax liability 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).\162\
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    \162\ Sec. 6662(a) and (d)(1)(A).
---------------------------------------------------------------------------

Reduction of understatement for certain positions

    For purposes of determining whether a substantial 
understatement penalty applies, the amount of any 
understatement generally is reduced by any portion attributable 
to an item if: (1) the treatment of the item is supported by 
substantial authority; or (2) facts relevant to the tax 
treatment of the item were adequately disclosed and there was a 
reasonable basis for its tax treatment.\163\
---------------------------------------------------------------------------
    \163\ Sec. 6662(d)(2)(B).
---------------------------------------------------------------------------
    The Secretary is required to publish annually in the 
Federal Register a list of positions for which the Secretary 
believes there is not substantial authority and which affect a 
significant number of taxpayers.\164\
---------------------------------------------------------------------------
    \164\ Sec. 6662(d)(2)(D).
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The Committee believes that the present-law definition of 
substantial understatement allows large corporate taxpayers to 
avoid the accuracy-related penalty on questionable transactions 
of a significant size. The Committee believes that an 
understatement of more than $10 million is substantial in and 
of itself, regardless of the proportion it represents of the 
taxpayer's total tax liability.
    The Committee believes that a higher compliance standard 
should be imposed on any taxpayer in order to reduce the amount 
of an understatement resulting from a transaction that the 
taxpayer did not adequately disclose. The Committee further 
believes that a taxpayer should not take a position on a tax 
return that could give rise to a substantial understatement 
penalty that the taxpayer does not believe is more likely than 
not the correct tax treatment unless this information is 
disclosed to the IRS.

                        EXPLANATION OF PROVISION

Definition of substantial understatement

    The provision modifies the definition of ``substantial'' 
for corporate taxpayers. Under the provision, a corporate 
taxpayer has a substantial understatement if the amount of the 
understatement for the taxable year exceeds the lesser of: (1) 
10 percent of the tax required to be shown on the return for 
the taxable year (or, if greater, $10,000); or (2) $10 million.

Reduction of understatement for certain positions

    The provision elevates the standard that a taxpayer must 
satisfy in order to reduce the amount of an understatement for 
undisclosed items. With respect to the treatment of an item 
whose facts are not adequately disclosed, a resulting 
understatement is reduced only if the taxpayer had a reasonable 
belief that the tax treatment was more likely than not the 
proper treatment. The provision also authorizes (but does not 
require) the Secretary to publish a list of positions for which 
it believes there is not substantial authority or there is no 
reasonable belief that the tax treatment is more likely than 
not the proper treatment (without regard to whether such 
positions affect a significant number of taxpayers). The list 
shall be published in the Federal Register or the Internal 
Revenue Bulletin.

                             EFFECTIVE DATE

    The provision is effective for taxable years beginning 
after date of enactment.

6. Tax shelter exception to confidentiality privileges relating to 
        taxpayer communications (sec. 406 of the bill and sec. 7525 of 
        the Code)

                              PRESENT LAW

    In general, a common law privilege of confidentiality 
exists for communications between an attorney and client with 
respect to the legal advice the attorney gives the client. The 
Code provides that, with respect to tax advice, the same common 
law protections of confidentiality that apply to a 
communication between a taxpayer and an attorney also apply to 
a communication between a taxpayer and a federally authorized 
tax practitioner to the extent the communication would be 
considered a privileged communication if it were between a 
taxpayer and an attorney. This rule is inapplicable to 
communications regarding corporate tax shelters.

                           REASONS FOR CHANGE

    The Committee believes that the rule currently applicable 
to corporate tax shelters should be applied to all tax 
shelters, regardless of whether or not the participant is a 
corporation.

                        EXPLANATION OF PROVISION

    The provision modifies the rule relating to corporate tax 
shelters by making it applicable to all tax shelters, whether 
entered into by corporations, individuals, partnerships, tax-
exempt entities, or any other entity. Accordingly, 
communications with respect to tax shelters are not subject to 
the confidentiality provision of the Code that otherwise 
applies to a communication between a taxpayer and a federally 
authorized tax practitioner.

                             EFFECTIVE DATE

    The provision is effective with respect to communications 
made on or after the date of enactment.

7. Disclosure of reportable transactions (secs. 407 and 408 of the bill 
        and secs. 6111 and 6707 of the Code)

                              PRESENT LAW

Registration of tax shelter arrangements

    An organizer of a tax shelter is required to register the 
shelter with the Secretary not later than the day on which the 
shelter is first offered for sale.\165\ A ``tax shelter'' means 
any investment with respect to which the tax shelter ratio\166\ 
for any investor as of the close of any of the first five years 
ending after the investment is offered for sale may be greater 
than two to one and which is: (1) required to be registered 
under Federal or State securities laws; (2) sold pursuant to an 
exemption from registration requiring the filing of a notice 
with a Federal or State securities agency; or (3) a substantial 
investment (greater than $250,000 and involving at least five 
investors).\167\
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    \165\ Sec. 6111(a).
    \166\ The tax shelter ratio is, with respect to any year, the ratio 
that the aggregate amount of the deductions and 350 percent of the 
credits, which are represented to be potentially allowable to any 
investor, bears to the investment base (money plus basis of assets 
contributed) as of the close of the tax year.
    \167\ Sec. 6111(c).
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    Other promoted arrangements are treated as tax shelters for 
purposes of the registration requirement if: (1) a significant 
purpose of the arrangement is the avoidance or evasion of 
Federal income tax by a corporate participant; (2) the 
arrangement is offered under conditions of confidentiality; and 
(3) the promoter may receive fees in excess of $100,000 in the 
aggregate.\168\
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    \168\ Sec. 6111(d).
---------------------------------------------------------------------------
    In general, a transaction has a ``significant purpose of 
avoiding or evading Federal income tax'' if the transaction: 
(1) is the same as or substantially similar to a ``listed 
transaction'',\169\ or (2) is structured to produce tax 
benefits that constitute an important part of the intended 
results of the arrangement and the promoter reasonably expects 
to present the arrangement to more than one taxpayer.\170\ 
Certain exceptions are provided with respect to the second 
category of transactions.\171\
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    \169\ Treas. Reg. sec. 301.6111-2(b)(2).
    \170\ Treas. Reg. sec. 301.6111-2(b)(3).
    \171\ Treas. Reg. sec. 301.6111-2(b)(4).
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    An arrangement is offered under conditions of 
confidentiality if: (1) an offeree has an understanding or 
agreement to limit the disclosure of the transaction or any 
significant tax features of the transaction; or (2) the 
promoter knows, or has reason to know, that the offeree's use 
or disclosure of information relating to the transaction is 
limited in any other manner.\172\
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    \172\ The regulations provide that the determination of whether an 
arrangement is offered under conditions of confidentiality is based on 
all the facts and circumstances surrounding the offer. If an offeree's 
disclosure of the structure or tax aspects of the transaction are 
limited in any way by an express or implied understanding or agreement 
with or for the benefit of a tax shelter promoter, an offer is 
considered made under conditions of confidentiality, whether or not 
such understanding or agreement is legally binding. Treas. Reg. sec. 
301.6111-2(c)(1).
---------------------------------------------------------------------------

Failure to register tax shelter

    The penalty for failing to timely register a tax shelter 
(or for filing false or incomplete information with respect to 
the tax shelter registration) generally is the greater of one 
percent of the aggregate amount invested in the shelter or 
$500.\173\ However, if the tax shelter involves an arrangement 
offered to a corporation under conditions of confidentiality, 
the penalty 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. Intentional disregard of the 
requirement to register increases the penalty to 75 percent of 
the applicable fees.
---------------------------------------------------------------------------
    \173\ Sec. 6707.
---------------------------------------------------------------------------
    Section 6707 also imposes: (1) a $100 penalty on the 
promoter for each failure to furnish the investor with the 
required tax shelter identification number; and (2) a $250 
penalty on the investor for each failure to include the tax 
shelter identification number on a return.

                           REASONS FOR CHANGE

    The Committee has been advised that the current promoter 
registration rules have not proven particularly helpful, 
because the rules are not appropriate for the kinds of abusive 
transactions now prevalent, and because the limitations 
regarding confidential corporate arrangements have proven easy 
to circumvent.
    The Committee believes that providing a single, clear 
definition regarding the types of transactions that must be 
disclosed by taxpayers and material advisors, coupled with more 
meaningful penalties for failing to disclose such transactions, 
are necessary tools if the effort to curb the use of abusive 
tax avoidance transactions is to be effective.

                        EXPLANATION OF PROVISION

Disclosure of reportable transactions by material advisors

    The provision repeals the present law rules with respect to 
registration of tax shelters. Instead, the provision requires 
each material advisor with respect to any reportable 
transaction (including any listed transaction)\174\ to timely 
file an information return with the Secretary (in such form and 
manner as the Secretary may prescribe). The return must be 
filed on such date as specified by the Secretary.
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    \174\ The terms ``reportable transaction'' and ``listed 
transaction'' have the same meaning as previously described in 
connection with the taxpayer-related provisions.
---------------------------------------------------------------------------
    The information return will include: (1) information 
identifying and describing the transaction; (2) information 
describing any potential tax benefits expected to result from 
the transaction; and (3) such other information as the 
Secretary may prescribe. It is expected that the Secretary may 
seek from the material advisor the same type of information 
that the Secretary may request from a taxpayer in connection 
with a reportable transaction.\175\
---------------------------------------------------------------------------
    \175\ See the previous discussion regarding the disclosure 
requirements under new section 6707A.
---------------------------------------------------------------------------
    A ``material advisor'' means any person: (1) who provides 
material aid, assistance, or advice with respect to organizing, 
promoting, selling, implementing, or carrying out any 
reportable transaction; and (2) who directly or indirectly 
derives gross income in excess of $250,000 ($50,000 in the case 
of a reportable transaction substantially all of the tax 
benefits from which are provided to natural persons) for such 
advice or assistance.
    The Secretary may prescribe regulations which provide: (1) 
that only one material advisor has to file an information 
return in cases in which two or more material advisors would 
otherwise be required to file information returns with respect 
to a particular reportable transaction; (2) exemptions from the 
requirements of this section; and (3) other rules as may be 
necessary or appropriate to carry out the purposes of this 
section (including, for example, rules regarding the 
aggregation of fees in appropriate circumstances).

Penalty for failing to furnish information regarding reportable 
        transactions

    The provision repeals the present law penalty for failure 
to register tax shelters. Instead, the provision imposes a 
penalty on any material advisor who fails to file an 
information return, or who files a false or incomplete 
information return, with respect to a reportable transaction 
(including a listed transaction).\176\ The amount of the 
penalty is $50,000. If the penalty is with respect to a listed 
transaction, the amount of the penalty is increased to the 
greater of: (1) $200,000; or (2) 50 percent of the gross income 
of such person with respect to aid, assistance, or advice which 
is provided with respect to the transaction before the date the 
information return that includes the transaction is filed. 
Intentional disregard by a material advisor of the requirement 
to disclose a listed transaction increases the penalty to 75 
percent of the gross income.
---------------------------------------------------------------------------
    \176\ The terms ``reportable transaction'' and ``listed 
transaction'' have the same meaning as previously described in 
connection with the taxpayer-related provisions.
---------------------------------------------------------------------------
    The penalty cannot be waived with respect to a listed 
transaction. As to reportable transactions, the penalty can be 
rescinded (or abated) only in exceptional circumstances.\177\ 
All or part of the penalty may be rescinded only if: (1) the 
material advisor on whom the penalty is imposed has a history 
of complying with the Federal tax laws; (2) it is shown that 
the violation is due to an unintentional mistake of fact; (3) 
imposing the penalty would be against equity and good 
conscience; and (4) rescinding the penalty would promote 
compliance with the tax laws and effective tax administration. 
The authority to rescind the penalty can only be exercised by 
the Commissioner personally or the head of the Office of Tax 
Shelter Analysis; this authority to rescind cannot otherwise be 
delegated by the Commissioner. Thus, a revenue agent, an 
Appeals officer, or other IRS personnel cannot rescind the 
penalty. The decision to rescind a penalty must be accompanied 
by a record describing the facts and reasons for the action and 
the amount rescinded. There will be no right to appeal a 
refusal to rescind a penalty. The IRS also is required to 
submit an annual report to Congress summarizing the application 
of the disclosure penalties and providing a description of each 
penalty rescinded under this provision and the reasons for the 
rescission.
---------------------------------------------------------------------------
    \177\ The Secretary's present-law authority to postpone certain 
tax-related deadlines because of Presidentially-declared disasters 
(sec. 7508A) will also encompass the authority to postpone the 
reporting deadlines established by the provision.
---------------------------------------------------------------------------

                             EFFECTIVE DATE

    The provision requiring disclosure of reportable 
transactions by material advisors applies to transactions with 
respect to which material aid, assistance or advice is provided 
after the date of enactment.
    The provision imposing a penalty for failing to disclose 
reportable transactions applies to returns the due date for 
which is after the date of enactment.

8. Modification of penalties for failure to register tax shelters or 
        maintain lists of investors (secs. 407 and 409 of the bill and 
        secs. 6112 and 6708 of the Code)

                              PRESENT LAW

Investor lists

    Any organizer or seller of a potentially abusive tax 
shelter must maintain a list identifying each person who was 
sold an interest in any such tax shelter with respect to which 
registration was required under section 6111 (even though the 
particular party may not have been subject to confidentiality 
restrictions).\178\ Recently issued regulations under section 
6112 contain rules regarding the list maintenance 
requirements.\179\ In general, the regulations apply to 
transactions that are potentially abusive tax shelters entered 
into, or acquired after, February 28, 2003.\180\
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    \178\ Sec. 6112.
    \179\ Treas. Reg. sec. 301-6112-1.
    \180\ A special rule applies the list maintenance requirements to 
transactions entered into after February 28, 2000 if the transaction 
becomes a listed transaction (as defined in Treas. Reg. 1.6011-4) after 
February 28, 2003.
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    The regulations provide that a person is an organizer or 
seller of a potentially abusive tax shelter if the person is a 
material advisor with respect to that transaction.\181\ A 
material advisor is defined any person who is required to 
register the transaction under section 6111, or expects to 
receive a minimum fee of: (1) $250,000 for a transaction that 
is a potentially abusive tax shelter if all participants are 
corporations; or (2) $50,000 for any other transaction that is 
a potentially abusive tax shelter.\182\ For listed transactions 
(as defined in the regulations under section 6011), the minimum 
fees are reduced to $25,000 and $10,000, respectively.
---------------------------------------------------------------------------
    \181\ Treas. Reg. sec. 301.6112-1(c)(1).
    \182\ Treas. Reg. sec. 301.6112-1(c)(2) and (3).
---------------------------------------------------------------------------
    A potentially abusive tax shelter is any transaction that: 
(1) is required to be registered under section 6111; (2) is a 
listed transaction (as defined under the regulations under 
section 6011); or (3) any transaction that a potential material 
advisor, at the time the transaction is entered into, knows is 
or reasonably expects will become a reportable transaction (as 
defined under the new regulations under section 6011).\183\
---------------------------------------------------------------------------
    \183\ Treas. Reg. sec. 301.6112-1(b).
---------------------------------------------------------------------------
    The Secretary is required to prescribe regulations which 
provide that, in cases in which two or more persons are 
required to maintain the same list, only one person would be 
required to maintain the list.\184\
---------------------------------------------------------------------------
    \184\ Sec. 6112(c)(2).
---------------------------------------------------------------------------

Penalty for failing to maintain investor lists

    Under section 6708, the penalty for failing to maintain the 
list required under section 6112 is $50 for each name omitted 
from the list (with a maximum penalty of $100,000 per year).

                           REASONS FOR CHANGE

    The Committee has been advised that the present-law 
penalties for failure to maintain customer lists are not 
meaningful and that promoters often have refused to provide 
requested information to the IRS. The Committee believes that 
requiring material advisors to maintain a list of advisees with 
respect to each reportable transaction, coupled with more 
meaningful penalties for failing to maintain an investor list, 
are important tools in the ongoing efforts to curb the use of 
abusive tax avoidance transactions.

                        EXPLANATION OF PROVISION

Investor lists

    Each material advisor \185\ with respect to a reportable 
transaction (including a listed transaction) \186\ is required 
to maintain a list that: (1) identifies each person with 
respect to whom the advisor acted as a material advisor with 
respect to the reportable transaction; and (2) contains other 
information as may be required by the Secretary. In addition, 
the provision authorizes (but does not require) the Secretary 
to prescribe regulations which provide that, in cases in which 
2 or more persons are required to maintain the same list, only 
one person would be required to maintain the list.
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    \185\ The term ``material advisor'' has the same meaning as when 
used in connection with the requirement to file an information return 
under section 6111.
    \186\ The terms ``reportable transaction'' and ``listed 
transaction'' have the same meaning as previously described in 
connection with the taxpayer-related provisions.
---------------------------------------------------------------------------
    The provision also clarifies that, for purposes of section 
6112, the identity of any person is not privileged under the 
common law attorney-client privilege (or, consequently, the 
section 7525 federally authorized tax practitioner 
confidentiality provision).

Penalty for failing to maintain investor lists

    The provision modifies the penalty for failing to maintain 
the required list by making it a time-sensitive penalty. Thus, 
a material advisor who is required to maintain an investor list 
and who fails to make the list available upon written request 
by the Secretary within 20 business days after the request will 
be subject to a $10,000 per day penalty. The penalty applies to 
a person who fails to maintain a list, maintains an incomplete 
list, or has in fact maintained a list but does not make the 
list available to the Secretary. The penalty can be waived if 
the failure to make the list available is due to reasonable 
cause.\187\
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    \187\ In no event will failure to maintain a list be considered 
reasonable cause for failing to make a list available to the Secretary.
---------------------------------------------------------------------------

                             EFFECTIVE DATE

    The provision requiring a material advisor to maintain an 
investor list applies to transactions with respect to which 
material aid, assistance or advice is provided after the date 
of enactment.
    The provision imposing a penalty for failing to maintain 
investor lists applies to requests made after the date of 
enactment.
    The provision clarifying that the identity of any person is 
not privileged for purposes of section 6112 is effective as if 
included in the amendments made by section 142 of the Deficit 
Reduction Act of 1984.

9. Modification of actions to enjoin certain conduct related to tax 
        shelters and reportable transactions (sec. 410 of the bill and 
        sec. 7408 of the Code)

                              PRESENT LAW

    The Code authorizes civil actions to enjoin any person from 
promoting abusive tax shelters or aiding or abetting the 
understatement of tax liability.\188\
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    \188\ Sec. 7408.
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The Committee understands that some promoters are blatantly 
ignoring the rules regarding registration and list maintenance 
regardless of the penalties. An injunction would place these 
promoters in a public proceeding under court order. Thus, the 
Committee believes that the types of tax shelter activities 
with respect to which an injunction may be sought should be 
expanded.

                        EXPLANATION OF PROVISION

    The provision expands this rule so that injunctions may 
also be sought with respect to the requirements relating to the 
reporting of reportable transactions \189\ and the keeping of 
lists of investors by material advisors.\190\ Thus, under the 
provision, an injunction may be sought against a material 
advisor to enjoin the advisor from (1) failing to file an 
information return with respect to a reportable transaction, or 
(2) failing to maintain, or to timely furnish upon written 
request by the Secretary, a list of investors with respect to 
each reportable transaction.
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    \189\ Sec. 6707, as amended by other provisions of this bill.
    \190\ Sec. 6708, as amended by other provisions of this bill.
---------------------------------------------------------------------------

                             EFFECTIVE DATE

    The provision is effective on the day after the date of 
enactment.

10. Understatement of taxpayer's liability by income tax return 
        preparer (sec. 411 of the bill and sec. 6694 of the Code)

                              PRESENT LAW

    An income tax return preparer who prepares a return with 
respect to which there is an understatement of tax that is due 
to a position for which there was not a realistic possibility 
of being sustained on its merits and the position was not 
disclosed (or was frivolous) is liable for a penalty of $250, 
provided that the preparer knew or reasonably should have known 
of the position. An income tax return preparer who prepares a 
return and engages in specified willful or reckless conduct 
with respect to preparing such a return is liable for a penalty 
of $1,000.

                           REASONS FOR CHANGE

    The Committee believes that the standards of conduct 
applicable to income tax return preparers should be the same as 
the standards applicable to taxpayers. Accordingly, the minimum 
standard for each undisclosed position on a tax return would be 
that the preparer must reasonably believe that the tax 
treatment is more likely than not the proper tax treatment. The 
Committee believes that this standard is appropriate because 
the tax return is signed under penalties of perjury, which 
implies a high standard of diligence in determining the facts 
and substantial accuracy in determining and applying the rules 
that govern those facts. The Committee believes that it is both 
appropriate and vital to the tax system that both taxpayers and 
their return preparers file tax returns that they reasonably 
believe are more likely than not correct. In addition, 
conforming the standards of conduct applicable to income tax 
return preparers to the standards applicable to taxpayers will 
simplify the law by reducing confusion inherent in different 
standards applying to the same behavior.

                        EXPLANATION OF PROVISION

    The provision alters the standards of conduct that must be 
met to avoid imposition of the first penalty. The provision 
replaces the realistic possibility standard with a requirement 
that there be a reasonable belief that the tax treatment of the 
position was more likely than not the proper treatment. The 
provision also replaces the not frivolous standard with the 
requirement that there be a reasonable basis for the tax 
treatment of the position.
    In addition, the provision increases the amount of these 
penalties. The penalty relating to not having a reasonable 
belief that the tax treatment was more likely than not the 
proper tax treatment is increased from $250 to $1,000. The 
penalty relating to willful or reckless conduct is increased 
from $1,000 to $5,000.

                             EFFECTIVE DATE

    The provision is effective for documents prepared after the 
date of enactment.

11. Penalty on failure to report interests in foreign financial 
        accounts (sec. 412 of the bill and sec. 5321 of Title 31, 
        United States Code)

                              PRESENT LAW

    The Secretary of the Treasury must require citizens, 
residents, or persons doing business in the United States to 
keep records and file reports when that person makes a 
transaction or maintains an account with a foreign financial 
entity.\191\ In general, individuals must fulfill this 
requirement by answering questions regarding foreign accounts 
or foreign trusts that are contained in Part III of Schedule B 
of the IRS Form 1040. Taxpayers who answer ``yes'' in response 
to the question regarding foreign accounts must then file 
Treasury Department Form TD F 90-22.1. This form must be filed 
with the Department of the Treasury, and not as part of the tax 
return that is filed with the IRS.
---------------------------------------------------------------------------
    \191\ 31 U.S.C. 5314.
---------------------------------------------------------------------------
    The Secretary of the Treasury may impose a civil penalty on 
any person who willfully violates this reporting requirement. 
The civil penalty is the amount of the transaction or the value 
of the account, up to a maximum of $100,000; the minimum amount 
of the penalty is $25,000.\192\ In addition, any person who 
willfully violates this reporting requirement is subject to a 
criminal penalty. The criminal penalty is a fine of not more 
than $250,000 or imprisonment for not more than five years (or 
both); if the violation is part of a pattern of illegal 
activity, the maximum amount of the fine is increased to 
$500,000 and the maximum length of imprisonment is increased to 
10 years.\193\
---------------------------------------------------------------------------
    \192\ 31 U.S.C. 5321(a)(5).
    \193\ 31 U.S.C. 5322.
---------------------------------------------------------------------------
    On April 26, 2002, the Secretary of the Treasury submitted 
to the Congress a report on these reporting requirements.\194\ 
This report, which was statutorily required,\195\ studies 
methods for improving compliance with these reporting 
requirements. It makes several administrative recommendations, 
but no legislative recommendations. A further report was 
required to be submitted by the Secretary of the Treasury to 
the Congress by October 26, 2002.
---------------------------------------------------------------------------
    \194\ A Report to Congress in Accordance with Sec. 361(b) of the 
Uniting and Strengthening America by Providing Appropriate Tools 
Required to Intercept and Obstruct Terrorism Act of 2001, April 26, 
2002.
    \195\ Sec. 361(b) of the USA PATRIOT Act of 2001 (Pub. L. 107-56).
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The Committee understands that the number of individuals 
involved in using offshore bank accounts to engage in abusive 
tax scams has grown significantly in recent years. For one 
scheme alone, the IRS estimates that there may be hundreds of 
thousands of taxpayers with offshore bank accounts attempting 
to conceal income from the IRS. The Committee is concerned 
about this activity and believes that improving compliance with 
this reporting requirement is vitally important to sound tax 
administration, to combating terrorism, and to preventing the 
use of abusive tax schemes and scams. Adding a new civil 
penalty that applies without regard to willfulness will improve 
compliance with this reporting requirement.

                        EXPLANATION OF PROVISION

    The provision adds an additional civil penalty that may be 
imposed on any person who violates this reporting requirement 
(without regard to willfulness). This new civil penalty is up 
to $5,000. The penalty may be waived if any income from the 
account was properly reported on the income tax return and 
there was reasonable cause for the failure to report.

                             EFFECTIVE DATE

    The provision is effective with respect to failures to 
report occurring on or after the date of enactment.

12. Frivolous tax submissions (sec. 413 of the bill and sec. 6702 of 
        the Code)

                              PRESENT LAW

    The Code provides that an individual who files a frivolous 
income tax return is subject to a penalty of $500 imposed by 
the IRS (sec. 6702). The Code also permits the Tax Court \196\ 
to impose a penalty of up to $25,000 if a taxpayer has 
instituted or maintained proceedings primarily for delay or if 
the taxpayer's position in the proceeding is frivolous or 
groundless (sec. 6673(a)).
---------------------------------------------------------------------------
    \196\ Because in general the Tax Court is the only pre-payment 
forum available to taxpayers, it deals with most of the frivolous, 
groundless, or dilatory arguments raised in tax cases.
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The IRS has been faced with a significant number of tax 
filers who are filing returns based on frivolous arguments or 
who are seeking to hinder tax administration by filing returns 
that are patently incorrect. In addition, taxpayers are using 
existing procedures for collection due process hearings, 
offers-in-compromise, installment agreements, and taxpayer 
assistance orders to impede or delay tax administration by 
raising frivolous arguments. These procedures were intended to 
provide assistance to taxpayers genuinely seeking to resolve 
legitimate disputes with the IRS, and the use of these 
procedures for impeding or delaying tax administration diverts 
scarce IRS resources away from resolving genuine disputes. 
Allowing the IRS to assert more substantial penalties for 
frivolous submissions and to dismiss frivolous requests without 
the need to follow otherwise mandated procedures will deter 
frivolous taxpayer behavior and enable the IRS to use its 
resources to better assist taxpayers in resolving genuine 
disputes.

                        EXPLANATION OF PROVISION

    The provision modifies the IRS-imposed penalty by 
increasing the amount of the penalty to up to $5,000 and by 
applying it to all taxpayers and to all types of Federal taxes.
    The provision also modifies present law with respect to 
certain submissions that raise frivolous arguments or that are 
intended to delay or impede tax administration. The submissions 
to which this provision applies are requests for a collection 
due process hearing, installment agreements, offers-in-
compromise, and taxpayer assistance orders. First, the 
provision permits the IRS to dismiss such requests. Second, the 
provision permits the IRS to impose a penalty of up to $5,000 
for such requests, unless the taxpayer withdraws the request 
after being given an opportunity to do so.
    The provision requires the IRS to publish a list of 
positions, arguments, requests, and submissions determined to 
be frivolous for purposes of these provisions.

                             EFFECTIVE DATE

    The provision is effective for submissions made and issues 
raised after the date on which the Secretary first prescribes 
the required list.

13. Regulation of individuals practicing before the Department of 
        Treasury (sec. 414 of the bill and sec. 330 of Title 31, United 
        States Code)

                              PRESENT LAW

    The Secretary of the Treasury is authorized to regulate the 
practice of representatives of persons before the Department of 
the Treasury.\197\ The Secretary is also authorized to suspend 
or disbar from practice before the Department a representative 
who is incompetent, who is disreputable, who violates the rules 
regulating practice before the Department, or who (with intent 
to defraud) willfully and knowingly misleads or threatens the 
person being represented (or a person who may be represented). 
The rules promulgated by the Secretary pursuant to this 
provision are contained in Circular 230.
---------------------------------------------------------------------------
    \197\ 31 U.S.C. 330.
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The Committee believes that it is critical that the 
Secretary have the authority to censure tax advisors as well as 
to impose monetary sanctions against tax advisors because of 
the important role of tax advisors in our tax system. Use of 
these sanctions is expected to curb the participation of tax 
advisors in both tax shelter activity and any other activity 
that is contrary to Circular 230 standards.

                        EXPLANATION OF PROVISION

    The provision makes two modifications to expand the 
sanctions that the Secretary may impose pursuant to these 
statutory provisions. First, the provision expressly permits 
censure as a sanction. Second, the provision permits the 
imposition of a monetary penalty as a sanction. If the 
representative is acting on behalf of an employer or other 
entity, the Secretary may impose a monetary penalty on the 
employer or other entity if it knew, or reasonably should have 
known, of the conduct. This monetary penalty on the employer or 
other entity may be imposed in addition to any monetary penalty 
imposed directly on the representative. These monetary 
penalties are not to exceed the gross income derived (or to be 
derived) from the conduct giving rise to the penalty. These 
monetary penalties may be in addition to, or in lieu of, any 
suspension, disbarment, or censure.
    The provision also confirms the present-law authority of 
the Secretary to impose standards applicable to written advice 
with respect to an entity, plan, or arrangement that is of a 
type that the Secretary determines as having a potential for 
tax avoidance or evasion.

                             EFFECTIVE DATE

    The modifications to expand the sanctions that the 
Secretary may impose are effective for actions taken after the 
date of enactment.

14. Penalty on promoters of tax shelters (sec. 415 of the bill and sec. 
        6700 of the Code)

                              PRESENT LAW

    A penalty is imposed on any person who organizes, assists 
in the organization of, or participates in the sale of any 
interest in, a partnership or other entity, any investment plan 
or arrangement, or any other plan or arrangement, if in 
connection with such activity the person makes or furnishes a 
qualifying false or fraudulent statement or a gross valuation 
overstatement.\198\ A qualified false or fraudulent statement 
is any statement with respect to the allowability of any 
deduction or credit, the excludability of any income, or the 
securing of any other tax benefit by reason of holding an 
interest in the entity or participating in the plan or 
arrangement which the person knows or has reason to know is 
false or fraudulent as to any material matter. A ``gross 
valuation overstatement'' means any statement as to the value 
of any property or services if the stated value exceeds 200 
percent of the correct valuation, and the value is directly 
related to the amount of any allowable income tax deduction or 
credit.
---------------------------------------------------------------------------
    \198\ Sec. 6700.
---------------------------------------------------------------------------
    The amount of the penalty is $1,000 (or, if the person 
establishes that it is less, 100 percent of the gross income 
derived or to be derived by the person from such activity). A 
penalty attributable to a gross valuation misstatement can be 
waived on a showing that there was a reasonable basis for the 
valuation and it was made in good faith.

                           REASONS FOR CHANGE

    The Committee believes that the present-law penalty rate is 
insufficient to deter the type of conduct that gives rise to 
the penalty.

                        EXPLANATION OF PROVISION

    The provision modifies the penalty amount to equal 50 
percent of the gross income derived by the person from the 
activity for which the penalty is imposed. The new penalty rate 
applies to any activity that involves a statement regarding the 
tax benefits of participating in a plan or arrangement if the 
person knows or has reason to know that such statement is false 
or fraudulent as to any material matter. The enhanced penalty 
does not apply to a gross valuation overstatement.

                             EFFECTIVE DATE

    The provision is effective for activities after the date of 
enactment.

15. Statute of limitations for taxable years for which required listed 
        transactions not disclosed (sec. 416 of the bill and sec. 6501 
        of the Code)

                              PRESENT LAW

    In general, the Code requires that taxes be assessed within 
three years \199\ after the date a return is filed.\200\ If 
there has been a substantial omission of items of gross income 
that totals more than 25 percent of the amount of gross income 
shown on the return, the period during which an assessment must 
be made is extended to six years.\201\ If an assessment is not 
made within the required time periods, the tax generally cannot 
be assessed or collected at any future time. Tax may be 
assessed at any time if the taxpayer files a false or 
fraudulent return with the intent to evade tax or if the 
taxpayer does not file a tax return at all.\202\
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    \199\ Sec. 6501(a).
    \200\ For this purpose, a return that is filed before the date on 
which it is due is considered to be filed on the required due date 
(sec. 6501(b)(1)).
    \201\ Sec. 6501(e).
    \202\ Sec. 6501(c).
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The Committee believes that extending the statute of 
limitations if a taxpayer required to disclose a listed 
transaction fails to do so will encourage taxpayers to provide 
the required disclosure and will afford the IRS additional time 
to discover the transaction if the taxpayer does not disclose 
it.

                        EXPLANATION OF PROVISION

    The provision extends the statute of limitations with 
respect to a listed transaction if a taxpayer fails to include 
on any return or statement for any taxable year any information 
with respect to a listed transaction \203\ which is required to 
be included (under section 6011) with such return or statement. 
The statute of limitations with respect to such a transaction 
will not expire before the date which is one year after the 
earlier of (1) the date on which the Secretary is furnished the 
information so required, or (2) the date that a material 
advisor (as defined in 6111) satisfies the list maintenance 
requirements (as defined by section 6112) with respect to a 
request by the Secretary. For example, if a taxpayer engaged in 
a transaction in 2005 that becomes a listed transaction in 2007 
and the taxpayer fails to disclose such transaction in the 
manner required by Treasury regulations, then the transaction 
is subject to the extended statute of limitations.\204\
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    \203\ The term ``listed transaction'' has the same meaning as 
described in a previous provision regarding the penalty for failure to 
disclose reportable transactions.
    \204\ If the Treasury Department lists a transaction in a year 
subsequent to the year in which a taxpayer entered into such 
transaction and the taxpayer's tax return for the year the transaction 
was entered into is closed by the statute of limitations prior to the 
date the transaction became a listed transaction, this provision does 
not re-open the statute of limitations with respect to such transaction 
for such year. However, if the purported tax benefits of the 
transaction are recognized over multiple tax years, the provision's 
extension of the statute of limitations shall apply to such tax 
benefits in any subsequent tax year in which the statute of limitations 
had not closed prior to the date the transaction became a listed 
transaction.
---------------------------------------------------------------------------

                             EFFECTIVE DATE

    The provision is effective for taxable years with respect 
to which the period for assessing a deficiency did not expire 
before the date of enactment.

16. Denial of deduction for interest on underpayments attributable to 
        nondisclosed reportable and noneconomic substance transactions 
        (sec. 417 of the bill and sec. 163 of the Code)

                              PRESENT LAW

    In general, corporations may deduct interest paid or 
accrued within a taxable year on indebtedness.\205\ Interest on 
indebtedness to the Federal government attributable to an 
underpayment of tax generally may be deducted pursuant to this 
provision.
---------------------------------------------------------------------------
    \205\ Sec. 163(a).
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The Committee believes that it is inappropriate for 
corporations to deduct interest paid to the Government with 
respect to certain tax shelter transactions.

                        EXPLANATION OF PROVISION

    The provision disallows any deduction for interest paid or 
accrued within a taxable year on any portion of an underpayment 
of tax that is attributable to an understatement arising from 
(1) an undisclosed reportable avoidance transaction, (2) an 
undisclosed listed transaction, or (3) a transaction that lacks 
economic substance.\206\
---------------------------------------------------------------------------
    \206\ The definitions of these transactions are the same as those 
previously described in connection with the provision to modify the 
accuracy-related penalty for listed and certain reportable transactions 
and the provision to impose a penalty on understatements attributable 
to transactions that lack economic substance.
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                             EFFECTIVE DATE

    The provision is effective for underpayments attributable 
to transactions entered into in taxable years beginning after 
the date of enactment.

17. Authorization of appropriations for tax law enforcement (sec. 418 
        of the bill)

                              PRESENT LAW

    There is no explicit authorization of appropriations to the 
Internal Revenue Service to be used to combat abusive tax 
avoidance transactions.

                           REASONS FOR CHANGE

    The Committee believes that authorizing an additional $300 
million to the Internal Revenue Service to be used to combat 
abusive tax avoidance transactions will aid in the 
implementation of the tax shelter measures the Committee is 
simultaneously approving.

                        EXPLANATION OF PROVISION

    The provision includes an authorization of an additional 
$300 million to the Internal Revenue Service to be used to 
combat abusive tax avoidance transactions.

                             EFFECTIVE DATE

    The provision is effective on the date of enactment.

                B. Other Corporate Governance Provisions


1. Affirmation of consolidated return regulation authority (sec. 421 of 
        the bill and sec. 502 of the Code)

                              PRESENT LAW

    An affiliated group of corporations may elect to file a 
consolidated return in lieu of separate returns. A condition of 
electing to file a consolidated return is that all corporations 
that are members of the consolidated group must consent to all 
the consolidated return regulations prescribed under section 
1502 prior to the last day prescribed by law for filing such 
return.\207\
---------------------------------------------------------------------------
    \207\ Sec. 1501.
---------------------------------------------------------------------------
    Section 1502 states:

          The Secretary shall prescribe such regulations as he 
        may deem necessary in order that the tax liability of 
        any affiliated group of corporations making a 
        consolidated return and of each corporation in the 
        group, both during and after the period of affiliation, 
        may be returned, determined, computed, assessed, 
        collected, and adjusted, in such manner as clearly to 
        reflect the income-tax liability and the various 
        factors necessary for the determination of such 
        liability, and in order to prevent the avoidance of 
        such tax liability.\208\
---------------------------------------------------------------------------
    \208\ Sec. 1502.

    Under this authority, the Treasury Department has issued 
extensive consolidated return regulations.\209\
---------------------------------------------------------------------------
    \209\ Regulations issued under the authority of section 1502 are 
considered to be ``legislative'' regulations rather than 
``interpretative'' regulations, and as such are usually given greater 
deference by courts in case of a taxpayer challenge to such a 
regulation. See, S. Rep. No. 960, 70th Cong., 1st Sess. at 15 (1928), 
describing the consolidated return regulations as ``legislative in 
character''. The Supreme Court has stated that ``* * * legislative 
regulations are given controlling weight unless they are arbitrary, 
capricious, or manifestly contrary to the statute.'' Chevron, U.S.A., 
Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837, 844 
(1984) (involving an environmental protection regulation). For examples 
involving consolidated return regulations, see, e.g., Wolter 
Construction Company v. Commissioner, 634 F.2d 1029 (6th Cir. 1980); 
Garvey, Inc. v. United States, 1 Ct. Cl. 108 (1983), aff'd 726 F.2d 
1569 (Fed. Cir. 1984), cert. denied, 469 U.S. 823 (1984). Compare, 
e.g., Audrey J. Walton v. Commissioner, 115 T.C. 589 (2000), describing 
different standards of review. The case did not involve a consolidated 
return regulation.
---------------------------------------------------------------------------
    In the recent case of Rite Aid Corp. v. United States,\210\ 
the Federal Circuit Court of Appeals addressed the application 
of a particular provision of certain consolidated return loss 
disallowance regulations, and concluded that the provision was 
invalid.\211\ The particular provision, known as the 
``duplicated loss'' provision,\212\ would have denied a loss on 
the sale of stock of a subsidiary by a parent corporation that 
had filed a consolidated return with the subsidiary, to the 
extent the subsidiary corporation had assets that had a built-
in loss, or had a net operating loss, that could be recognized 
or used later.\213\
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    \210\ 255 F.3d 1357 (Fed. Cir. 2001), reh'g denied, 2001 U.S. App. 
LEXIS 23207 (Fed. Cir. Oct. 3, 2001).
    \211\ Prior to this decision, there had been a few instances 
involving prior laws in which certain consolidated return regulations 
were held to be invalid. See, e.g., American Standard, Inc. v. United 
States, 602 F.2d 256 (Ct. Cl. 1979), discussed in the text infra. see 
also Union Carbide Corp. v. United States, 612 F.2d 558 (Ct. Cl. 1979), 
and Allied Corporation v. United States, 685 F. 2d 396 (Ct. Cl. 1982), 
all three cases involving the allocation of income and loss within a 
consolidated group for purposes of computation of a deduction allowed 
under prior law by the Code for Western Hemisphere Trading 
Corporations. See also Joseph Weidenhoff v. Commissioner, 32 T.C. 1222, 
1242-1244 (1959), involving the application of certain regulations to 
the excess profits tax credit allowed under prior law, and concluding 
that the Commissioner had applied a particular regulation in an 
arbitrary manner inconsistent with the wording of the regulation and 
inconsistent with even a consolidated group computation. Cf. Kanawha 
Gas & Utilities Co. v. Commissioner, 214 F.2d 685 (1954), concluding 
that the substance of a transaction was an acquisition of assets rather 
than stock. Thus, a regulation governing basis of the assets of 
consolidated subsidiaries did not apply to the case. See also General 
Machinery Corporation v. Commissioner, 33 B.T.A. 1215 (1936); Lefcourt 
Realty Corporation, 31 B.T.A. 978 (1935); Helvering v. Morgans, Inc., 
293 U.S. 121 (1934), interpreting the term ``taxable year.''
    \212\ Treas. Reg. Sec. 1.1502-20(c)(1)(iii).
    \213\ Treasury Regulation section 1.1502-20, generally imposing 
certain ``loss disallowance'' rules on the disposition of subsidiary 
stock, contained other limitations besides the ``duplicated loss'' rule 
that could limit the loss available to the group on a disposition of a 
subsidiary's stock. Treasury Regulation section 1.1502-20 as a whole 
was promulgated in connection with regulations issued under section 
337(d), principally in connection with the so-called General Utilities 
repeal of 1986 (referring to the case of General Utilities & Operating 
Company v. Helvering, 296 U.S. 200 (1935)). Such repeal generally 
required a liquidating corporation, or a corporation acquired in a 
stock acquisition treated as a sale of assets, to pay corporate level 
tax on the excess of the value of its assets over the basis. Treasury 
regulation section 1.1502-20 principally reflected an attempt to 
prevent corporations filing consolidated returns from offsetting income 
with a loss on the sale of subsidiary stock. Such a loss could result 
from the unique upward adjustment of a subsidiary's stock basis 
required under the consolidated return regulations for subsidiary 
income earned in consolidation, an adjustment intended to prevent 
taxation of both the subsidiary and the parent on the same income or 
gain. As one example, absent a denial of certain losses on a sale of 
subsidiary stock, a consolidated group could obtain a loss deduction 
with respect to subsidiary stock, the basis of which originally 
reflected the subsidiary's value at the time of the purchase of the 
stock, and that had then been adjusted upward on recognition of any 
built-in income or gain of the subsidiary reflected in that value. The 
regulations also contained the duplicated loss factor addressed by the 
court in Rite Aid. The preamble to the regulations stated: ``it is not 
administratively feasible to differentiate between loss attributable to 
built-in gain and duplicated loss.'' T.D. 8364, 1991-2 C.B. 43, 46 
(Sept. 13, 1991). The government also argued in the Rite Aid case that 
duplicated loss was a separate concern of the regulations. 255 F.3d at 
1360.
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    The Federal Circuit Court opinion contained language 
discussing the fact that the regulation produced a result 
different than the result that would have obtained if the 
corporations had filed separate returns rather than 
consolidated returns.\214\
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    \214\ For example, the court stated: ``The duplicated loss factor * 
* * addresses a situation that arises from the sale of stock regardless 
of whether corporations file separate or consolidated returns. With 
I.R.C. secs. 382 and 383, Congress has addressed this situation by 
limiting the subsidiary's potential future deduction, not the parent's 
loss on the sale of stock under I.R.C. sec. 165.'' 255 F.3d 1357, 1360 
(Fed. Cir. 2001).
---------------------------------------------------------------------------
    The Federal Circuit Court opinion cited a 1928 Senate 
Finance Committee Report to legislation that authorized 
consolidated return regulations, which stated that ``many 
difficult and complicated problems, * * * have arisen in the 
administration of the provisions permitting the filing of 
consolidated returns'' and that the committee ``found it 
necessary to delegate power to the commissioner to prescribe 
regulations legislative in character covering them.'' \215\ The 
Court's opinion also cited a previous decision of the Court of 
Claims for the proposition, interpreting this legislative 
history, that section 1502 grants the Secretary ``the power to 
conform the applicable income tax law of the Code to the 
special, myriad problems resulting from the filing of 
consolidated income tax returns;'' but that section 1502 ``does 
not authorize the Secretary to choose a method that imposes a 
tax on income that would not otherwise be taxed.'' \216\
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    \215\ S. Rep. No. 960, 70th Cong., 1st Sess. 15 (1928). Though not 
quoted by the court in Rite Aid, the same Senate report also indicated 
that one purpose of the consolidated return authority was to permit 
treatment of the separate corporations as if they were a single unit, 
stating ``The mere fact that by legal fiction several corporations 
owned by the same shareholders are separate entities should not obscure 
the fact that they are in reality one and the same business owned by 
the same individuals and operated as a unit.'' S. Rep. No. 960, 70th 
Cong., 1st Sess. 29 (1928).
    \216\ American Standard, Inc. v. United States, 602 F.2d 256, 261 
(Ct. Cl. 1979). That case did not involve the question of separate 
returns as compared to a single return approach. It involved the 
computation of a Western Hemisphere Trade Corporation (``WHTC'') 
deduction under prior law (which deduction would have been computed as 
a percentage of each WHTC's taxable income if the corporations had 
filed separate returns), in a case where a consolidated group included 
several WHTCs as well as other corporations. The question was how to 
apportion income and losses of the admittedly consolidated WHTCs and 
how to combine that computation with the rest of the group's 
consolidated income or losses. The court noted that the new, changed 
regulations approach varied from the approach taken to a similar 
problem involving public utilities within a group and previously 
allowed for WHTCs. The court objected that the allocation method 
adopted by the regulation allowed non-WHTC losses to reduce WHTC 
income. However, the court did not disallow a method that would net 
WHTC income of one WHTC with losses of another WHTC, a result that 
would not have occurred under separate returns. Nor did the court 
expressly disallow a different fractional method that would net both 
income and losses of the WHTCs with those of other corporations in the 
consolidated group. The court also found that the regulation had been 
adopted without proper notice.
---------------------------------------------------------------------------
    The Federal Circuit Court construed these authorities and 
applied them to invalidate Treas. Reg. Sec. 1.1502-
20(c)(1)(iii), stating that:

          The loss realized on the sale of a former 
        subsidiary's assets after the consolidated group sells 
        the subsidiary's stock is not a problem resulting from 
        the filing of consolidated income tax returns. The 
        scenario also arises where a corporate shareholder 
        sells the stock of a non-consolidated subsidiary. The 
        corporate shareholder could realize a loss under I.R.C. 
        sec. 1001, and deduct the loss under I.R.C. sec. 165. 
        The subsidiary could then deduct any losses from a 
        later sale of assets. The duplicated loss factor, 
        therefore, addresses a situation that arises from the 
        sale of stock regardless of whether corporations file 
        separate or consolidated returns. With I.R.C. secs. 382 
        and 383, Congress has addressed this situation by 
        limiting the subsidiary's potential future deduction, 
        not the parent's loss on the sale of stock under I.R.C. 
        sec. 165.\217\
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    \217\ Rite Aid, 255 F.3d at 1360.

    The Treasury Department has announced that it will not 
continue to litigate the validity of the duplicated loss 
provision of the regulations, and has issued interim 
regulations that permit taxpayers for all years to elect a 
different treatment, though they may apply the provision for 
the past if they wish.\218\
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    \218\ See Temp. Reg. Sec. 1.1502-20T(i)(2), Temp. Reg. Sec. 
1.337(d)-2T, and Temp. Reg. Sec. 1.1502-35T. The Treasury Department 
has also indicated its intention to continue to study all the issues 
that the original loss disallowance regulations addressed (including 
issues of furthering single entity principles) and possibly issue 
different regulations (not including the particular approach of Treas. 
Reg. Sec. 1.1502-20(c)(1)(iii)) on the issues in the future. See Notice 
2002-11, 2002-7 I.R.B. 526 (Feb. 19, 2002); T.D. 8984, 67 F.R. 11034 
(March 12, 2002); REG-102740-02, 67 F.R. 11070 (March 12, 2002); see 
also Notice 2002-18, 2002-12 I.R.B. 644 (March 25, 2002); REG-131478-
02, 67 F.R. 65060 (October 18, 2002); and T.D. 9048, 68 F.R. 12287 
(March 14, 2003).
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                           REASONS FOR CHANGE

    The Committee is concerned that Treasury Department 
resources might be unnecessarily devoted to defending 
challenges to consolidated return regulations on the mere 
assertion by a taxpayer that the result under the consolidated 
return regulations is different than the result for separate 
taxpayers. The consolidated return regulations offer many 
benefits that are not available to separate taxpayers, 
including generally rules that tax income received by the group 
once and attempt to avoid a second tax on that same income when 
stock of a subsidiary is sold.
    The existing statute authorizes adjustments to clearly 
reflect the income of the group and of the separate members of 
the group, during and after the period of affiliation. The 
Committee believes that this standard, which is stated in the 
present law statute, should be reiterated.

                        EXPLANATION OF PROVISION

    The bill confirms that, in exercising its authority under 
section 1502 to issue consolidated return regulations, the 
Treasury Department may provide rules treating corporations 
filing consolidated returns differently from corporations 
filing separate returns.
    Thus, under the statutory authority of section 1502, the 
Treasury Department is authorized to issue consolidated return 
regulations utilizing either a single taxpayer or separate 
taxpayer approach or a combination of the two approaches, as 
Treasury deems necessary in order that the tax liability of any 
affiliated group of corporations making a consolidated return, 
and of each corporation in the group, both during and after the 
period of affiliation, may be determined and adjusted in such 
manner as clearly to reflect the income-tax liability and the 
various factors necessary for the determination of such 
liability, and in order to prevent avoidance of such liability.
    Rite Aid is thus overruled to the extent it suggests that 
the Secretary is required to identify a problem created from 
the filing of consolidated returns in order to issue 
regulations that change the application of a Code provision. 
The Secretary may promulgate consolidated return regulations to 
change the application of a tax code provision to members of a 
consolidated group, provided that such regulations are 
necessary to clearly reflect the income tax liability of the 
group and each corporation in the group, both during and after 
the period of affiliation.
    The bill nevertheless allows the result of the Rite Aid 
case to stand with respect to the type of factual situation 
presented in the case. That is, the legislation provides for 
the override of the regulatory provision that took the approach 
of denying a loss on a deconsolidating disposition of stock of 
a consolidated subsidiary \219\ to the extent the subsidiary 
had net operating losses or built in losses that could be used 
later outside the group.\220\
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    \219\ Treas. Reg. Sec. 1.1502-20(c)(1)(iii).
    \220\ The provision is not intended to overrule the current 
Treasury Department regulations, which allow taxpayers in certain 
circumstances for the past to follow Treasury Regulations Section 
1.1502-20(c)(1)(iii), if they choose to do so. Temp. Reg. Sec. 1.1502-
20T(i)(2).
---------------------------------------------------------------------------
    Retaining the result in the Rite Aid case with respect to 
the particular regulation section 1.1502-20(c)(1)(iii) as 
applied to the factual situation of the case does not in any 
way prevent or invalidate the various approaches Treasury has 
announced it will apply or that it intends to consider in lieu 
of the approach of that regulation, including, for example, the 
denial of a loss ona stock sale if inside losses of a 
subsidiary may also be used by the consolidated group, and the possible 
requirement that inside attributes be adjusted when a subsidiary leaves 
a group.\221\
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    \221\ See, e.g., Notice 2002-11, 2002-7 I.R.B. 526 (Feb. 19, 2002); 
Temp. Reg. Sec. 1.337(d)-2T, (T.D. 8984, 67 F.R. 11034 (March 12, 2002) 
and T.D. 8998, 67 F.R. 37998 (May 31, 2002)); REG-102740-02, 67 F.R. 
11070 (March 12, 2002); See also Notice 2002-18, 2002-12 I.R.B. 644 
(March 25, 2002); REG-131478-02, 67 F.R. 65060 (October 18, 2002); 
Temp. Reg. Sec. 1.1502-35T (T.D. 9048, 68 F.R. 12287 (March 14, 2003)). 
In exercising its authority under section 1502, the Secretary is also 
authorized to prescribe rules that protect the purpose of General 
Utilities repeal using presumptions and other simplifying conventions.
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                            EFFECTIVE DATE.

    The provision is effective for all years, whether beginning 
before, on, or after the date of enactment of the provision. No 
inference is intended that the results following from this 
provision are not the same as the results under present law.

2. Chief Executive Officer required to sign corporate income tax 
        returns (sec. 422 of the bill and sec. 6062 of the Code)

                              PRESENT LAW

    The Code requires \222\ that the income tax return of a 
corporation must be signed by either the president, the vice-
president, the treasurer, the assistant treasurer, the chief 
accounting officer, or any other officer of the corporation 
authorized by the corporation to sign the return.
---------------------------------------------------------------------------
    \222\ Sec. 6062.
---------------------------------------------------------------------------
    The Code also imposes \223\ a criminal penalty on any 
person who willfully signs any tax return under penalties of 
perjury that that person does not believe to be true and 
correct with respect to every material matter at the time of 
filing. If convicted, the person is guilty of a felony; the 
Code imposes a fine of not more than $100,000 \224\ ($500,000 
in the case of a corporation) or imprisonment of not more than 
three years, or both, together with the costs of prosecution.
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    \223\ Sec. 7206.
    \224\ Pursuant to 18 U.S.C. 3571, the maximum fine for an 
individual convicted of a felony is $250,000.
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The Committee believes that the filing of accurate tax 
returns is essential to the proper functioning of the tax 
system. The Committee believes that requiring that the chief 
executive officer of a corporation sign a declaration that its 
corporate income tax return complies with the Internal Revenue 
Code will elevate both the level of care given to the 
preparation of those returns and the level of compliance with 
the Code's requirements, which will in turn help ensure that 
the proper amount of tax is being paid.

                        EXPLANATION OF PROVISION

    The provision requires that the chief executive officer of 
a corporation sign a declaration under penalties of perjury 
that the corporation's income tax return complies with the 
Internal Revenue Code and that the CEO was provided reasonable 
assurance of the accuracy of all material aspects of the 
return. This declaration is part of the income tax return. The 
provision is in addition to the requirement of present law as 
to the signing of the income tax return itself. Because a CEO's 
duties generally do not require a detailed or technical 
understanding of the corporation's tax return, it is 
anticipated that this declaration of the CEO will be more 
limited in scope than the declaration of the officer required 
to sign the return itself.
    The Secretary of the Treasury shall prescribe the matters 
to which the declaration of the CEO applies. It is intended 
that the declaration help insure that the preparation and 
completion of the corporation's tax return be given an 
appropriate level of care. For example, it is anticipated that 
the CEO would declare that processes and procedures have been 
implemented to ensure that the return complies with the 
Internal Revenue Code and all regulations and rules promulgated 
thereunder. Although appropriate processes and procedures can 
vary for each taxpayer depending on the size and nature of the 
taxpayer's business, in every case the CEO should be briefed on 
all material aspects of the corporation's tax return by the 
corporation's chief financial officer (or another person 
authorized to sign the return under present law).
    It is also anticipated that, as part of the declaration, 
the CEO would certify that, to the best of the CEO's knowledge 
and belief: (1) the processes and procedures for ensuring that 
the corporation files a tax return that complies with the 
requirements of the Code are operating effectively; (2) the 
return is true, accurate, and complete; (3) the officer signing 
the return did so under no compulsion to adopt any tax position 
with which that person did not agree; (4) the CEO was briefed 
on all listed transactions as well as all reportable tax 
avoidance transactions otherwise required to be disclosed on 
the tax return; and (5) all required disclosures have been 
filed with the return. The Secretary may by regulations 
prescribe additional requirements for this declaration.\225\
---------------------------------------------------------------------------
    \225\ Sec. 6011(a).
---------------------------------------------------------------------------
    If the corporation does not have a chief executive officer, 
the IRS may designate another officer of the corporation; 
otherwise, no other person is permitted to sign the 
declaration. It is intended that the IRS issue general 
guidance, such as a revenue procedure, to: (1) address 
situations when a corporation does not have a chief executive 
officer; and (2) define who the chief executive officer is, in 
situations (for example) when the primary official bears a 
different title, when a corporation has multiple chief 
executive officers, or when the corporation is aforeign 
corporation and the CEO is not a U.S. resident.\226\ It is intended 
that, in every instance, the highest ranking corporate officer 
(regardless of title) sign this declaration.
---------------------------------------------------------------------------
    \226\ With respect to foregin corporations, it is intended that the 
rules for signing this declaration generally parallel the present-law 
rules for signing the return. See Treas. Reg. sec. 1.6062-1(a)(3).
---------------------------------------------------------------------------
    The provision does not apply to the income tax returns of 
mutual funds; \227\ they are required to be signed as under 
present law.
---------------------------------------------------------------------------
    \227\ The provision does, however, apply to the income tax returns 
of mutual fund management companies and advisors.
---------------------------------------------------------------------------

                             EFFECTIVE DATE

    The provision is effective for returns filed after the date 
of enactment.

3. Denial of deduction for certain fines, penalties, and other amounts 
        (sec. 423 of the bill and sec. 162 of the Code)

                              PRESENT LAW

    Under present law, no deduction is allowed as a trade or 
business expense under section 162(a) for the payment of a fine 
or similar penalty to a government for the violation of any law 
(sec. 162(f)). The enactment of section 162(f) in 1969 codified 
existing case law that denied the deductibility of fines as 
ordinary and necessary business expenses on the grounds that 
``allowance of the deduction would frustrate sharply defined 
national or State policies proscribing the particular types of 
conduct evidenced by some governmental declaration thereof.'' 
\228\
---------------------------------------------------------------------------
    \228\ S. Rep. 91-552, 91st Cong., 1st. Sess., 273-74 (1969), 
referring to Tank Truck Rentals, Inc.v. Commissioner, 356 U.S. 30 
(1958).
---------------------------------------------------------------------------
    Treasury regulation section 1.162-21(b)(1) provides that a 
fine or similar penalty includes an amount: (1) paid pursuant 
to conviction or a plea of guilty or nolo contendere for a 
crime (felony or misdemeanor) in a criminal proceeding; (2) 
paid as a civil penalty imposed by Federal, State, or local 
law, including additions to tax and additional amounts and 
assessable penalties imposed by chapter 68 of the Code; (3) 
paid in settlement of the taxpayer's actual or potential 
liability for a fine or penalty (civil or criminal); or (4) 
forfeited as collateral posted in connection with a proceeding 
which could result in imposition of such a fine or penalty. 
Treasury regulation section 1.162-21(b)(2) provides, among 
other things, that compensatory damages (including damages 
under section 4A of the Clayton Act (15 U.S.C. 15a), as 
amended) paid to a government do not constitute a fine or 
penalty.

                           REASONS FOR CHANGE

    The Committee is concerned that there is a lack of clarity 
and consistency under present law regarding when taxpayers may 
deduct payments made in settlement of government investigations 
of potential wrongdoing, as well as in situations where there 
has been a final determination of wrongdoing. If a taxpayer 
deducts payments made in settlement of an investigation of 
potential wrongdoing or as a result of a finding of wrongdoing, 
the publicly announced amount of the settlement payment does 
not reflect the true after-tax penalty on the taxpayer. The 
Committee also is concerned that allowing a deduction for such 
payments in effect shifts a portion of the penalty to the 
Federal government and to the public.

                        EXPLANATION OF PROVISION

    The bill modifies the rules regarding the determination 
whether payments are nondeductible payments of fines or 
penalties under section 162(f). In particular, the bill 
generally provides that amounts paid or incurred (whether by 
suit, agreement, or otherwise) to, or at the direction of, a 
government in relation to the violation of any law or the 
governmental investigation or inquiry into the potential 
violation of any law \229\ are nondeductible under any 
provision of the income tax provisions.\230\ The bill applies 
to deny a deduction for any such payments, including those 
where there is no admission of guilt or liability and those 
made for the purpose of avoiding further investigation or 
litigation. An exception applies to payments that the taxpayer 
establishes are restitution.\231\
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    \229\ The bill does not affect amounts paid or incurred in 
performing routine audits or reviews such as annual audits that are 
required of all organizations or individuals in a similar business 
sector, or profession, as a requirement for being allowed to conduct 
business. However, if the government or regulator raises an issue of 
compliance and a payment is required in settlement of such issue, the 
bill would affect such payment. In such cases, the restitution 
exception could permit otherwise allowable deductions of amounts paid 
with respect to specific property or persons to avoid noncompliance or 
to bring the taxpayer into compliance with the required standards (for 
example, to bring a machine up to required emissions or other 
standards).
    \230\ The bill provides that such amounts are nondeductible under 
chapter 1 of the Internal Revenue Code.
    \231\ The bill does not affect the treatment of antitrust payments 
made under section 4 of the Clayton Act, which will continue to be 
governed by the provisions of section 162(g).
---------------------------------------------------------------------------
    The bill applies only where a government (or other entity 
treated in a manner similar to a government under the bill) is 
a complainant or investigator with respect to the violation or 
potential violation of any law.\232\
---------------------------------------------------------------------------
    \232\ Thus, for example, the bill would not apply to payments made 
by one private party to another in a lawsuit between private parties, 
merely because a judge or jury acting in the capacity as a court 
directs the payment to be made. The mere fact that a court enters a 
judgment or directs a result in a private dispute does not cause a 
payment to be made ``at the direction of a government'' for purposes of 
the provision.
---------------------------------------------------------------------------
    It is intended that a payment will be treated as 
restitution only if substantially all of the payment is 
required to be paid to the specific persons, or in relation to 
the specific property, actually harmed (or, in the case of 
property, not in compliance with the required standards) bythe 
conduct of the taxpayer that resulted in the payment. Thus, a payment 
to or with respect to a class substantially broader than the specific 
persons or property that were actually harmed (e.g., to a class 
including similarly situated persons or property) does not qualify as 
restitution.\233\ Restitution is limited to the amount that bears a 
substantial quantitative relationship to the harm (or, in the case of 
property, to the correction of noncompliance) caused by the past 
conduct or actions of the taxpayer that resulted in the payment in 
question. If the party harmed is a government or other entity, then 
restitution includes payment to such harmed government or entity, 
provided the payment bears a substantial quantitative relationship to 
the harm. However, restitution does not include reimbursement of 
government investigative or litigation costs, or payments to 
whistleblowers.
---------------------------------------------------------------------------
    \233\ Similarly, a payment to a charitable organization benefitting 
a substantially broader class than the persons or property actually 
harmed, or to be paid out without a substantial quantitative 
relationship to the harm caused, would not qualify as restitution. 
Under the provision, such a payment not deductible under section 162 
would also not be deductible under section 170.
---------------------------------------------------------------------------
    Amounts paid or incurred (whether by suit, agreement, or 
otherwise) to, or at the direction of, any self-regulatory 
entity that regulates a financial market or other market that 
is a qualified board or exchange under section 1256(g)(7), and 
that is authorized to impose sanctions (e.g., the National 
Association of Securities Dealers) are likewise subject to the 
provision if paid in relation to a violation, or investigation 
or inquiry into a potential violation, of any law (or any rule 
or other requirement of such entity). To the extent provided in 
regulations, amounts paid or incurred to, or at the direction 
of, any other nongovernmental entity that exercises self-
regulatory powers as part of performing an essential 
governmental function are similarly subject to the provision. 
The exception for payments that the taxpayer establishes are 
restitution likewise applies in these cases.
    No inference is intended as to the treatment of payments as 
nondeductible fines or penalties under present law. In 
particular, the bill is not intended to limit the scope of 
present-law section 162(f) or the regulations thereunder.

                             EFFECTIVE DATE

    The bill is effective for amounts paid or incurred on or 
after April 28, 2003; however the bill does not apply to 
amounts paid or incurred under any binding order or agreement 
entered into before such date. Any order or agreement requiring 
court approval is not a binding order or agreement for this 
purpose unless such approval was obtained on or before April 
27, 2003.

4. Denial of deduction for punitive damages (sec. 424 of the bill and 
        sec. 162 of the Code)

                              PRESENT LAW

    In general, a deduction is allowed for all ordinary and 
necessary expenses that are paid or incurred by the taxpayer 
during the taxable year in carrying on any trade or 
business.\234\ However, no deduction is allowed for any payment 
that is made to an official of any 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 
and is illegal under Federal law.\235\ In addition, no 
deduction is allowed under present law for any fine or similar 
payment made to a government for violation of any law.\236\ 
Furthermore, no deduction is permitted for two-thirds of any 
damage payments made by a taxpayer who is convicted of a 
violation of the Clayton antitrust law or any related antitrust 
law.\237\
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    \234\ Sec. 162(a).
    \235\ Sec. 162(c).
    \236\ Sec. 162(f).
    \237\ Sec. 162(g).
---------------------------------------------------------------------------
    In general, gross income does not include amounts received 
on account of personal physical injuries and physical 
sickness.\238\ However, this exclusion does not apply to 
punitive damages.\239\
---------------------------------------------------------------------------
    \238\ Sec. 104(a).
    \239\ Sec. 104(a)(2).
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The Committee believes that allowing a tax deduction for 
punitive damages undermines the societal role of punitive 
damages in discouraging and penalizing the activities or 
actions for which punitive damages are imposed. Furthermore, 
the Committee believes that determining the amount of punitive 
damages to be disallowed as a tax deduction is not 
administratively burdensome because taxpayers generally can 
make such a determination readily by reference to pleadings 
filed with a court, and plaintiffs already make such a 
determination in determining the taxable portion of any 
payment.

                        EXPLANATION OF PROVISION

    The provision denies any deduction for punitive damages 
that are paid or incurred by the taxpayer as a result of a 
judgment or in settlement of a claim. If the liability for 
punitive damages is covered by insurance, any such punitive 
damages paid by the insurer are included in gross income of the 
insured person and the insurer is required to report such 
amounts to both the insured person and the IRS.

                             EFFECTIVE DATE

    The provision is effective for punitive damages that are 
paid or incurred on or after the date of enactment.

5. Increase the maximum criminal fraud penalty for individuals to the 
        amount of the tax at issue (sec. 425 of the bill and secs. 
        7201, 7203, and 7206 of the Code)

                              PRESENT LAW

Attempt to evade or defeat tax

    In general, section 7201 imposes a criminal penalty on 
persons who willfully attempt to evade or defeat any tax 
imposed by the Code. Upon conviction, the Code provides that 
the penalty is up to $100,000 or imprisonment of not more than 
five years (or both). In the case of a corporation, the Code 
increases the monetary penalty to a maximum of $500,000.

Willful failure to file return, supply information, or pay tax

    In general, section 7203 imposes a criminal penalty on 
persons required to make estimated tax payments, pay taxes, 
keep records, or supply information under the Code who 
willfully fails to do so. Upon conviction, the Code provides 
that the penalty is up to $25,000 or imprisonment of not more 
than one year (or both). In the case of a corporation, the Code 
increases the monetary penalty to a maximum of $100,000.

Fraud and false statements

    In general, section 7206 imposes a criminal penalty on 
persons who make fraudulent or false statements under the Code. 
Upon conviction, the Code provides that the penalty is up to 
$100,000 or imprisonment of not more than three years (or 
both). In the case of a corporation, the Code increases the 
monetary penalty to a maximum of $500,000.

Uniform sentencing guidelines

    Under the uniform sentencing guidelines established by 18 
U.S.C. 3571, a defendant found guilty of a criminal offense is 
subject to a maximum fine that is the greatest of: (a) the 
amount specified in the underlying provision, (b) for a felony 
\240\ $250,000 for an individual or $500,000 for an 
organization, or (c) twice the gross gain if a person derives 
pecuniary gain from the offense. This Title 18 provision 
applies to all criminal provisions in the United States Code, 
including those in the Internal Revenue Code. For example, for 
an individual, the maximum fine under present law upon 
conviction of violating section 7206 is $250,000 or, if 
greater, twice the amount of gross gain from the offense.
---------------------------------------------------------------------------
    \240\ Section 7206 states that this offense is a felony. In 
addition, it is a felony pursuant to the classification guidelines of 
18 U.S.C. 3559(a)(5).
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    In light of the recent reports of possibly criminal 
behavior in connection with the filing and preparation of tax 
returns, the Committee believes it is important to strengthen 
the criminal tax penalties.

                        EXPLANATION OF PROVISION

Attempt to evade or defeat tax

    The provision increases the criminal penalty under section 
7201 of the Code for individuals to $250,000 and for 
corporations to $1,000,000. The provision increases the maximum 
prison sentence to ten years.

Willful failure to file return, supply information, or pay tax

    The provision increases the criminal penalty under section 
7203 of the Code from a misdemeanor to a felony and increases 
the maximum prison sentence to ten years.

Fraud and false statements

    The provision increases the criminal penalty under section 
7206 of the Code for individuals to $250,000 and for 
corporations to $1,000,000. The provision increases the maximum 
prison sentence to five years. The provision also provides that 
in no event shall the amount of the monetary penalty under this 
provision be less than the amount of the underpayment or 
overpayment attributable to fraud.

                             EFFECTIVE DATE

    The provision is effective for underpayments and 
overpayments attributable to actions occurring after the date 
of enactment.

                C. Enron-Related Tax Shelter Provisions


1. Limitation on transfer and importation of built-in losses (sec. 431 
        of the bill and secs. 362 and 334 of the Code)

                              PRESENT LAW

    Generally, no gain or loss is recognized when one or more 
persons transfer property to a corporation in exchange for 
stock and immediately after the exchange such person or persons 
control the corporation.\241\ The transferor's basis in the 
stock of the controlled corporation is the same as the basis of 
the property contributed to the controlled corporation, 
increased by the amount of any gain (or dividend) recognized by 
the transferor on the exchange, and reduced by the amount of 
any money or property received, and by the amount of any loss 
recognized by the transferor.\242\
---------------------------------------------------------------------------
    \241\ Sec. 351.
    \242\ Sec. 358.
---------------------------------------------------------------------------
    The basis of property received by a corporation, whether 
from domestic or foreign transferors, in a tax-free 
incorporation, reorganization, or liquidation of a subsidiary 
corporation is the same as the adjusted basis in the hands of 
the transferor, adjusted for gain or loss recognized by the 
transferor.\243\
---------------------------------------------------------------------------
    \243\ Secs. 334(b) and 362(a) and (b).
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The Joint Committee on Taxation staff's investigative 
report of Enron Corporation \244\ and other information reveal 
that taxpayers are engaging in various tax motivated 
transactions to duplicate a single economic loss and, 
subsequently, deduct such loss more than once. Congress has 
previously taken actions to limit the ability of taxpayers to 
engage in specific transactions that purport to duplicate a 
single economic loss. However, new schemes that purport to 
duplicate losses continue to proliferate. In furtherance of the 
overall tax policy objective of accurately measuring taxable 
income, the Committee believes that a single economic loss 
should not be deducted more than once. Thus, the Committee 
believes that it is generally appropriate to limit a 
corporation's basis in property acquired in a tax-free transfer 
to the fair market value of such property. In addition, the 
Committee believes that it is appropriate to prevent the 
importation of economic losses into the U.S. tax system if such 
losses arose prior to the assets becoming subject to the U.S. 
tax system.
---------------------------------------------------------------------------
    \244\ See Joint Committee on Taxation, Report of Investigation of 
Enron Corporation and Related Entities Regarding Federal Tax and 
Compensation Issues, and Policy Recommendations (JCS-3-03), February 
2003.
---------------------------------------------------------------------------

                        EXPLANATION OF PROVISION

Importation of built-in losses

    The provision provides that if a net built-in loss is 
imported into the U.S. in a tax-free organization or 
reorganization from persons not subject to U.S. tax, the basis 
of each property so transferred is its fair market value. A 
similar rule applies in the case of the tax-free liquidation by 
a domestic corporation of its foreign subsidiary.
    Under the provision, a net built-in loss is treated as 
imported into the U.S. if the aggregate adjusted bases of 
property received by a transferee corporation exceeds the fair 
market value of the properties transferred. Thus, for example, 
if in a tax-free incorporation, some properties are received by 
a corporation from U.S. persons subject to tax, and some 
properties are received from foreign persons not subject to 
U.S. tax, this provision applies to limit the adjusted basis of 
each property received from the foreign persons to the fair 
market value of the property. In the case of a transfer by a 
partnership (either domestic or foreign), this provision 
applies as if each partner had transferred such partner's 
proportionate share of the property of such partnership.

Limitation on transfer of built-in-losses in section 351 transactions

    The provision provides that if the aggregate adjusted bases 
of property contributed by a transferor (or by a control group 
of which the transferor is a member) to a corporation exceed 
the aggregate fair market value of the property transferred in 
a tax-free incorporation, the transferee's aggregate bases of 
the property is limited to the aggregate fair market value of 
the transferred property. Under the provision, any required 
basis reduction is allocated among the transferred properties 
in proportion to their built-in-loss immediately before the 
transaction. In the case of a transfer after which the 
transferor owns at least 80 percent of the vote and value of 
the stock of the transferee corporation, any basis reduction 
required by the provision is made to the stock received by the 
transferor and not to the assets transferred.

                             EFFECTIVE DATE

    The provision applies to transactions after February 13, 
2003.

2. No reduction of basis under section 734 in stock held by partnership 
        in corporate partner (sec. 432 of the bill and sec. 755 of the 
        Code)

                              PRESENT LAW

In general

    Generally, a partner and the partnership do not recognize 
gain or loss on a contribution of property to the 
partnership.\245\ Similarly, a partner and the partnership 
generally do not recognize gain or loss on the distribution of 
partnership property.\246\ This includes current distributions 
and distributions in liquidation of a partner's interest.
---------------------------------------------------------------------------
    \245\ Sec. 721(a).
    \246\ Sec. 731(a) and (b).
---------------------------------------------------------------------------

Basis of property distributed in liquidation

    The basis of property distributed in liquidation of a 
partner's interest is equal to the partner's tax basis in its 
partnership interest (reduced by any money distributed in the 
same transaction).\247\ Thus, the partnership's tax basis in 
the distributed property is adjusted (increased or decreased) 
to reflect the partner's tax basis in the partnership interest.
---------------------------------------------------------------------------
    \247\ Sec. 732(b).
---------------------------------------------------------------------------

Election to adjust basis of partnership property

    When a partnership distributes partnership property, 
generally, the basis of partnership property is not adjusted to 
reflect the effects of the distribution or transfer. The 
partnership is permitted, however, to make an election 
(referred to as a 754 election) to adjust the basis of 
partnership property in the case of a distribution of 
partnership property.\248\ The effect of the 754 election is 
that the partnership adjusts the basis of its remaining 
property to reflect any change in basis of the distributed 
property in the hands of the distributee partner resulting from 
the distribution transaction. Such a change could be a basis 
increase due to gain recognition, or a basis decrease due to 
the partner's adjusted basis in its partnership interest 
exceeding the adjusted basis of the property received. If the 
754 election is made, it applies to the taxable year with 
respect to which such election was filed and all subsequent 
taxable years.
---------------------------------------------------------------------------
    \248\ Sec. 754.
---------------------------------------------------------------------------
    In the case of a distribution of partnership property to a 
partner with respect to which the 754 election is in effect, 
the partnership increases the basis of partnership property by 
(1) any gain recognized by the distributee partner and (2) the 
excess of the adjusted basis of the distributed property to the 
partnership immediately before its distribution over the basis 
of the property to the distributee partner, and decreases the 
basis of partnership property by (1) any loss recognized by the 
distributee partner and (2) the excess of the basis of the 
property to the distributee partner over the adjusted basis of 
the distributed property to the partnership immediately before 
the distribution.
    The allocation of the increase or decrease in basis of 
partnership property is made in a manner that has the effect of 
reducing the difference between the fair market value and the 
adjusted basis of partnership properties.\249\ In addition, the 
allocation rules require that any increase or decrease in basis 
be allocated to partnership property of a like character to the 
property distributed. For this purpose, the two categories of 
assets are (1) capital assets and depreciable and real property 
used in the trade or business held for more than one year, and 
(2) any other property.\250\
---------------------------------------------------------------------------
    \249\ Sec. 755(a).
    \250\ Sec. 755(b).
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The Joint Committee on Taxation staff's investigative 
report of Enron Corporation \251\ revealed that certain 
transactions were being undertaken that purported to use the 
interaction of the partnership basis adjustment rules and the 
rules protecting a corporation from recognizing gain on its 
stock to obtain unintended tax results. These transactions 
generally purport to increase the tax basis of depreciable 
assets and to decrease, by a corresponding amount, the tax 
basis of the stock of a partner. Because the tax rules protect 
a corporation from gain on the sale of its stock (including 
through a partnership), the transactions enable taxpayers to 
duplicate tax deductions at no economic cost. The provision 
precludes the ability to reduce the basis of corporate stock of 
a partner (or related party) in certain transactions.
---------------------------------------------------------------------------
    \251\ See Joint Committee on Taxation, Report of Investigation of 
Enron Corporation and Related Entities Regarding Federal Tax and 
Compensation Issues, and Policy Recommendations (JCS-3-03), February 
2003.
---------------------------------------------------------------------------

                        EXPLANATION OF PROVISION

    The provision provides that in applying the basis 
allocation rules to a distribution in liquidation of a 
partner's interest, a partnership is precluded from decreasing 
the basis of corporate stock of a partner or a related person. 
Any decrease in basis that, absent the provision, would have 
been allocated to the stock is allocated to other partnership 
assets. If the decrease in basis exceeds the basis of the other 
partnership assets, then gain is recognized by the partnership 
in the amount of the excess.

                             EFFECTIVE DATE

    The provision applies to distributions after February 13, 
2003.

3. Repeal of special rules for FASITs (sec. 433 of the bill and secs. 
        860H through 860L of the Code)

                              PRESENT LAW

Financial asset securitization investment trusts

    In 1996, Congress created a new type of statutory entity 
called a ``financial asset securitization trust'' (``FASIT'') 
that facilitates the securitization of debt obligations such as 
credit card receivables, home equity loans, and auto 
loans.\252\ A FASIT generally is not taxable; the FASIT's 
taxable income or net loss flows through to the owner of the 
FASIT.
---------------------------------------------------------------------------
    \252\ Sections 860H through 860L.
---------------------------------------------------------------------------
    The ownership interest of a FASIT generally is required to 
be entirely held by a single domestic C corporation. In 
addition, a FASIT generally may hold only qualified debt 
obligations, and certain other specified assets, and is subject 
to certain restrictions on its activities. An entity that 
qualifies as a FASIT can issue one or more classes of 
instruments that meet certain specified requirements and treat 
those instruments as debt for Federal income tax purposes. 
Instruments issued by a FASIT bearing yields to maturity over 
five percentage points above the yield to maturity on specified 
United States government obligations (i.e., ``high-yield 
interests'') must be held, directly or indirectly, only by 
domestic C corporations that are not exempt from income tax.
            Qualification as a FASIT
    To qualify as a FASIT, an entity must: (1) make an election 
to be treated as a FASIT for the year of the election and all 
subsequent years; \253\ (2) have assets substantially all of 
which (including assets that the FASIT is treated as owning 
because they support regular interests) are specified types 
called ``permitted assets''; (3) have non-ownership interests 
be certain specified types of debt instruments called ``regular 
interests''; (4) have a single ownership interest which is held 
by an ``eligible holder''; and (5) not qualify as a regulated 
investment company (``RIC''). Any entity, including a 
corporation, partnership, or trust may be treated as a FASIT. 
In addition, a segregated pool of assets may qualify as a 
FASIT.
---------------------------------------------------------------------------
    \253\ Once an election to be a FASIT is made, the election applies 
from the date specified in the election and all subsequent years until 
the entity ceases to be a FASIT. If an election to be a FASIT is made 
after the initial year of an entity, all of the assets in the entity at 
the time of the FASIT election are deemed contributed to the FASIT at 
that time and, accordingly, any gain (but not loss) on such assets will 
be recognized at that time.
---------------------------------------------------------------------------
    An entity ceases qualifying as a FASIT if the entity's 
owner ceases being an eligible corporation. Loss of FASIT 
status is treated as if all of the regular interests of the 
FASIT were retired and then reissued without the application of 
the rule that deems regular interests of a FASIT to be debt.
            Permitted assets
    For an entity or arrangement to qualify as a FASIT, 
substantially all of its assets must consist of the following 
``permitted assets'': (1) cash and cash equivalents; (2) 
certain permitted debt instruments; (3) certain foreclosure 
property; (4) certain instruments or contracts that represent a 
hedge or guarantee of debt held or issued by the FASIT; (5) 
contract rights to acquire permitted debt instruments or 
hedges; and (6) a regular interest in another FASIT. Permitted 
assets may be acquired at any time by a FASIT, including any 
time after its formation.
            ``Regular interests'' of a FASIT
    ``Regular interests'' of a FASIT are treated as debt for 
Federal income tax purposes, regardless of whether instruments 
with similar terms issued by non-FASITs might be characterized 
as equity under general tax principles. To be treated as a 
``regular interest'', an instrument must have fixed terms and 
must: (1) unconditionally entitle the holder to receive a 
specified principal amount; (2) pay interest that is based on 
(a) fixed rates, or (b) except as provided by regulations 
issued by the Treasury Secretary, variable rates permitted with 
respect to real estate mortgage investment conduit interests 
under section 860G(a)(1)(B)(i); (3) have a term to maturity of 
no more than 30 years, except as permitted by Treasury 
regulations; (4) be issued to the public with a premium of not 
more than 25 percent of its stated principal amount; and (5) 
have a yield to maturity determined on the date of issue of 
less than five percentage points above the applicable Federal 
rate (``AFR'') for the calendar month in which the instrument 
is issued.
            Permitted ownership holder
    A permitted holder of the ownership interest in a FASIT 
generally is a non-exempt (i.e., taxable) domestic C 
corporation, other than a corporation that qualifies as a RIC, 
REIT, REMIC, or cooperative.
            Transfers to FASITs
    In general, gain (but not loss) is recognized immediately 
by the owner of the FASIT upon the transfer of assets to a 
FASIT. Where property is acquired by a FASIT from someone other 
than the FASIT's owner (or a person related to the FASIT's 
owner), the property is treated as being first acquired by the 
FASIT's owner for the FASIT's cost in acquiring the asset from 
the non-owner and then transferred by the owner to the FASIT.
    Valuation rules.--In general, except in the case of debt 
instruments, the value of FASIT assets is their fair market 
value. Similarly, in the case of debt instruments that are 
traded on an established securities market, the market price is 
used for purposes of determining the amount of gain realized 
upon contribution of such assets to a FASIT. However, in the 
case of debt instruments that are not traded on an established 
securities market, special valuation rules apply for purposes 
of computing gain on the transfer of such debt instruments to a 
FASIT. Under these rules, the value of such debt instruments is 
the sum of the present values of the reasonably expected cash 
flows from such obligations discounted over the weighted 
average life of such assets. The discount rate is 120 percent 
of the AFR, compounded semiannually, or such other rate that 
the Treasury Secretary shall prescribe by regulations.
            Taxation of a FASIT
    A FASIT generally is not subject to tax. Instead, all of 
the FASIT's assets and liabilities are treated as assets and 
liabilities of the FASIT's owner and any income, gain, 
deduction or loss of the FASIT is allocable directly to its 
owner. Accordingly, income tax rules applicable to a FASIT 
(e.g., related party rules, sec. 871(h), sec. 165(g)(2)) are to 
be applied in the same manner as they apply to the FASIT's 
owner. The taxable income of a FASIT is calculated using an 
accrual method of accounting. The constant yield method and 
principles that apply for purposes of determining original 
issue discount (``OID'') accrual on debt obligations whose 
principal is subject to acceleration apply to all debt 
obligations held by a FASIT to calculate the FASIT's interest 
and discount income and premium deductions or adjustments.
            Taxation of holders of FASIT regular interests
    In general, a holder of a regular interest is taxed in the 
same manner as a holder of any other debt instrument, except 
that the regular interest holder is required to account for 
income relating to the interest on an accrual method of 
accounting, regardless of the method of accounting otherwise 
used by the holder.
            Taxation of holders of FASIT ownership interests
    Because all of the assets and liabilities of a FASIT are 
treated as assets and liabilities of the holder of a FASIT 
ownership interest, the ownership interest holder takes into 
account all of the FASIT's income, gain, deduction, or loss in 
computing its taxable income or net loss for the taxable year. 
The character of the income to the holder of an ownership 
interest is the same as its character to the FASIT, except tax-
exempt interest is included in the income of the holder as 
ordinary income.
    Although the recognition of losses on assets contributed to 
the FASIT is not allowed upon contribution of the assets, such 
losses may be allowed to the FASIT owner upon their disposition 
by the FASIT. Furthermore, the holder of a FASIT ownership 
interest is not permitted to offset taxable income from the 
FASIT ownership interest (including gain or loss from the sale 
of the ownership interest in the FASIT) with other losses of 
the holder. In addition, any net operating loss carryover of 
the FASIT owner shall be computed by disregarding any income 
arising by reason of a disallowed loss. Where the holder of a 
FASIT ownership interest is a member of a consolidated group, 
this rule applies to the consolidated group of corporations of 
which the holder is a member as if the group were a single 
taxpayer.

Real estate mortgage investment conduits

    In general, a real estate mortgage investment conduit 
(``REMIC'') is a self-liquidating entity that holds a fixed 
pool of mortgages and issues multiple classes of investor 
interests. A REMIC is not treated as a separate taxable entity. 
Rather, the income of the REMIC is allocated to, and taken into 
account by, the holders of the interests in the REMIC under 
detailed rules.\254\ In order to qualify as a REMIC, 
substantially all of the assets of the entity must consist of 
qualified mortgages and permitted investments as of the close 
of the third month beginning after the startup day of the 
entity. A ``qualified mortgage'' generally includes any 
obligation which is principally secured by an interest in real 
property, and which is either transferred to the REMIC on the 
startup day of the REMIC in exchange for regular or residual 
interests in the REMIC or purchased by the REMIC within three 
months after the startup day pursuant to a fixed-price contract 
in effect on the startup day. A ``permitted investment'' 
generally includes any intangible property that is held for 
investment and is part of a reasonably required reserve to 
provide for full payment of certain expenses of the REMIC or 
amounts due on regular interests.
---------------------------------------------------------------------------
    \254\ See sections 860A through 860G.
---------------------------------------------------------------------------
    All of the interests in the REMIC must consist of one or 
more classes of regular interests and a single class of 
residual interests. A ``regular interest'' is an interest in a 
REMIC that is issued with a fixed term, designated as a regular 
interest, and unconditionally entitles the holder to receive a 
specified principal amount (or other similar amount) with 
interest payments that are either based on a fixed rate (or, to 
the extent provided in regulations, a variable rate) or consist 
of a specified portion of the interest payments on qualified 
mortgages that does not vary during the period such interest is 
outstanding. In general, a ``residual interest'' is any 
interest in the REMIC other than a regular interest, and which 
is so designated by the REMIC, provided that there is only one 
class of such interest and that all distributions (if any) with 
respect to such interests are pro rata. Holders of residual 
REMIC interests are subject to tax on the portion of the income 
of the REMIC that is not allocated to the regular interest 
holders.
            Original issue discount accruals with respect to debt 
                    instruments and pools of debt instruments subject 
                    to acceleration of principal payment
    The holder of a debt instrument with original issue 
discount (``OID'') generally accrues and includes in gross 
income, as interest, the OID over the life of the obligation, 
even though the amount of the interest may not be received 
until the maturity of the instrument.\255\ In general, issuers 
of debt instruments with OID accrue and deduct the amount of 
OID as interest expense in the same manner as the holder.
---------------------------------------------------------------------------
    \255\ The amount of OID with respect to a debt instrument is the 
excess of the stated redemption price at maturity over the issue price 
of the debt instrument. The stated redemption price at maturity 
includes all amounts payable at maturity. The amount of OID in a debt 
instrument is allocated over the life of the instrument through a 
series of adjustments to the issue price for each accrual period. The 
adjustment to the issue price is determined by multiplying the adjusted 
issue price (i.e., the issue price increased by adjustments prior to 
the accrual period) by the instrument's yield to maturity, and then 
subtracting the interest payable during the accrual period.
---------------------------------------------------------------------------
    Special rules for determining the amount of OID allocated 
to a period apply to certain instruments and pools of 
instruments that may be subject to prepayment. First, if a 
borrower can reduce the yield on a debt by exercising a 
prepayment option, the OID rules assume that the borrower will 
prepay the debt. In addition, in the case of (1) any regular 
interest in a REMIC or qualified mortgage held by a REMIC, (2) 
any other debt instrument if payments under the instrument may 
be accelerated by reason of prepayments of other obligations 
securing the instrument, or (3) any pool of debt instruments 
the yield on which may be affected by reason of prepayments, 
the daily portions of the OID on such debt instruments and 
pools of debt instruments generally are determined by taking 
into account an assumption regarding the prepayment of 
principal for such instruments. The prepayment assumption to be 
used for this purpose is that which the parties use in pricing 
the particular transaction.

                           REASONS FOR CHANGE

    The Joint Committee on Taxation staff's investigative 
report of Enron Corporation \256\ described two structured tax-
motivated transactions--Projects Apache and Renegade--that 
Enron undertook in which the use of a FASIT was a key component 
in the structure of the transactions. The Committee is aware 
that FASITs are not being used widely in the manner envisioned 
by the Congress and, consequently, the FASIT rules have not 
served the purpose for which they originally were intended. 
Moreover, the Joint Committee's report indicates that FASITs 
are particularly prone to abuse and likely are being used 
primarily to facilitate tax avoidance transactions. Therefore, 
the Committee believes that the potential for abuse that is 
inherent in FASITs far outweighs any beneficial purpose that 
the FASIT rules may serve. Accordingly, the Committee believes 
that these rules should be repealed, with appropriate 
transition relief for existing FASITs and appropriate 
modifications to the present-law REMIC rules to permit the use 
of REMICs by taxpayers that have relied upon FASITs to 
securitize certain obligations secured by an interest in real 
property.
---------------------------------------------------------------------------
    \256\ See Joint Committee on Taxation, Report of Investigation of 
Enron Corporation and Related Entities Regarding Federal Tax and 
Compensation Issues, and Policy Recommendations (JCS-3-03), February 
2003.
---------------------------------------------------------------------------

                        EXPLANATION OF PROVISION

    The provision repeals the special rules for FASITs. The 
provision provides a transition period for existing FASITs, 
pursuant to which the repeal of the FASIT rules would not apply 
to any FASIT in existence on the date of enactment to the 
extent that regular interests issued by the FASIT prior to such 
date continue to remain outstanding in accordance with their 
original terms.
    For purposes of the REMIC rules, the provision also 
modifies the definitions of REMIC regular interests, qualified 
mortgages, and permitted investments so that certain types of 
real estate loans and loan pools can be transferred to, or 
purchased by, a REMIC. Specifically, the provision modifies the 
present-law definition of a REMIC ``regular interest'' to 
provide that an interest in a REMIC does not fail to qualify as 
a regular interest solely because the specified principal 
amount of such interest or the amount of interest accrued on 
such interest could be reduced as a result of the nonoccurrence 
of one or more contingent payments with respect to one or more 
reverse mortgages loans, as defined below, that are held by the 
REMIC, provided that on the startup day for the REMIC, the 
REMIC sponsor reasonably believes that all principal and 
interest due under the interest will be paid at or prior to the 
liquidation of the REMIC. For this purpose, a reasonable belief 
concerning ultimate payment of all amounts due under an 
interest is presumed to exist if, as of the startup day, the 
interest receives an investment grade rating from at least one 
nationally recognized statistical rating agency.
    In addition, the provision makes three modifications to the 
present-law definition of a ``qualified mortgage.'' First, the 
provision modifies the definition to include an obligation 
principally secured by real property which represents an 
increase in the principal amount under the original terms of an 
obligation, provided such increase: (1) is attributable to an 
advance made to the obligor pursuant to the original terms of 
the obligation; (2) occurs after the REMIC startup day; and (3) 
is purchased by the REMIC pursuant to a fixed price contract in 
effect on the startup day. Second, the provision modifies the 
definition to generally include reverse mortgage loans and the 
periodic advances made to obligors on such loans. For this 
purpose, a ``reverse mortgage loan'' is defined as a loan that: 
(1) is secured by an interest in real property; (2) provides 
for one or more advances of principal to the obligor (each such 
advance giving rise to a ``balance increase''), provided such 
advances are principally secured by an interest in the same 
real property as that which secures the loan; (3) may provide 
for a contingent payment at maturity based upon the value or 
appreciation in value of the real property securing the loan; 
(4) provides for an amount due at maturity that cannot exceed 
the value, or a specified fraction of the value, of the real 
property securing the loan; (5) provides that all payments 
under the loan are due only upon the maturity of the loan; and 
(6) matures after a fixed term or at the time the obligor 
ceases to use as a personal residence the real property 
securing the loan. Third, the provision modifies the definition 
to provide that, if more than 50 percent of the obligations 
transferred to, or purchased by, the REMIC are (1) originated 
by the United States or any State (or any political 
subdivision, agency, or instrumentality of the United States or 
any State) and (2) principally secured by an interest in real 
property, then each obligation transferred to, or purchased by, 
the REMIC shall be treated as secured by an interest in real 
property.
    In addition, the provision modifies the present-law 
definition of a ``permitted investment'' to include intangible 
investment property held as part of a reasonably required 
reserve to provide a source of funds for the purchase of 
obligations described above as part of the modified definition 
of a ``qualified mortgage.''
    The provision also modifies the OID rules with respect to 
certain instruments and pools of instruments that may be 
subject to principal prepayment by directing the Secretary to 
prescribe regulations permitting the use of a current 
prepayment assumption determined as of the close of the accrual 
period (or such other time as the Secretary may prescribe 
during the taxable year in which the accrual period ends).

                             EFFECTIVE DATE

    Except as provided by the transition period for existing 
FASITs, the provision is effective after February 13, 2003.

4. Expanded disallowance of deduction for interest on convertible debt 
        (sec. 434 of the bill and sec. 163 of the Code)

                              PRESENT LAW

    Whether an instrument qualifies for tax purposes as debt or 
equity is determined under all the facts and circumstances 
based on principles developed in case law. If an instrument 
qualifies as equity, the issuer generally does not receive a 
deduction for dividends paid and the holder generally includes 
such dividends in income (although corporate holders generally 
may obtain a dividends-received deduction of at least 70 
percent of the amount of the dividend). If an instrument 
qualifies as debt, the issuer may receive a deduction for 
accrued interest and the holder generally includes interest in 
income, subject to certain limitations.
    Original issue discount (``OID'') on a debt instrument is 
the excess of the stated redemption price at maturity over the 
issue price of the instrument. An issuer of a debt instrument 
with OID generally accrues and deducts the discount as interest 
over the life of the instrument even though interest may not be 
paid until theinstrument even though interest may not be paid 
until the instrument matures. The holder of such a debt instrument also 
generally includes the OID in income on an accrual basis.
    Under present law, no deduction is allowed for interest or 
OID on a debt instrument issued by a corporation (or issued by 
a partnership to the extent of its corporate partners) that is 
payable in equity of the issuer or a related party (within the 
meaning of sections 267(b) and 707(b)), including a debt 
instrument a substantial portion of which is mandatorily 
convertible or convertible at the issuer's option into equity 
of the issuer or a related party.\257\ In addition, a debt 
instrument is treated as payable in equity if a substantial 
portion of the principal or interest is required to be 
determined, or may be determined at the option of the issuer or 
related party, by reference to the value of equity of the 
issuer or related party.\258\ A debt instrument also is treated 
as payable in equity if it is part of an arrangement that is 
designed to result in the payment of the debt instrument with 
or by reference to such equity, such as in the case of certain 
issuances of a forward contract in connection with the issuance 
of debt, nonrecourse debt that is secured principally by such 
equity, or certain debt instruments that are paid in, converted 
to, or determined with reference to the value of equity if it 
may be so required at the option of the holder or a related 
party and there is a substantial certainty that option will be 
exercised.\259\
---------------------------------------------------------------------------
    \257\ Sec. 163(l), enacted in the Taxpayer Relief Act of 1997, Pub. 
L. No. 105-34, sec. 1005(a).
    \258\ Sec. 163(l)(3)(B).
    \259\ Sec. 163(l)(3)(C).
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The Joint Committee on Taxation staff's investigative 
report of Enron Corporation \260\ described two structured 
financing transactions that Enron undertook in 1995 and 1999 
involving what the report referred to as ``investment unit 
securities.'' In substance, these securities featured principal 
repayment that was not unconditional in amount, as generally is 
required in order for debt characterization to be respected for 
tax purposes. Instead, principal on the securities was payable 
upon maturity in stock of an Enron affiliate (or in cash 
equivalent to the value of such stock).
---------------------------------------------------------------------------
    \260\ See Joint Committee on Taxation, Report of Investigation of 
Enron Corporation and Related Entities Regarding Federal Tax and 
Compensation Issues, and Policy Recommendations (JCS-3-03), February 
2003.
---------------------------------------------------------------------------
    The Committee believes that the financing activities 
undertaken by Enron in 1995 and 1999 using investment unit 
securities cast doubt upon the tax policy rationale for 
excluding stock ownership interests of 50 percent or less (by 
virtue of the present-law related party definition) from the 
application of the interest expense disallowance rules for 
certain convertible equity-linked debt instruments. With regard 
to the securities issued by Enron, the fact that Enron owned 
more than 50 percent of the affiliate stock at the time of the 
1995 issuance but owned less than 50 percent of such stock at 
the time of the 1999 issuance (or shortly thereafter) had no 
discernible bearing on the intent or economic consequences of 
either transaction. In each instance, the transaction did not 
involve a borrowing by Enron in substance for which an interest 
deduction is appropriate. Rather, these transactions had the 
purpose and effect of carrying out a monetization of the 
affiliate stock. Nevertheless, the tax consequences of the 1995 
issuance likely would have been different from those of the 
1999 issuance if the present-law rules had been in effect at 
the time of both transactions, rather than only at the time of 
the 1999 transaction (to which the interest expense 
disallowance rules did not apply because of the present-law 50-
percent related party threshold). Therefore, the Committee 
believes that eliminating the related party threshold for the 
application of these rules furthers the tax policy objective of 
similar tax treatment of economically equivalent transactions. 
The Committee further believes that disallowed interest under 
this provision should increase the basis of the equity to which 
the equity is linked in a manner similar to that contemplated 
under currently proposed Treasury regulations.\261\
---------------------------------------------------------------------------
    \261\ Prop. Treas. reg. sec. 1.263(g)-4.
---------------------------------------------------------------------------

                        EXPLANATION OF PROVISION

    The provision expands the present-law disallowance of 
interest deductions on certain corporate convertible or equity-
linked debt that is payable in, or by reference to the value 
of, equity. Under the provision, the disallowance is expanded 
to include interest on corporate debt that is payable in, or by 
reference to the value of, any equity held by the issuer (or 
any related party) in any other person, without regard to 
whether such equity represents more than a 50-percent ownership 
interest in such person. The basis of such equity is increased 
by the amount of interest deductions that is disallowed by the 
provision. The provision directs the Treasury Department to 
issue regulations that provide rules for determining the manner 
in which the basis of equity held by the issuer (or related 
party) is increased by the amount of interest deductions that 
is disallowed under the provision.
    The provision does not apply to debt that is issued by an 
active dealer in securities (or a related party) if the debt is 
payable in, or by reference to the value of, equity that is 
held by the securities dealer in its capacity as a dealer in 
securities.

                             EFFECTIVE DATE

    This provision applies to debt instruments that are issued 
after February 13, 2003.

5. Expanded authority to disallow tax benefits under section 269 (sec. 
        435 of the bill and sec. 269 of the Code)

                              PRESENT LAW

    Section 269 provides that if a taxpayer acquires, directly 
or indirectly, control (defined as at least 50 percent of vote 
or value) of a corporation, and the principal purpose of the 
acquisition is the evasion or avoidance of Federal income tax 
by securing the benefit of a deduction, credit, or other 
allowance that would not otherwise have been available, the 
Secretary may disallow the such tax benefits.\262\ Similarly, 
if a corporation acquires, directly or indirectly, property of 
another corporation (not controlled, directly or indirectly, by 
the acquiring corporation or its stockholders immediately 
before the acquisition), the basis of such property is 
determined by reference to the basis in the hands of the 
transferor corporation, and the principal purpose of the 
acquisition is the evasion or avoidance of Federal income tax 
by securing a tax benefit that would not otherwise have been 
available, the Secretary may disallow such tax benefits.\263\
---------------------------------------------------------------------------
    \262\ Sec. 269(a)(1).
    \263\ Sec. 269(a)(2).
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The Joint Committee on Taxation staff's investigative 
report of Enron Corporation \264\ highlights the limited reach 
of section 269. Present-law section 269, as it applies to the 
acquisition of property, is circumscribed because it only 
applies to tax benefits that can be obtained only through the 
acquisition of control. The Committee believes it is 
appropriate to expand section 269 by the removal of such 
requirement.
---------------------------------------------------------------------------
    \264\ See Joint Committee on Taxation, Report of Investigation of 
Enron Corporation and Related Entities Regarding Federal Tax and 
Compensation Issues, and Policy Recommendations (JCS-3-03), February 
2003.
---------------------------------------------------------------------------

                        EXPLANATION OF PROVISION

    The provision expands section 269 by repealing the 
requirement that the acquisition of property be from a 
corporation not controlled by the acquirer. Thus, under the 
provision, section 269 disallows the tax benefits of: (1) any 
acquisition of stock sufficient to obtain control of a 
corporation (as under present law); and (2) any acquisition by 
a corporation of property from a corporation in which the basis 
of such property is determined by reference to the basis in the 
hands of the transferor corporation, if the principal purpose 
of such acquisition is the evasion or avoidance of Federal 
income tax.

                             EFFECTIVE DATE

    The provision applies to stock and property acquired after 
February 13, 2003.

6. Modification of interaction between subpart F and passive foreign 
        investment company rules (sec. 436 of the bill and sec. 1297 of 
        the Code)

                              PRESENT LAW

    The United States employs a ``worldwide'' tax system, under 
which domestic corporations generally are taxed on all income, 
whether derived in the United States or abroad. Income earned 
by a domestic parent corporation from foreign operations 
conducted by foreign corporate subsidiaries generally is 
subject to U.S. tax when the income is distributed as a 
dividend to the domestic corporation. Until such repatriation, 
the U.S. tax on such income generally is deferred. However, 
certain anti-deferral regimes may cause the domestic parent 
corporation to be taxed on a current basis in the United States 
with respect to certain categories of passive or highly mobile 
income earned by its foreign subsidiaries, regardless of 
whether the income has been distributedas a dividend to the 
domestic parent corporation. The main anti-deferral regimes in this 
context are the controlled foreign corporation rules of subpart F \265\ 
and the passive foreign investment company rules.\266\ A foreign tax 
credit generally is available to offset, in whole or in part, the U.S. 
tax owed on foreign-source income, whether earned directly by the 
domestic corporation, repatriated as an actual dividend, or included 
under one of the anti-deferral regimes.\267\
---------------------------------------------------------------------------
    \265\ Secs. 951-964.
    \266\ Secs. 1291-1298.
    \267\ Secs. 901, 902, 960, 1291(g).
---------------------------------------------------------------------------
    Generally, income earned indirectly by a domestic 
corporation through a foreign corporation is subject to U.S. 
tax only when the income is distributed to the domestic 
corporation, because corporations generally are treated as 
separate taxable persons for Federal tax purposes. However, 
this deferral of U.S. tax is limited by anti-deferral regimes 
that impose current U.S. tax on certain types of income earned 
by certain corporations, in order to prevent taxpayers from 
avoiding U.S. tax by shifting passive or other highly mobile 
income into low-tax jurisdictions. Deferral of U.S. tax is 
considered appropriate, on the other hand, with respect to most 
types of active business income earned abroad.
    Subpart F,\268\ applicable to controlled foreign 
corporations and their shareholders, is the main anti-deferral 
regime of relevance to a U.S.-based multinational corporate 
group. A controlled foreign corporation generally is defined as 
any foreign corporation if U.S. persons own (directly, 
indirectly, or constructively) more than 50 percent of the 
corporation's stock (measured by vote or value), taking into 
account only those U.S. persons that own at least 10 percent of 
the stock (measured by vote only).\269\ Under the subpart F 
rules, the United States generally taxes the U.S. 10-percent 
shareholders of a controlled foreign corporation on their pro 
rata shares of certain income of the controlled foreign 
corporation (referred to as ``subpart F income''), without 
regard to whether the income is distributed to the 
shareholders.\270\
---------------------------------------------------------------------------
    \268\ Secs. 951-964.
    \269\ Secs. 951(b), 957, 958.
    \270\ Sec. 951(a).
---------------------------------------------------------------------------
    Subpart F income generally includes passive income and 
other income that is readily movable from one taxing 
jurisdiction to another. Subpart F income consists of foreign 
base company income,\271\ insurance income,\272\ and certain 
income relating to international boycotts and other violations 
of public policy.\273\ Foreign base company income consists of 
foreign personal holding company income, which includes passive 
income (e.g., dividends, interest, rents, and royalties), as 
well as a number of categories of non-passive income, including 
foreign base company sales income, foreign base company 
services income, foreign base company shipping income and 
foreign base company oil-related income.\274\
---------------------------------------------------------------------------
    \271\ Sec. 954.
    \272\ Sec. 953.
    \273\ Sec. 952(a)(3)-(5).
    \274\ Sec. 954.
---------------------------------------------------------------------------
    In effect, the United States treats the U.S. 10-percent 
shareholders of a controlled foreign corporation as having 
received a current distribution out of the corporation's 
subpart F income. In addition, the U.S. 10-percent shareholders 
of a controlled foreign corporation are required to include 
currently in income for U.S. tax purposes their pro rata shares 
of the corporation's earnings invested in U.S. property.\275\
---------------------------------------------------------------------------
    \275\ Secs. 951(a)(1)(B), 956.
---------------------------------------------------------------------------
    The Tax Reform Act of 1986 established an additional anti-
deferral regime, for passive foreign investment companies. A 
passive foreign investment company generally is defined as any 
foreign corporation if 75 percent or more of its gross income 
for the taxable year consists of passive income, or 50 percent 
or more of its assets consists of assets that produce, or are 
held for the production of, passive income.\276\ Alternative 
sets of income inclusion rules apply to U.S. persons that are 
shareholders in a passive foreign investment company, 
regardless of their percentage ownership in the company. One 
set of rules applies to passive foreign investment companies 
that are ``qualified electing funds,'' under which electing 
U.S. shareholders currently include in gross income their 
respective shares of the company's earnings, with a separate 
election to defer payment of tax, subject to an interest 
charge, on income not currently received.\277\ A second set of 
rules applies to passive foreign investment companies that are 
not qualified electing funds, under which U.S. shareholders pay 
tax on certain income or gain realized through the company, 
plus an interest charge that is attributable to the value of 
deferral.\278\ A third set of rules applies to passive foreign 
investment company stock that is marketable, under which 
electing U.S. shareholders currently take into account as 
income (or loss) the difference between the fair market value 
of the stock as of the close of the taxable year and their 
adjusted basis in such stock (subject to certain limitations), 
often referred to as ``marking to market.'' \279\
---------------------------------------------------------------------------
    \276\ Sec. 1297.
    \277\ Sec. 1293-1295.
    \278\ Sec. 1291.
    \279\ Sec. 1296.
---------------------------------------------------------------------------
    Under section 1297(e), which was enacted in 1997 to address 
the overlap of the passive foreign investment company rules and 
subpart F, a controlled foreign corporation generally is not 
also treated as a passive foreign investment company with 
respect to a U.S. shareholder of the corporation. This 
exception applies regardless of the likelihood that the U.S. 
shareholder would actually be taxed under subpart F in the 
event that the controlled foreign corporation earns subpart F 
income. Thus, even in a case in which a controlled foreign 
corporation's subpart Fincome would be allocated to a different 
shareholder under the subpart F allocation rules, a U.S. shareholder 
would still qualify for the exception from the passive foreign 
investment company rules under section 1297(e).

                           REASONS FOR CHANGE

    The Committee is aware that section 1297(e) may enable a 
U.S. shareholder (like Enron Corporation in its ``Project 
Apache'' transaction) \280\ to claim exemption from the passive 
foreign investment company rules with respect to ownership of 
controlled foreign corporation stock on the basis of mere 
status as a U.S. shareholder, despite the fact that the U.S. 
shareholder may have implemented a structure intended to render 
it impossible for such shareholder to recognize any income 
under subpart F in connection with the stock. The Committee 
believes that the passive foreign investment company rules 
should be available to serve as a backstop to subpart F in such 
circumstances, and thus believes that the exception to the 
passive foreign investment company rules for U.S. shareholders 
of controlled foreign corporations should be geared more 
closely to the U.S. shareholder's potential taxability under 
subpart F, as opposed to mere status as a U.S. shareholder 
under subpart F.
---------------------------------------------------------------------------
    \280\ See Joint Committee on Taxation, Report of Investigation of 
Enron Corporation and Related Entities Regarding Federal Tax and 
Compensation Issues, and Policy Recommendations (JCS-3-03), February 
2003, vol. I at 255, 258-59.
---------------------------------------------------------------------------

                        EXPLANATION OF PROVISION

    The provision adds an exception to section 1297(e) for U.S. 
shareholders that face only a remote likelihood of incurring a 
subpart F inclusion in the event that a controlled foreign 
corporation earns subpart F income, thus preserving the 
potential application of the passive foreign investment company 
rules in such cases.

                             EFFECTIVE DATE

    The provision is effective for taxable years of controlled 
foreign corporations beginning after February 13, 2003, and for 
taxable years of U.S. shareholders in which or with which such 
taxable years of controlled foreign corporations end.

                D. Provisions To Discourage Expatriation


1. Tax treatment of inversion transactions (sec. 441 of the bill and 
        new sec. 7874 of the Code)

                              PRESENT LAW

Determination of corporate residence

    The U.S. tax treatment of a multinational corporate group 
depends significantly on whether the top-tier ``parent'' 
corporation of the group is domestic or foreign. For purposes 
of U.S. tax law, a corporation is treated as domestic if it is 
incorporated under the law of the United States or of any 
State. All other corporations (i.e., those incorporated under 
the laws of foreign countries) are treated as foreign. Thus, 
place of incorporation determines whether a corporation is 
treated as domestic or foreign for purposes of U.S. tax law, 
irrespective of other factors that might be thought to bear on 
a corporation's ``nationality,'' such as the location of the 
corporation's management activities, employees, business 
assets, operations, or revenue sources, the exchanges on which 
the corporation's stock is traded, or the residence of the 
corporation's managers and shareholders.

U.S. taxation of domestic corporations

    The United States employs a ``worldwide'' tax system, under 
which domestic corporations generally are taxed on all income, 
whether derived in the United States or abroad. In order to 
mitigate the double taxation that may arise from taxing the 
foreign-source income of a domestic corporation, a foreign tax 
credit for income taxes paid to foreign countries is provided 
to reduce or eliminate the U.S. tax owed on such income, 
subject to certain limitations.
    Income earned by a domestic parent corporation from foreign 
operations conducted by foreign corporate subsidiaries 
generally is subject to U.S. tax when the income is distributed 
as a dividend to the domestic corporation. Until such 
repatriation, the U.S. tax on such income is generally 
deferred. However, certain anti-deferral regimes may cause the 
domestic parent corporation to be taxed on a current basis in 
the United States with respect to certain categories of passive 
or highly mobile income earned by its foreign subsidiaries, 
regardless of whether the income has been distributed as a 
dividend to the domestic parent corporation. The main anti-
deferral regimes in this context are the controlled foreign 
corporation rules of subpart F \281\ and the passive foreign 
investment company rules.\282\ A foreign tax credit is 
generally available to offset, in whole or in part, the U.S. 
tax owed on this foreign-source income, whether repatriated as 
an actual dividend or included under one of the anti-deferral 
regimes.
---------------------------------------------------------------------------
    \281\ Secs. 951-964.
    \282\ Secs. 1291-1298.
---------------------------------------------------------------------------

U.S. taxation of foreign corporations

    The United States taxes foreign corporations only on income 
that has a sufficient nexus to the United States. Thus, a 
foreign corporation is generally subject to U.S. tax only on 
income that is ``effectively connected'' with the conduct of a 
trade or business in the United States. Such ``effectively 
connected income'' generally is taxed in the same manner and at 
the same rates as the income of a U.S. corporation. An 
applicable tax treaty may limit the imposition of U.S. tax on 
business operations of a foreign corporation to cases in which 
the business is conducted through a ``permanent establishment'' 
in the United States.
    In addition, foreign corporations generally are subject to 
a gross-basis U.S. tax at a flat 30-percent rate on the receipt 
of interest, dividends, rents, royalties, and certain similar 
types of income derived from U.S. sources, subject to certain 
exceptions. The tax generally is collected by means of 
withholding by the person making the payment. This tax may be 
reduced or eliminated under an applicable tax treaty.

U.S. tax treatment of inversion transactions

    Under present law, U.S. corporations may reincorporate in 
foreign jurisdictions and thereby replace the U.S. parent 
corporation of a multinational corporate group with a foreign 
parent corporation. These transactions are commonly referred to 
as ``inversion'' transactions. Inversion transactions may take 
many different forms, including stock inversions, asset 
inversions, and various combinations of and variations on the 
two. Most of the known transactions to date have been stock 
inversions. In one example of a stock inversion, a U.S. 
corporation forms a foreign corporation, which in turn forms a 
domestic merger subsidiary. The domestic merger subsidiary then 
merges into the U.S. corporation, with the U.S. corporation 
surviving, now as a subsidiary of the new foreign corporation. 
The U.S. corporation's shareholders receive shares of the 
foreign corporation and are treated as having exchanged their 
U.S. corporation shares for the foreign corporation shares. An 
asset inversion reaches a similar result, but through a direct 
merger of the top-tier U.S. corporation into a new foreign 
corporation, among other possible forms. An inversion 
transaction may be accompanied or followed by further 
restructuring of the corporate group. For example, in the case 
of a stock inversion, in order to remove income from foreign 
operations from the U.S. taxing jurisdiction, the U.S. 
corporation may transfer some or all of its foreign 
subsidiaries directly to the new foreign parent corporation or 
other related foreign corporations.
    In addition to removing foreign operations from the U.S. 
taxing jurisdiction, the corporate group may derive further 
advantage from the inverted structure by reducing U.S. tax on 
U.S.-source income through various ``earnings stripping'' or 
other transactions. This may include earnings stripping through 
payment by a U.S. corporation of deductible amounts such as 
interest, royalties, rents, or management service fees to the 
new foreign parent or other foreign affiliates. In this 
respect, the post-inversion structure enables the group to 
employ the same tax-reduction strategies that are available to 
other multinational corporate groups with foreign parents and 
U.S. subsidiaries, subject to the same limitations. These 
limitations under present law include section 163(j), which 
limits the deductibility of certain interest paid to related 
parties, if the payor's debt-equity ratio exceeds 1.5 to 1 and 
the payor's net interest expense exceeds 50 percent of its 
``adjusted taxable income.'' More generally, section 482 and 
the regulations thereunder require that all transactions 
between related parties be conducted on terms consistent with 
an ``arm's length'' standard, and permit the Secretary of the 
Treasury to reallocate income and deductions among such parties 
if that standard is not met.
    Inversion transactions may give rise to immediate U.S. tax 
consequences at the shareholder and/or the corporate level, 
depending on the type of inversion. In stock inversions, the 
U.S. shareholders generally recognize gain (but not loss) under 
section 367(a), based on the difference between the fair market 
value of the foreign corporation shares received and the 
adjusted basis of the domestic corporation stock exchanged. To 
the extent that a corporation's share value has declined, and/
or it has many foreign or tax-exempt shareholders, the impact 
of this section 367(a) ``toll charge'' is reduced. The transfer 
of foreign subsidiaries or other assets to the foreign parent 
corporation also may give rise to U.S. tax consequences at the 
corporate level (e.g., gain recognition and earnings and 
profits inclusions under sections 1001, 311(b), 304, 367, 1248 
or other provisions). The tax on any income recognized as a 
result of these restructurings may be reduced or eliminated 
through the use of net operating losses, foreign tax credits, 
and other tax attributes.
    In asset inversions, the U.S. corporation generally 
recognizes gain (but not loss) under section 367(a) as though 
it had sold all of its assets, but the shareholders generally 
do not recognize gain or loss, assuming the transaction meets 
the requirements of a reorganization under section 368.

                           REASONS FOR CHANGE

    The Committee believes that inversion transactions 
resulting in a minimal presence in a foreign country of 
incorporation are a means of avoiding U.S. tax and should be 
curtailed. In particular, these transactions permit 
corporations and other entities to continue to conduct business 
in the same manner as they did prior to the inversion, but with 
the result that the inverted entity avoids U.S. tax on foreign 
operations and may engage in earnings-stripping techniques to 
avoid U.S. tax on domestic operations. The Committee believes 
that certain inversion transactions (involving 80 percent or 
greater identity of stock ownership) have little or no non-tax 
effect or purpose and should be disregarded for U.S. tax 
purposes. The Committee believes that other inversion 
transactions (involving greater than 50 but less than 80 
percent identity of stock ownership) may have sufficient non-
tax effect and purpose to be respected, but warrant heightened 
scrutiny and other restrictions to ensure that the U.S. tax 
base is not eroded through related-party transactions.

                        EXPLANATION OF PROVISION

In general

    The provision defines two different types of corporate 
inversion transactions and establishes a different set of 
consequences for each type. Certain partnership transactions 
also are covered.

Transactions involving at least 80 percent identity of stock ownership

    The first type of inversion is a transaction in which, 
pursuant to a plan or a series of related transactions: (1) a 
U.S. corporation becomes a subsidiary of a foreign-incorporated 
entity or otherwise transfers substantially all of its 
properties to such an entity; \283\ (2) the former shareholders 
of the U.S. corporation hold (by reason of holding stock in the 
U.S. corporation) 80 percent or more (by vote or value) of the 
stock of the foreign-incorporated entity after the transaction; 
and (3) the foreign-incorporated entity, considered together 
with all companies connected to it by a chain of greater than 
50 percent ownership (i.e., the ``expanded affiliated group''), 
does not have substantial business activities in the entity's 
country of incorporation, compared to the total worldwide 
business activities of the expanded affiliated group. The 
provision denies the intended tax benefits of this type of 
inversion by deeming the top-tier foreign corporation to be a 
domestic corporation for all purposes of the Code.\284\
---------------------------------------------------------------------------
    \283\ It is expected that the Treasury Secretary will issue 
regulations applying the term ``substantially all'' in this context and 
will not be bound in this regard by interpretations of the term in 
other contexts under the Code.
    \284\ Since the top-tier foreign corporation is treated for all 
purposes of the Code as domestic, the shareholder-level ``toll charge'' 
of sec. 367(a) does not apply to these inversion transactions. However, 
with respect to inversion transactions completed before 2004, regulated 
investment companies and certain similar entities are allowed to elect 
to recognize gain as if sec. 367(a) did apply.
---------------------------------------------------------------------------
    Except as otherwise provided in regulations, the provision 
does not apply to a direct or indirect acquisition of the 
properties of a U.S. corporation no class of the stock of which 
was traded on an established securities market at any time 
within the four-year period preceding the acquisition. In 
determining whether a transaction would meet the definition of 
an inversion under the provision, stock held by members of the 
expanded affiliated group that includes the foreign 
incorporated entity is disregarded. For example, if the former 
top-tier U.S. corporation receives stock of the foreign 
incorporated entity (e.g., so-called ``hook'' stock), the stock 
would not be considered in determining whether the transaction 
meets the definition. Stock sold in a public offering (whether 
initial or secondary) or private placement related to the 
transaction also is disregarded for these purposes. 
Acquisitions with respect to a domestic corporation or 
partnership are deemed to be ``pursuant to a plan'' if they 
occur within the four-year period beginning on the date which 
is two years before the ownership threshold under the provision 
is met with respect to such corporation or partnership.
    Transfers of properties or liabilities as part of a plan a 
principal purpose of which is to avoid the purposes of the 
provision are disregarded. In addition, the Treasury Secretary 
is granted authority to prevent the avoidance of the purposes 
of the provision, including avoidance through the use of 
related persons, pass-through or other noncorporate entities, 
or other intermediaries, and through transactions designed to 
qualify or disqualify a person as a related person, a member of 
an expanded affiliated group, or a publicly traded corporation. 
Similarly, the Treasury Secretary is granted authority to treat 
certain non-stock instruments as stock, and certain stock as 
not stock, where necessary to carry out the purposes of the 
provision.

Transactions involving greater than 50 percent but less than 80 percent 
        identity of stock ownership

    The second type of inversion is a transaction that would 
meet the definition of an inversion transaction described 
above, except that the 80-percent ownership threshold is not 
met. In such a case, if a greater-than-50-percent ownership 
threshold is met, then a second set of rules applies to the 
inversion. Under these rules, the inversion transaction is 
respected (i.e., the foreign corporation is treated as 
foreign), but: (1) any applicable corporate-level ``toll 
charges'' for establishing the inverted structure may not be 
offset by tax attributes such as net operating losses or 
foreign tax credits; (2) the accuracy-related penalty is 
increased; and (3) section 163(j), relating to ``earnings 
stripping'' through related-party debt, is strengthened. These 
measures generally apply for a 10-year period following the 
inversion transaction. In addition, inverting entities are 
required to provide information to shareholders or partners and 
the IRS with respect to the inversion transaction.
    With respect to ``toll charges,'' any applicable corporate-
level income or gain required to be recognized under sections 
304, 311(b), 367, 1001, 1248, or any other provision with 
respect to the transfer of controlled foreign corporation stock 
or other assets by a U.S. corporation as part of the inversion 
transaction or after such transaction to a related foreign 
person is taxable, without offset by any tax attributes (e.g., 
net operating losses or foreign tax credits). To the extent 
provided in regulations, this rule will not apply to certain 
transfers of inventory and similar transactions conducted in 
the ordinary course of the taxpayer's business.
    The 20-percent penalty for negligence or disregard of rules 
or regulations, substantial understatement of income tax, and 
substantial valuation misstatement is increased to 30 percent 
with respect to taxpayers related to the inverted entity. In 
addition, the 40-percent penalty for gross valuation 
misstatement is increased to 50 percent with respect to such 
taxpayers.
    The ``earnings stripping'' rules of section 163(j), which 
deny or defer deductions for certain interest paid to foreign 
related parties, are strengthened for inverted corporations. 
With respect to such corporations, the provision eliminates the 
debt-equity threshold generally applicable under section 163(j) 
and reduces the 50-percent thresholds for ``excess interest 
expense'' and ``excess limitation'' to 25 percent.
    In cases in which a U.S. corporate group acquires 
subsidiaries or other assets from an unrelated inverted 
corporate group, the provisions described above generally do 
not apply to the acquiring U.S. corporate group or its related 
parties (including the newly acquired subsidiaries or assets) 
by reason of acquiring the subsidiaries or assets that were 
connected with the inversion transaction. The Treasury 
Secretary is given authority to issue regulations appropriate 
to carry out the purposes of this provision and to prevent its 
abuse.

Partnership transactions

    Under the provision, both types of inversion transactions 
include certain partnership transactions. Specifically, both 
parts of the provision apply to transactions in which a 
foreign-incorporated entity acquires substantially all of the 
properties constituting a trade or business of a domestic 
partnership (whether or not publicly traded), if after the 
acquisition at least 80 percent(or more than 50 percent but 
less than 80 percent, as the case may be) of the stock of the entity is 
held by former partners of the partnership (by reason of holding their 
partnership interests), and the ``substantial business activities'' 
test is not met. For purposes of determining whether these tests are 
met, all partnerships that are under common control within the meaning 
of section 482 are treated as one partnership, except as provided 
otherwise in regulations. In addition, the modified ``toll charge'' 
provisions apply at the partner level.

                             EFFECTIVE DATE

    The regime applicable to transactions involving at least 80 
percent identity of ownership applies to inversion transactions 
completed after March 20, 2002. The rules for inversion 
transactions involving greater-than-50-percent identity of 
ownership apply to inversion transactions completed after 1996 
that meet the 50-percent test and to inversion transactions 
completed after 1996 that would have met the 80-percent test 
but for the March 20, 2002 date.

2. Impose mark-to-market tax on individuals who expatriate (sec. 442 of 
        the bill and secs. 102, 877, 2107, 2501, 7701 and 6039G of the 
        Code)

                              PRESENT LAW

In general

    U.S. citizens and residents generally are subject to U.S. 
income taxation on their worldwide income. The U.S. tax may be 
reduced or offset by a credit allowed for foreign income taxes 
paid with respect to foreign-source income. Nonresidents who 
are not U.S. citizens are taxed at a flat rate of 30 percent 
(or a lower treaty rate) on certain types of passive income 
derived from U.S. sources, and at regular graduated rates on 
net profits derived from a U.S. business.

Income tax rules with respect to expatriates

    An individual who relinquishes his or her U.S. citizenship 
or terminates his or her U.S. residency with a principal 
purpose of avoiding U.S. taxes is subject to an alternative 
method of income taxation for the 10 taxable years ending after 
the expatriation or residency termination under section 877. 
The alternative method of taxation for expatriates modifies the 
rules generally applicable to the taxation of nonresident 
noncitizens in several ways. First, the individual is subject 
to tax on his or her U.S.-source income at the rates applicable 
to U.S. citizens rather than the rates applicable to other 
nonresident noncitizens. Unlike U.S. citizens, however, 
individuals subject to section 877 are not taxed on foreign-
source income. Second, the scope of items treated as U.S.-
source income for section 877 purposes is broader than those 
items generally considered to be U.S.-source income under the 
Code.\285\ Third, individuals subject to section 877 are taxed 
on exchanges of certain types of property that give rise to 
U.S.-source income for property that gives rise to foreign-
source income.\286\ Fourth, an individual subject to section 
877 who contributes property to a controlled foreign 
corporation is treated as receiving income or gain from such 
property directly and is taxable on such income or gain. The 
alternative method of taxation for expatriates applies only if 
it results in a higher U.S. tax liability than would otherwise 
be determined if the individual were taxed as a nonresident 
noncitizen.
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    \285\ For example, gains on the sale or exchange of personal 
property located in the United States, and gains on the sale or 
exchange of stocks and securities issued by U.S. persons, generally are 
not considered to be U.S.-source income under the Code. Thus, such 
gains would not be taxable to a nonresident noncitizen. However, if an 
individual is subject to the alternative regime under sec. 877, such 
gains are treated as U.S.-source income with respect to that 
individual.
    \286\ For example, a former citizen who is subject to the 
alternative tax regime and who removes appreciated artwork that he or 
she owns from the United States could be subject to immediate U.S. tax 
on the appreciation. In this regard, the removal from the United States 
of appreciated tangible personal property having an aggregate fair 
market value in excess of $250,000 within the 15-year period beginning 
five years prior to the expatriation will be treated as an ``exchange'' 
subject to these rules.
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    The expatriation tax provisions apply to long-term 
residents of the United States whose U.S. residency is 
terminated. For this purpose, a long-term resident is any 
individual who was a lawful permanent resident of the United 
States for at least 8 out of the 15 taxable years ending with 
the year in which such termination occurs. In applying the 8-
year test, an individual is not considered to be a lawful 
permanent resident for any year in which the individual is 
treated as a resident of another country under a treaty tie-
breaker rule (and the individual does not elect to waive the 
benefits of such treaty).
    Subject to the exceptions described below, an individual is 
treated as having expatriated or terminated residency with a 
principal purpose of avoiding U.S. taxes if either: (1) the 
individual's average annual U.S. Federal income tax liability 
for the 5 taxable years ending before the date of the 
individual's loss of U.S. citizenship or termination of U.S. 
residency is greater than $100,000 (the ``tax liability 
test''); or (2) the individual's net worth as of the date of 
such loss or termination is $500,000 or more (the ``net worth 
test''). The dollar amount thresholds contained in the tax 
liability test and the net worth test are indexed for inflation 
in the case of a loss of citizenship or termination of 
residency occurring in any calendar year after 1996. An 
individual who falls below these thresholds is not 
automatically treated as having a principal purpose of tax 
avoidance, but nevertheless is subject to the expatriation tax 
provisions if the individual's loss of citizenship or 
termination of residency in fact did have as one of its 
principal purposes the avoidance of tax.
    Certain exceptions from the treatment that an individual 
relinquished his or her U.S. citizenship or terminated his or 
her U.S. residency for tax avoidance purposes may also apply. 
For example, a U.S. citizen who loses his or her citizenship 
and who satisfies either the tax liability test or the net 
worth test (described above) can avoid being deemed to have a 
principal purpose of tax avoidance if the individual falls 
within certain categories (such as being a dual citizen) and 
the individual, within one year from the date of loss of 
citizenship, submits a ruling request for a determination by 
the Secretary of the Treasury as to whether such loss had as 
one of its principal purposes the avoidance of taxes.

Estate tax rules with respect to expatriates

    Nonresident noncitizens generally are subject to estate tax 
on certain transfers of U.S.-situated property at death.\287\ 
Such property includes real estate and tangible property 
located within the United States. Moreover, for estate tax 
purposes, stock held by nonresident noncitizens is treated as 
U.S.-situated if issued by a U.S. corporation.
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    \287\ The Economic Growth and Tax Relief Reconciliation Act of 2001 
(the ``Act'') repealed the estate tax for estates of decedents dying 
after December 31, 2009. However, the Act included a ``sunset'' 
provision, pursuant to which the Act's provisions (including estate tax 
repeal) do not apply to estates of decedents dying after December 31, 
2010.
---------------------------------------------------------------------------
    Special rules apply to U.S. citizens who relinquish their 
citizenship and long-term residents who terminate their U.S. 
residency within the 10 years prior to the date of death, 
unless the loss of status did not have as one its principal 
purposes the avoidance of tax (sec. 2107). Under these rules, 
the decedent's estate includes the proportion of the decedent's 
stock in a foreign corporation that the fair market value of 
the U.S.-situs assets owned by the corporation bears to the 
total assets of the corporation. This rule applies only if (1) 
the decedent owned, directly, at death 10 percent or more of 
the combined voting power of all voting stock of the 
corporation and (2) the decedent owned, directly or indirectly, 
at death more than 50 percent of the total voting stock of the 
corporation or more than 50 percent of the total value of all 
stock of the corporation.
    Taxpayers are deemed to have a principal purpose of tax 
avoidance if they meet the five-year tax liability test or the 
net worth test, discussed above. Exceptions from this tax 
avoidance treatment apply in the same circumstances as those 
described above (relating to certain dual citizens and other 
individuals who submit a timely and complete ruling request 
with the IRS as to whether their expatriation or residency 
termination had a principal purpose of tax avoidance).

Gift tax rules with respect to expatriates

    Nonresident noncitizens generally are subject to gift tax 
on certain transfers by gift of U.S.-situated property. Such 
property includes real estate and tangible property located 
within the United States. Unlike the estate tax rules for U.S. 
stock held by nonresidents, however, nonresident noncitizens 
generally are not subject to U.S. gift tax on the transfer of 
intangibles, such as stock or securities, regardless of where 
such property is situated.
    Special rules apply to U.S. citizens who relinquish their 
U.S. citizenship or long-term residents of the United States 
who terminate their U.S. residency within the 10 years prior to 
the date of transfer, unless such loss did not have as one of 
its principal purposes the avoidance of tax (sec. 2501(a)(3)). 
Under these rules, nonresident noncitizens are subject to gift 
tax on transfers of intangibles, such as stock or securities. 
Taxpayers are deemed to have a principal purpose of tax 
avoidance if they meet the five-year tax liability test or the 
net worth test, discussed above. Exceptions from this tax 
avoidance treatment apply in the same circumstances as those 
described above (relating to certain dual citizens and other 
individuals who submit a timely and complete ruling request 
with the IRS as to whether their expatriation or residency 
termination had a principal purpose of tax avoidance).

Other tax rules with respect to expatriates

    The expatriation tax provisions permit a credit against the 
U.S. tax imposed under such provisions for any foreign income, 
gift, estate, or similar taxes paid with respect to the items 
subject to such taxation. This credit is available only against 
the tax imposed solely as a result of the expatriation tax 
provisions, and is not available to be used to offset any other 
U.S. tax liability.
    In addition, certain information reporting requirements 
apply. Under these rules, a U.S. citizen who loses his or her 
citizenship is required to provide a statement to the State 
Department (or other designated government entity) that 
includes the individual's social security number, forwarding 
foreign address, new country of residence and citizenship, a 
balance sheet in the case of individuals with a net worth of at 
least $500,000, and such other information as the Secretary may 
prescribe. The information statement must be provided no later 
than the earliest day on which the individual: (1) renounces 
the individual's U.S. nationality before a diplomatic or 
consular officer of the United States; (2) furnishes to the 
U.S. Department of State a statement of voluntary 
relinquishment of U.S. nationality confirming an act of 
expatriation; (3) is issued a certificate of loss of U.S. 
nationality by the U.S. Department of State; or (4) loses U.S. 
nationality because the individual's certificate of 
naturalization is canceled by a U.S. court. The entity to which 
such statement is to be provided is required to provide to the 
Secretary of the Treasury copies of all statements received and 
the names of individuals who refuse to provide such statements. 
A long-term resident whose U.S. residency is terminated is 
required to attach a similar statement to his or her U.S. 
income tax return for the year of such termination. An 
individual's failure to provide the required statement results 
in the imposition of a penalty for each year the failure 
continues equal to the greater of (1) 5 percent of the 
individual's expatriation tax liability for such year, or (2) 
$1,000.
    The State Department is required to provide the Secretary 
of the Treasury with a copy of each certificate of loss of 
nationality approved by the State Department. Similarly, the 
agency administering the immigration laws is required to 
provide the Secretary of the Treasury with the name of each 
individual whose status as a lawful permanent resident has been 
revoked or has been determined to have been abandoned. Further, 
the Secretary of the Treasury is required to publish in the 
Federal Register the names of all former U.S. citizens with 
respect to whom it receives the required statements or whose 
names or certificates of loss of nationality it receives under 
the foregoing information-sharing provisions.

Immigration rules with respect to expatriates

    Under U.S. immigration laws, any former U.S. citizen who 
officially renounces his or her U.S. citizenship and who is 
determined by the Attorney General to have renounced for the 
purpose of U.S. tax avoidance is ineligible to receive a U.S. 
visa and will be denied entry into the United States. This 
provision was included as an amendment (the ``Reed amendment'') 
to immigration legislation that was enacted in 1996.

                           REASONS FOR CHANGE

    The Committee is aware that some individuals each year 
relinquish their U.S. citizenship or terminate their U.S. 
residency for the purpose of avoiding U.S. income, estate, and 
gift taxes. By so doing, such individuals reduce their annual 
U.S. income tax liability and reduce or eliminate their U.S. 
estate tax liability.
    The Committee recognizes that citizens and residents of the 
United States have a right not only physically to leave the 
United States to live elsewhere, but also to relinquish their 
citizenship or terminate their residency. The Committee does 
not believe that the Internal Revenue Code should be used to 
stop U.S. citizens and residents from relinquishing citizenship 
or terminating residency; however, the Committee also does not 
believe that the Code should provide a tax incentive for doing 
so. In other words, to the extent possible, an individual's 
decision to relinquish citizenship or terminate residency 
should be tax-neutral.
    The Committee is concerned that the present-law 
expatriation tax rules are difficult to administer. In 
addition, the Committee is concerned that the alternative 
method of taxation under section 877 can be avoided by 
postponing the realization of U.S.-source income for 10 years. 
The Committee believes that the expatriation tax rules are 
largely ineffective in taxing U.S. citizens and residents who 
relinquish citizenship or terminate residency with a principal 
purpose to avoid tax.
    The Committee believes that the present-law expatriation 
tax rules should be replaced with a tax regime applicable to 
former citizens and residents that does not rely on 
establishing a tax avoidance motive. Because U.S. citizens and 
residents who retain their citizenship or residency generally 
are subject to income tax on accrued appreciation when they 
dispose of their assets, as well as estate tax on the full 
value of assets that are held until death, the Committee 
believes it fair to tax individuals on the appreciation in 
their assets when they relinquish their citizenship or 
terminate their residency. The Committee believes that an 
exception from such a tax should be provided for individuals 
with a relatively modest amount of appreciated assets. The 
Committee also believes that, where U.S. estate or gift taxes 
are avoided with respect to a transfer of property to a U.S. 
person by reason of the expatriation of the donor, it is 
appropriate for the recipient to be subject to an income tax 
based on the value of the property.
    The Committee also believes that the present-law 
immigration rules applicable to former citizens are 
ineffective. The Committee believes that the rules should be 
modified to eliminate the requirement of proof of a tax 
avoidance purpose, and to coordinate the application of those 
rules with the tax rules provided under the new regime.

                        EXPLANATION OF PROVISION

In general

    The provision generally subjects certain U.S. citizens who 
relinquish their U.S. citizenship and certain long-term U.S. 
residents who terminate their U.S. residence to tax on the net 
unrealized gain in their property as if such property were sold 
for fair market value on the day before the expatriation or 
residency termination. Gain from the deemed sale is taken into 
account at that time without regard to other Code provisions; 
any loss from the deemed sale generally would be taken into 
account to the extent otherwise provided in the Code. Any net 
gain on the deemed sale is recognized to the extent it exceeds 
$600,000 ($1.2 million in the case of married individuals 
filing a joint return, both of whom relinquish citizenship or 
terminate residency). The $600,000 amount is increased by a 
cost of living adjustment factor for calendar years after 2002.

Individuals covered

    Under the provision, the mark-to-market tax applies to U.S. 
citizens who relinquish citizenship and long-term residents who 
terminate U.S. residency. An individual is a long-term resident 
if he or she was a lawful permanent resident for at least eight 
out of the 15 taxable years ending with the year in which the 
termination of residency occurs. An individual is considered to 
terminate long-term residency when either the individual ceases 
to be a lawful permanent resident (i.e., loses his or her green 
card status), or the individual is treated as a resident of 
another country under a tax treaty and the individual does not 
waive the benefits of the treaty.
    Exceptions from the mark-to-market tax are provided in two 
situations. The first exception applies to an individual who 
was born with citizenship both in the United States and in 
another country; provided that: (1) as of the expatriation date 
the individual continues to be a citizen of, and is taxed as a 
resident of, such other country; and (2) the individual was not 
a resident of the United States for the five taxable years 
ending with the year of expatriation. The second exception 
applies to a U.S. citizen who relinquishes U.S. citizenship 
before reaching age 18 and a half, provided that the individual 
was a resident of the United States for no more than five 
taxable years before such relinquishment.

Election to be treated as a U.S. citizen

    Under the provision, an individual is permitted to make an 
irrevocable election to continue to be taxed as a U.S. citizen 
with respect to all property that otherwise is covered by the 
expatriation tax. This election is an ``all or nothing'' 
election; an individual is not permitted to elect this 
treatment for some property but not for other property. The 
election, if made, would apply to all property that would be 
subject to the expatriation tax and to any property the basis 
of which is determined by reference to such property. Under 
this election, the individual would continue to pay U.S. income 
taxes at the rates applicable to U.S. citizens following 
expatriation on any income generated by the property and on any 
gain realized on the disposition of the property. In addition, 
the property would continue to be subject to U.S. gift, estate, 
and generation-skipping transfer taxes. In order to make this 
election, the taxpayer would be required to waive any treaty 
rights that would preclude the collection of the tax.
    The individual also would be required to provide security 
to ensure payment of the tax under this election in such form, 
manner, and amount as the Secretary of the Treasury requires. 
The amount of mark-to-market tax that would have been owed but 
for this election (including any interest, penalties, and 
certain other items) shall be a lien in favor of the United 
States on all U.S.-situs property owned by the individual. This 
lien shall arise on the expatriation date and shall continue 
until the tax liability is satisfied, the tax liability has 
become unenforceable by reason of lapse of time, or the 
Secretary is satisfied that no further tax liability may arise 
by reason of this provision. The rules of section 6324A(d)(1), 
(3), and (4) (relating to liens arisingin connection with the 
deferral of estate tax under section 6166) apply to liens arising under 
this provision.

Date of relinquishment of citizenship

    Under the provision, an individual is treated as having 
relinquished U.S. citizenship on the earliest of four possible 
dates: (1) the date that the individual renounces U.S. 
nationality before a diplomatic or consular officer of the 
United States (provided that the voluntary relinquishment is 
later confirmed by the issuance of a certificate of loss of 
nationality); (2) the date that the individual furnishes to the 
State Department a signed statement of voluntary relinquishment 
of U.S. nationality confirming the performance of an 
expatriating act (again, provided that the voluntary 
relinquishment is later confirmed by the issuance of a 
certificate of loss of nationality); (3) the date that the 
State Department issues a certificate of loss of nationality; 
or (4) the date that a U.S. court cancels a naturalized 
citizen's certificate of naturalization.

Deemed sale of property upon expatriation or residency termination

    The deemed sale rule of the provision generally applies to 
all property interests held by the individual on the date of 
relinquishment of citizenship or termination of residency. 
Special rules apply in the case of trust interests, as 
described below. U.S. real property interests, which remain 
subject to U.S. tax in the hands of nonresident noncitizens, 
generally are excepted from the provision. Regulatory authority 
is granted to the Treasury to except other types of property 
from the provision.
    Under the provision, an individual who is subject to the 
mark-to-market tax is required to pay a tentative tax equal to 
the amount of tax that would be due for a hypothetical short 
tax year ending on the date the individual relinquished 
citizenship or terminated residency. Thus, the tentative tax is 
based on all income, gain, deductions, loss, and credits of the 
individual for the year through such date, including amounts 
realized from the deemed sale of property. The tentative tax is 
due on the 90th day after the date of relinquishment of 
citizenship or termination of residency.

Retirement plans and similar arrangements

    Subject to certain exceptions, the provision applies to all 
property interests held by the individual at the time of 
relinquishment of citizenship or termination of residency. 
Accordingly, such property includes an interest in an employer-
sponsored retirement plan or deferred compensation arrangement 
as well as an interest in an individual retirement account or 
annuity (i.e., an IRA).\288\ However, the provision contains a 
special rule for an interest in a ``qualified retirement 
plan.'' For purposes of the provision, a ``qualified retirement 
plan'' includes an employer-sponsored qualified plan (sec. 
401(a)), a qualified annuity (sec. 403(a)), a tax-sheltered 
annuity (sec. 403(b)), an eligible deferred compensation plan 
of a governmental employer (sec. 457(b)), or an IRA (sec. 408). 
The special retirement plan rule applies also, to the extent 
provided in regulations, to any foreign plan or similar 
retirement arrangement or program. An interest in a trust that 
is part of a qualified retirement plan or other arrangement 
that is subject to the special retirement plan rule is not 
subject to the rules for interests in trusts (discussed below).
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    \288\ Application of the provision is not limited to an interest 
that meets the definition of property under section 83 (relating to 
property transferred in connection with the performance of services).
---------------------------------------------------------------------------
    Under the special rule, an amount equal to the present 
value of the individual's vested, accrued benefit under a 
qualified retirement plan is treated as having been received by 
the individual as a distribution under the plan on the day 
before the individual's relinquishment of citizenship or 
termination of residency. It is not intended that the plan 
would be deemed to have made a distribution for purposes of the 
tax-favored status of the plan, such as whether a plan may 
permit distributions before a participant has severed 
employment. In the case of any later distribution to the 
individual from the plan, the amount otherwise includible in 
the individual's income as a result of the distribution is 
reduced to reflect the amount previously included in income 
under the special retirement plan rule. The amount of the 
reduction applied to a distribution is the excess of: (1) the 
amount included in income under the special retirement plan 
rule; over (2) the total reductions applied to any prior 
distributions. However, under the provision, the retirement 
plan, and any person acting on the plan's behalf, will treat 
any later distribution in the same manner as the distribution 
would be treated without regard to the special retirement plan 
rule.
    It is expected that the Treasury Department will provide 
guidance for determining the present value of an individual's 
vested, accrued benefit under a qualified retirement plan, such 
as the individual's account balance in the case of a defined 
contribution plan or an IRA, or present value determined under 
the qualified joint and survivor annuity rules applicable to a 
defined benefit plan (sec. 417(e)).

Deferral of payment of tax

    Under the provision, an individual is permitted to elect to 
defer payment of the mark-to-market tax imposed on the deemed 
sale of the property. Interest is charged for the period the 
tax is deferred at a rate two percentage points higher than the 
rate normally applicable to individual underpayments. Under 
this election, the mark-to-market tax attributable to a 
particular property is due when the property is disposed of 
(or, if the property is disposed of in whole or in part in a 
nonrecognition transaction, at such other time as the Secretary 
may prescribe). The mark-to-market tax attributable to a 
particular property is an amount that bears the same ratio to 
the total mark-to-market tax for the year as the gain taken 
into account with respect to such property bears to the total 
gain taken into account under these rules for the year. The 
deferral of the mark-to-market tax may not be extended beyond 
the individual's death.
    In order to elect deferral of the mark-to-market tax, the 
individual is required to provide adequate security to the 
Treasury to ensure that the deferred tax and interest will be 
paid. Other security mechanisms are permitted provided that the 
individual establishes to the satisfaction of the Secretary 
that the security is adequate. In the event that the security 
provided with respect to a particular property subsequently 
becomes inadequate and the individual fails to correct the 
situation, the deferred tax and the interest with respect to 
such property will become due. As a further condition to making 
the election, the individual is required to consent to the 
waiver of any treaty rights that would preclude the collection 
of the tax.
    The deferred amount (including any interest, penalties, and 
certain other items) shall be a lien in favor of the United 
States on all U.S.-situs property owned by the individual. This 
lien shall arise on the expatriation date and shall continue 
until the tax liability is satisfied, the tax liability has 
become unenforceable by reason of lapse of time, or the 
Secretary is satisfied that no further tax liability may arise 
by reason of this provision. The rules of section 6324A(d)(1), 
(3), and (4) (relating to liens arising in connection with the 
deferral of estate tax under section 6166) apply to liens 
arising under this provision.

Interests in trusts

    Under the provision, detailed rules apply to trust 
interests held by an individual at the time of relinquishment 
of citizenship or termination of residency. The treatment of 
trust interests depends on whether the trust is a qualified 
trust. A trust is a qualified trust if a court within the 
United States is able to exercise primary supervision over the 
administration of the trust and one or more U.S. persons have 
the authority to control all substantial decisions of the 
trust.
    Constructive ownership rules apply to a trust beneficiary 
that is a corporation, partnership, trust, or estate. In such 
cases, the shareholders, partners, or beneficiaries of the 
entity are deemed to be the direct beneficiaries of the trust 
for purposes of applying these provision. In addition, an 
individual who holds (or who is treated as holding) a trust 
instrument at the time of relinquishment of citizenship or 
termination of residency is required to disclose on his or her 
tax return the methodology used to determine his or her 
interest in the trust, and whether such individual knows (or 
has reason to know) that any other beneficiary of the trust 
uses a different method.
    Nonqualified trusts.--If an individual holds an interest in 
a trust that is not a qualified trust, a special rule applies 
for purposes of determining the amount of the mark-to-market 
tax due with respect to such trust interest. The individual's 
interest in the trust is treated as a separate trust consisting 
of the trust assets allocable to such interest. Such separate 
trust is treated as having sold its net assets as of the date 
of relinquishment of citizenship or termination of residency 
and having distributed the assets to the individual, who then 
is treated as having recontributed the assets to the trust. The 
individual is subject to the mark-to-market tax with respect to 
any net income or gain arising from the deemed distribution 
from the trust.
    The election to defer payment is available for the mark-to-
market tax attributable to a nonqualified trust interest. 
Interest is charged for the period the tax is deferred at a 
rate two percentage points higher than the rate normally 
applicable to individual underpayments. A beneficiary's 
interest in a nonqualified trust is determined under all the 
facts and circumstances, including the trust instrument, 
letters of wishes, and historical patterns of trust 
distributions.
    Qualified trusts.--If an individual has an interest in a 
qualified trust, the amount of unrealized gain allocable to the 
individual's trust interest is calculated at the time of 
expatriation or residency termination. In determining this 
amount, all contingencies and discretionary interests are 
assumed to be resolved in the individual's favor (i.e., the 
individual is allocated the maximum amount that he or she could 
receive). The mark-to-market tax imposed on such gains is 
collected when the individual receives distributions from the 
trust, or if earlier, upon the individual's death. Interest is 
charged for the period the tax is deferred at a rate two 
percentage points higher than the rate normally applicable to 
individual underpayments.
    If an individual has an interest in a qualified trust, the 
individual is subject to the mark-to-market tax upon the 
receipt of distributions from the trust. These distributions 
also may be subject to other U.S. income taxes. If a 
distribution from a qualified trust is made after the 
individual relinquishes citizenship or terminates residency, 
the mark-to-market tax is imposed in an amount equal to the 
amount of the distribution multiplied by the highest tax rate 
generally applicable to trusts and estates, but in no event 
will the tax imposed exceed the deferred tax amount with 
respect to the trust interest. For this purpose, the deferred 
tax amount is equal to: (1) the tax calculated with respect to 
the unrealized gain allocable to the trust interest at the time 
of expatriation or residency termination; (2) increased by 
interest thereon; and (3) reduced by any mark-to-market tax 
imposed on prior trust distributions to the individual.
    If any individual's interest in a trust is vested as of the 
expatriation date (e.g., if the individual's interest in the 
trust is non-contingent and non-discretionary), the gain 
allocable to the individual's trust interest is determined 
based on the trust assets allocable to his or her trust 
interest. If the individual's interest in the trust is not 
vested as of the expatriation date (e.g., if the individual's 
trust interest is a contingent or discretionary interest), the 
gain allocable to his or her trust interest is determined based 
on all of the trust assets that could be allocable to his or 
her trust interest, determined by resolving all contingencies 
and discretionary powers in the individual's favor. In the case 
where more than one trust beneficiary is subject to the 
expatriation tax with respect to trust interests that are not 
vested, the rules are intended to apply so that the same 
unrealized gain with respect to assets in the trust is not 
taxed to both individuals.
    Mark-to-market taxes become due if the trust ceases to be a 
qualified trust, the individual disposes of his or her 
qualified trust interest, or the individual dies. In such 
cases, the amount of mark-to-market tax equals the lesser of 
(1) the tax calculated under the rules for nonqualified trust 
interests as of the date of the triggering event, or (2) the 
deferred tax amount with respect to the trust interest as of 
that date.
    The tax that is imposed on distributions from a qualified 
trust generally is deducted and withheld by the trustees. If 
the individual does not agree to waive treaty rights that would 
preclude collection of the tax, the tax with respect to such 
distributions is imposed on the trust, the trustee is 
personally liable for the tax, and any other beneficiary has a 
right of contribution against such individual with respect to 
the tax. Similar rules apply when the qualified trust interest 
is disposed of, the trust ceases to be a qualified trust, or 
the individual dies.

Coordination with present-law alternative tax regime

    The provision provides a coordination rule with the 
present-law alternative tax regime. Under the provision, the 
expatriation income tax rules under section 877, and the 
expatriation estate and gift tax rules under sections 2107 and 
2501(a)(3) (described above), do not apply to a former citizen 
or former long-term resident whose expatriation or residency 
termination occurs on or after February 5, 2003.

Treatment of gifts and inheritances from a former citizen or former 
        long-term resident

    Under the provision, the exclusion from income provided in 
section 102 (relating to exclusions from income for the value 
of property acquired by gift or inheritance) does not apply to 
the value of any property received by gift or inheritance from 
a former citizen or former long-term resident (i.e., an 
individual who relinquished U.S. citizenship or terminated U.S. 
residency), subject to the exceptions described above relating 
to certain dual citizens and minors. Accordingly, a U.S. 
taxpayer who receives a gift or inheritance from such an 
individual is required to include the value of such gift or 
inheritance in gross income and is subject to U.S. tax on such 
amount. Having included the value of the property in income, 
the recipient would then take a basis in the property equal to 
that value. The tax does not apply to property that is shown on 
a timely filed gift tax return and that is a taxable gift by 
the former citizen or former long-term resident, or property 
that is shown on a timely filed estate tax return and included 
in the gross U.S. estate of the former citizen or former long-
term resident (regardless of whether the tax liability shown on 
such a return is reduced by credits, deductions, or exclusions 
available under the estate and gift tax rules). In addition, 
the tax does not apply to property in cases in which no estate 
or gift tax return is required to be filed, where no such 
return would have been required to be filed if the former 
citizen or former long-term resident had not relinquished 
citizenship or terminated residency, as the case may be. 
Applicable gifts or bequests that are made in trust are treated 
as made to the beneficiaries of the trust in proportion to 
their respective interests in the trust.

Information reporting

    The provision provides that certain information reporting 
requirements under present law (sec. 6039G) applicable to 
former citizens and former long-term residents also apply for 
purposes of the provision.

Immigration rules

    The provision amends the immigration rules that deny tax-
motivated expatriates reentry into the United States by 
removing the requirement that the expatriation be tax-
motivated, and instead denies former citizens reentry into the 
United States if the individual is determined not to be in 
compliance with his or her tax obligations under the 
provision's expatriation tax provisions (regardless of the 
subjective motive for expatriating). For this purpose, the 
provision permits the IRS to disclose certain items of return 
information of an individual, upon written request of the 
Attorney General or his delegate, as is necessary for making a 
determination under section 212(a)(10)(E) of the Immigration 
and Nationality Act. Specifically, the provision would permit 
the IRS to disclose to the agency administering section 
212(a)(10)(E) whether such taxpayer is in compliance with 
section 877A and identify the items of noncompliance. 
Recordkeeping requirements, safeguards, and civil and criminal 
penalties for unauthorized disclosure or inspection would apply 
to return information disclosed under this provision.

                             EFFECTIVE DATE

    The provision generally is effective for U.S. citizens who 
relinquish citizenship or long-term residents who terminate 
their residency on or after February 5, 2003. The provisions 
relating to gifts and inheritances are effective for gifts and 
inheritances received from former citizens and former long-term 
residents on or after February 5, 2003, whose expatriation or 
residency termination occurs on or after such date. The 
provisions relating to former citizens under U.S. immigration 
laws are effective on or after the date of enactment.

3. Excise tax on stock compensation of insiders of inverted 
        corporations (sec. 443 of the bill and new sec. 5000A of the 
        Code)

                              PRESENT LAW

    The income taxation of a nonstatutory \289\ compensatory 
stock option is determined under the rules that apply to 
property transferred in connection with the performance of 
services (sec. 83). If a nonstatutory stock option does not 
have a readily ascertainable fair market value at the time of 
grant, which is generally the case unless the option is 
actively traded on an established market, no amount is included 
in the gross income of the recipient with respect to the option 
until the recipient exercises the option.\290\ Upon exercise of 
such an option, the excess of the fair market value of the 
stock purchased over the option price is included in the 
recipient's gross income as ordinary income in such taxable 
year.
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    \289\ Nonstatutory stock options refer to stock options other than 
incentive stock options and employee stock purchase plans, the taxation 
of which is determined under sections 421-424.
    \290\ If an individual receives a grant of a nonstatutory option 
that has a readily ascertainable fair market value at the time the 
option is granted, the excess of the fair market value of the option 
over the amount paid for the option is included in the recipient's 
gross income as ordinary income in the first taxable year in which the 
option is either transferable or not subject to a substantial risk of 
forfeiture.
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    The tax treatment of other forms of stock-based 
compensation (e.g., restricted stock and stock appreciation 
rights) is also determined under section 83. The excess of the 
fair market value over the amount paid (if any) for such 
property is generally includable in gross income in the first 
taxable year in which the rights to the property are 
transferable or are not subject to substantial risk of 
forfeiture.
    Shareholders are generally required to recognize gain upon 
stock inversion transactions. An inversion transaction is 
generally not a taxable event for holders of stock options and 
other stock-based compensation.

                           REASONS FOR CHANGE

    The Committee believes that certain inversion transactions 
are a means of avoiding U.S. tax and should be curtailed. The 
Committee is concerned that, while shareholders are generally 
required to recognize gain upon stock inversion transactions, 
executives holding stock options and certain stock-based 
compensation are not taxed upon such transactions. Since such 
executives are often instrumental in deciding whether to engage 
in inversion transactions, the Committee believes that, upon 
certain inversion transactions, it is appropriate to impose an 
excise tax on certain executives holding stock options and 
other stock-based compensation.

                        EXPLANATION OF PROVISION

    Under the provision, specified holders of stock options and 
other stock-based compensation are subject to an excise tax 
upon certain inversion transactions. The provision imposes a 20 
percent excise tax on the value of specified stock compensation 
held (directly or indirectly) by or for the benefit of a 
disqualified individual, or a member of such individual's 
family, at any time during the 12-month period beginning six 
months before the corporation's inversion date. Specified stock 
compensation is treated as held for the benefit of a 
disqualified individual if such compensation is held by an 
entity, e.g., a partnership or trust, in which the individual, 
or a member of the individual's family, has an ownership 
interest.
    A disqualified individual is any individual who, with 
respect to a corporation, is, at any time during the 12-month 
period beginning on the date which is six months before the 
inversion date, subject to the requirements of section 16(a) of 
the Securities and Exchange Act of 1934 with respect to the 
corporation, or would be subject to such requirements if the 
corporation was an issuer of equity securities referred to in 
section 16(a). Disqualified individuals generally include 
officers (as defined by section 16(a)),\291\ directors, and 10-
percent owners of private and publicly-held corporations.
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    \291\ An officer is defined as the president, principal financial 
officer, principal accounting officer (or, if there is no such 
accounting officer, the controller), any vice-president in charge of a 
principal business unit, division or function (such as sales, 
administration or finance), any other officer who performs a policy-
making function, or any other person who performs similar policy-making 
functions.
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    The excise tax is imposed on a disqualified individual of 
an inverted corporation only if gain (if any) is recognized in 
whole or part by any shareholder by reason of either the 80 
percent or 50 percent identity of stock ownership corporate 
inversion transactions previously described in the bill.
    Specified stock compensation subject to the excise tax 
includes any payment \292\ (or right to payment) granted by the 
inverted corporation (or any member of the corporation's 
expanded affiliated group \293\) to any person in connection 
with the performance of services by a disqualified individual 
for such corporation (or member of the corporation's expanded 
affiliated group) if the value of the payment or right is based 
on, or determined by reference to, the value or change in value 
of stock of such corporation (or any member of the 
corporation's expanded affiliated group). In determining 
whether such compensation exists and valuing such compensation, 
all restrictions, other than non-lapse restrictions, are 
ignored. Thus, the excise tax applies, and the value subject to 
the tax is determined, without regard to whether such specified 
stock compensation is subject to a substantial risk of 
forfeiture or is exercisable at the time of the inversion 
transaction. Specified stock compensation includes compensatory 
stock and restricted stock grants, compensatory stock options, 
and other forms of stock-based compensation, including stock 
appreciation rights, phantom stock, and phantom stock options. 
Specified stock compensation also includes nonqualified 
deferred compensation that is treated as though it were 
invested in stock or stock options of the inverting corporation 
(or member). For example, the provision applies to a 
disqualified individual's deferred compensation if company 
stock is one of the actual or deemed investment options under 
the nonqualified deferred compensation plan.
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    \292\ Under the provision, any transfer of property is treated as a 
payment and any right to a transfer of property is treated as a right 
to a payment.
    \293\ An expanded affiliated group is an affiliated group (under 
section 1504) except that such group is determined without regard to 
the exceptions for certain corporations and is determined applying a 
greater than 50 percent threshold, in lieu of the 80 percent test.
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    Specified stock compensation includes a compensation 
arrangement that gives the disqualified individual an economic 
stake substantially similar to that of a corporate shareholder. 
Thus, the excise tax does not apply where a payment is simply 
triggered by a target value of the corporation's stock or where 
a payment depends on a performance measure other than the value 
of the corporation's stock. Similarly, the tax does not apply 
if the amount of the payment is not directly measured by the 
value of the stock or an increase in the value of the stock. 
For example, an arrangement under which a disqualified 
individual is paid a cash bonus of $500,000 if the 
corporation's stock increased in value by 25 percent over two 
years or $1,000,000 if the stock increased by 33 percent over 
two years is not specified stock compensation, even though the 
amount of the bonus generally is keyed to an increase in the 
value of the stock. By contrast, an arrangement under which a 
disqualified individual is paid a cash bonus equal to $10,000 
for every $1 increase in the share price of the corporation's 
stock is subject to the provision because the direct connection 
between the compensation amount and the value of the 
corporation's stock gives the disqualified individual an 
economic stake substantially similar to that of a shareholder.
    The excise tax applies to any such specified stock 
compensation previously granted to a disqualified individual 
but cancelled or cashed-out within the six-month period ending 
with the inversion transaction, and to any specified stock 
compensation awarded in the six-month period beginning with the 
inversion transaction. As a result, for example, if a 
corporation were to cancel outstanding options three months 
before the transaction and then reissue comparable options 
three months after the transaction, the tax applies both to the 
cancelled options and the newly granted options. It is intended 
that the Treasury Secretary issue guidance to avoid double 
counting with respect to specified stock compensation that is 
cancelled and then regranted during the applicable twelve-month 
period.
    Specified stock compensation subject to the tax does not 
include a statutory stock option or any payment or right from a 
qualified retirement plan or annuity, a tax-sheltered annuity, 
a simplified employee pension, or a simple retirement account. 
In addition, under the provision, the excise tax does not apply 
to any stock option that is exercised on the inversion date or 
during the six-month period before such date and to the stock 
acquired pursuant to such exercise, if income is recognized 
under section 83 on or before the inversion date with respect 
to the stock acquired pursuant to such exercise. The excise tax 
also does not apply to any specified stock compensation that is 
exercised, sold, exchanged, distributed, cashed-out, or 
otherwise paid during such period in a transaction in which 
gain or loss is recognized in full.
    For specified stock compensation held on the inversion 
date, the amount of the tax is determined based on the value of 
the compensation on such date. The tax imposed on specified 
stock compensation cancelled during the six-month period before 
the inversion date isdetermined based on the value of the 
compensation on the day before such cancellation, while specified stock 
compensation granted after the inversion date is valued on the date 
granted. Under the provision, the cancellation of a non-lapse 
restriction is treated as a grant.
    The value of the specified stock compensation on which the 
excise tax is imposed is the fair value in the case of stock 
options (including warrants and other similar rights to acquire 
stock) and stock appreciation rights and the fair market value 
for all other forms of compensation. For purposes of the tax, 
the fair value of an option (or a warrant or other similar 
right to acquire stock) or a stock appreciation right is 
determined using an appropriate option-pricing model, as 
specified or permitted by the Treasury Secretary, that takes 
into account the stock price at the valuation date; the 
exercise price under the option; the remaining term of the 
option; the volatility of the underlying stock and the expected 
dividends on it; and the risk-free interest rate over the 
remaining term of the option. Options that have no intrinsic 
value (or ``spread'') because the exercise price under the 
option equals or exceeds the fair market value of the stock at 
valuation nevertheless have a fair value and are subject to tax 
under the provision. The value of other forms of compensation, 
such as phantom stock or restricted stock, are the fair market 
value of the stock as of the date of the inversion transaction. 
The value of any deferred compensation that could be valued by 
reference to stock is the amount that the disqualified 
individual would receive if the plan were to distribute all 
such deferred compensation in a single sum on the date of the 
inversion transaction (or the date of cancellation or grant, if 
applicable). It is expected that the Treasury Secretary issue 
guidance on valuation of specified stock compensation, 
including guidance similar to the revenue procedures issued 
under section 280G, except that the guidance would not permit 
the use of a term other than the full remaining term and would 
be modified as necessary or appropriate to carry out the 
purposes of the provision. Pending the issuance of guidance, it 
is intended that taxpayers could rely on the revenue procedure 
issued under section 280G (except that the full remaining term 
must be used and recalculation is not permitted).
    The excise tax also applies to any payment by the inverted 
corporation or any member of the expanded affiliated group made 
to an individual, directly or indirectly, in respect of the 
tax. Whether a payment is made in respect of the tax is 
determined under all of the facts and circumstances. Any 
payment made to keep the individual in the same after-tax 
position that the individual would have been in had the tax not 
applied is a payment made in respect of the tax. This includes 
direct payments of the tax and payments to reimburse the 
individual for payment of the tax. It is expected that the 
Treasury Secretary issue guidance on determining when a payment 
is made in respect of the tax and that such guidance would 
include certain factors that give rise to a rebuttable 
presumption that a payment is made in respect of the tax, 
including a rebuttable presumption that if the payment is 
contingent on the inversion transaction, it is made in respect 
to the tax. Any payment made in respect of the tax is 
includible in the income of the individual, but is not 
deductible by the corporation.
    To the extent that a disqualified individual is also a 
covered employee under section 162(m), the $1,000,000 limit on 
the deduction allowed for employee remuneration for such 
employee is reduced by the amount of any payment (including 
reimbursements) made in respect of the tax under the provision. 
As discussed above, this includes direct payments of the tax 
and payments to reimburse the individual for payment of the 
tax.
    The payment of the excise tax has no effect on the 
subsequent tax treatment of any specified stock compensation. 
Thus, the payment of the tax has no effect on the individual's 
basis in any specified stock compensation and no effect on the 
tax treatment for the individual at the time of exercise of an 
option or payment of any specified stock compensation, or at 
the time of any lapse or forfeiture of such specified stock 
compensation. The payment of the tax is not deductible and has 
no effect on any deduction that might be allowed at the time of 
any future exercise or payment.
    Under the provision, the Treasury Secretary is authorized 
to issue regulations as may be necessary or appropriate to 
carry out the purposes of the section.

                             EFFECTIVE DATE

    The provision is effective as of July 11, 2002, except that 
periods before July 11, 2002, are not taken into account in 
applying the tax to specified stock compensation held or 
cancelled during the six-month period before the inversion 
date.

4. Reinsurance agreements (sec. 444 of the bill and sec. 845 of the 
        Code)

                              PRESENT LAW

    In the case of a reinsurance agreement between two or more 
related persons, present law provides the Treasury Secretary 
with authority to allocate among the parties or recharacterize 
income (whether investment income, premium or otherwise), 
deductions, assets, reserves, credits and any other items 
related to the reinsurance agreement, or make any other 
adjustment, in order to reflect the proper source and character 
of the items for each party.\294\ For this purpose, related 
persons are defined as in section 482. Thus, persons are 
related if they are organizations, trades or businesses 
(whether or not incorporated, whether or not organized in the 
United States, and whether or not affiliated) that are owned or 
controlled directly or indirectly by the same interests. The 
provision may apply to a contract even if one of the related 
parties is not a domestic company.\295\ In addition, the 
provision also permits such allocation, recharacterization, or 
other adjustments in a case in which one of the parties to a 
reinsurance agreement is, with respect to any contract covered 
by the agreement, in effect an agent of another party to the 
agreement, or a conduit between related persons.
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    \294\ Sec. 845(a).
    \295\ See S. Rep. No. 97-494, ``Tax Equity and Fiscal 
Responsibility Act of 1982,'' July 12, 1982, 337 (describing provisions 
relating to the repeal of modified coinsurance provisions).
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                           REASONS FOR CHANGE

    The Committee is concerned that reinsurance transactions 
are being used to allocate income, deductions, or other items 
inappropriately among U.S. and foreign related persons. The 
Committee is concerned that foreign related party reinsurance 
arrangements may be a technique for eroding the U.S. tax base. 
The Committee believes that the provision of present law 
permitting the Treasury Secretary to allocate or recharacterize 
items related to a reinsuranceagreement should be applied to 
prevent misallocation, improper characterization, or to make any other 
adjustment in the case of such reinsurance transactions between U.S. 
and foreign related persons (or agents or conduits). The Committee also 
wishes to clarify that, in applying the authority with respect to 
reinsurance agreements, the amount, source or character of the items 
may be allocated, recharacterized or adjusted.

                        EXPLANATION OF PROVISION

    The provision clarifies the rules of section 845, relating 
to authority for the Treasury Secretary to allocate items among 
the parties to a reinsurance agreement, recharacterize items, 
or make any other adjustment, in order to reflect the proper 
source and character of the items for each party. The provision 
authorizes such allocation, recharacterization, or other 
adjustment, in order to reflect the proper source, character or 
amount of the item. It is intended that this authority \296\ be 
exercised in a manner similar to the authority under section 
482 for the Treasury Secretary to make adjustments between 
related parties. It is intended that this authority be applied 
in situations in which the related persons (or agents or 
conduits) are engaged in cross-border transactions that require 
allocation, recharacterization, or other adjustments in order 
to reflect the proper source, character or amount of the item 
or items. No inference is intended that present law does not 
provide this authority with respect to reinsurance agreements.
---------------------------------------------------------------------------
    \296\ The authority to allocate, recharacterize or make other 
adjustments was granted in connection with the repeal of provisions 
relating to modified coinsurance transactions.
---------------------------------------------------------------------------
    No regulations have been issued under section 845(a). It is 
expected that the Treasury Secretary will issue regulations 
under section 845(a) to address effectively the allocation of 
income (whether investment income, premium or otherwise) and 
other items, the recharacterization of such items, or any other 
adjustment necessary to reflect the proper amount, source or 
character of the item.

                             EFFECTIVE DATE

    The provision is effective for any risk reinsured after 
April 11, 2002.

5. Reporting of taxable mergers and acquisitions (sec. 445 of the bill 
        and new sec. 6043A of the Code)

                              PRESENT LAW

    Under section 6045 and the regulations thereunder, brokers 
(defined to include stock transfer agents) are required to make 
information returns and to provide corresponding payee 
statements as to sales made on behalf of their customers, 
subject to the penalty provisions of sections 6721-6724. Under 
the regulations issued under section 6045, this requirement 
generally does not apply with respect to taxable transactions 
other than exchanges for cash (e.g., stock inversion 
transactions taxable to shareholders by reason of section 
367(a)).

                           REASONS FOR CHANGE

    The Committee believes that administration of the tax laws 
would be improved by greater information reporting with respect 
to taxable non-cash transactions, and that the Treasury 
Secretary's authority to require such enhanced reporting should 
be made explicit in the Code.

                        EXPLANATION OF PROVISION

    Under the provision, if gain or loss is recognized in whole 
or in part by shareholders of a corporation by reason of a 
second corporation's acquisition of the stock or assets of the 
first corporation, then the acquiring corporation (or the 
acquired corporation, if so prescribed by the Treasury 
Secretary) is required to make a return containing:
          (1) A description of the transaction;
          (2) The name and address of each shareholder of the 
        acquired corporation that recognizes gain as a result 
        of the transaction (or would recognize gain, if there 
        was a built-in gain on the shareholder's shares);
          (3) The amount of money and the value of stock or 
        other consideration paid to each shareholder described 
        above; and
          (4) Such other information as the Treasury Secretary 
        may prescribe.
    Alternatively, a stock transfer agent who records transfers 
of stock in such transaction may make the return described 
above in lieu of the second corporation.
    In addition, every person required to make a return 
described above is required to furnish to each shareholder (or 
the shareholder's nominee \297\) whose name is required to be 
set forth in such return a written statement showing:
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    \297\ In the case of a nominee, the nominee must furnish the 
information to the shareholder in the manner prescribed by the 
Secretary of the Treasury.
---------------------------------------------------------------------------
          (1) The name, address, and phone number of the 
        information contact of the person required to make such 
        return;
          (2) The information required to be shown on that 
        return; and
          (3) Such other information as the Treasury Secretary 
        may prescribe.
    This written statement is required to be furnished to the 
shareholder on or before January 31 of the year following the 
calendar year during which the transaction occurred.
    The present-law penalties for failure to comply with 
information reporting requirements is extended to failures to 
comply with the requirements set forth under the provision.

                             EFFECTIVE DATE

    The provision is effective for acquisitions after the date 
of enactment.

                          E. International Tax


1. Clarification of banking business for purposes of determining 
        investment of earnings in U.S. property (sec. 451 of the bill 
        and sec. 956 of the Code)

                              PRESENT LAW

    In general, the subpart F rules \298\ require the U.S. 10-
percent shareholders of a controlled foreign corporation to 
include in income currently their pro rata shares of certain 
income of the controlled foreign corporation (referred to as 
``subpart F income''), whether or not such earnings are 
distributed currently to the shareholders. In addition, the 
U.S. 10-percent shareholders of a controlled foreign 
corporation are subject to U.S. tax currently on their pro rata 
shares of the controlled foreign corporation's earnings to the 
extent invested by the controlled foreign corporation in 
certain U.S. property.\299\
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    \298\ Secs. 951-964.
    \299\ Sec. 951(a)(1)(B).
---------------------------------------------------------------------------
    A shareholder's current income inclusion with respect to a 
controlled foreign corporation's investment in U.S. property 
for a taxable year is based on the controlled foreign 
corporation's average investment in U.S. property for such 
year. For this purpose, the U.S. property held (directly or 
indirectly) by the controlled foreign corporation must be 
measured as of the close of each quarter in the taxable 
year.\300\ The amount taken into account with respect to any 
property is the property's adjusted basis as determined for 
purposes of reporting the controlled foreign corporation's 
earnings and profits, reduced by any liability to which the 
property is subject. The amount determined for current 
inclusion is the shareholder's pro rata share of an amount 
equal to the lesser of: (1) the controlled foreign 
corporation's average investment in U.S. property as of the end 
of each quarter of such taxable year, to the extent that such 
investment exceeds the foreign corporation's earnings and 
profits that were previously taxed on that basis; or (2) the 
controlled foreign corporation's current or accumulated 
earnings and profits (but not including a deficit), reduced by 
distributions during the year and by earnings that have been 
taxed previously as earnings invested in U.S. property.\301\ An 
income inclusion is required only to the extent that the amount 
so calculated exceeds the amount of the controlled foreign 
corporation's earnings that have been previously taxed as 
subpart F income.\302\
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    \300\ Sec. 956(a).
    \301\ Secs. 956 and 959.
    \302\ Secs. 951(a)(1)(B) and 959.
---------------------------------------------------------------------------
    For purposes of section 956, U.S. property generally is 
defined to include tangible property located in the United 
States, stock of a U.S. corporation, an obligation of a U.S. 
person, and certain intangible assets including a patent or 
copyright, an invention, model or design, a secret formula or 
process or similar property right which is acquired or 
developed by the controlled foreign corporation for use in the 
United States.\303\
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    \303\ Sec. 956(c)(1).
---------------------------------------------------------------------------
    Specified exceptions from the definition of U.S. property 
are provided for: (1) obligations of the United States, money, 
or deposits with persons carrying on the banking business; (2) 
certain export property; (3) certain trade or business 
obligations; (4) aircraft, railroad rolling stock, vessels, 
motor vehicles or containers used in transportation in foreign 
commerce and used predominantly outside of the United States; 
(5) certain insurance company reserves and unearned premiums 
related to insurance of foreign risks; (6) stock or debt of 
certain unrelated U.S. corporations; (7) moveable property 
(other than a vessel or aircraft) used for the purpose of 
exploring, developing, or certain other activities in 
connection with the ocean waters of the U.S. Continental Shelf; 
(8) an amount of assets equal to the controlled foreign 
corporation's accumulated earnings and profits attributable to 
income effectively connected with a U.S. trade or business; (9) 
property (to the extent provided in regulations) held by a 
foreign sales corporation and related to its export activities; 
(10) certain deposits or receipts of collateral or margin by a 
securities or commodities dealer, if such deposit is made or 
received on commercial terms in the ordinary course of the 
dealer's business as a securities or commodities dealer; and 
(11) certain repurchase and reverse repurchase agreement 
transactions entered into by or with a dealer in securities or 
commodities in the ordinary course of its business as a 
securities or commodities dealer.\304\
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    \304\ Sec. 956(c)(2).
---------------------------------------------------------------------------
    With regard to the exception for deposits with persons 
carrying on the banking business, the U.S. Court of Appeals for 
the Sixth Circuit in The Limited, Inc. v. Commissioner \305\ 
concluded that a U.S. subsidiary of a U.S. shareholder was 
``carrying on the banking business'' even though its operations 
were limited to the administration of the private label credit 
card program of the U.S. shareholder. Therefore, the court held 
that a controlled foreign corporation of the U.S. shareholder 
could make deposits with the subsidiary (e.g., through the 
purchase of certificates of deposit) under this exception, and 
avoid taxation of the deposits under section 956 as an 
investment in U.S. property.
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    \305\ 286 F.3d 324 (6th Cir. 2002), rev'g 113 T.C. 169 (1999).
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The Committee believes that further guidance is necessary 
under the U.S. property investment provisions of subpart F with 
regard to the treatment of deposits with persons carrying on 
the banking business. In particular, the Committee believes 
that the transaction at issue in The Limited case was not 
contemplated or intended by Congress when it excepted from the 
definition of U.S. property deposits with persons carrying on 
the banking business. Therefore, the Committee believes that it 
is appropriate and necessary to clarify the scope of this 
exception so that it applies only to deposits with regulated 
banking businesses and their affiliates.

                        EXPLANATION OF PROVISION

    The provision provides that the exception from the 
definition of U.S. property under section 956 for deposits with 
persons carrying on the banking business is limited to deposits 
with: (1) any bank (as defined by section 2(c) of the Bank 
Holding Company Act of 1956 (12 U.S.C. 1841(c), without regard 
to paragraphs (C) and (G) of paragraph (2) of such section); or 
(2) any other corporation with respect to which a bank holding 
company (as defined by section 2(a) of such Act) or financial 
holding company (as defined by section 2(p) of such Act) owns 
directly or indirectly more than 80 percent by vote or value of 
the stock of such corporation.
    No inference is intended as to the meaning of the phrase 
``carrying on the banking business'' under present law or 
whether this phrase was correctly interpreted by the Sixth 
Circuit in The Limited.

                             EFFECTIVE DATE

    This provision is effective on the date of enactment.

2. Prohibition on nonrecognition of gain through complete liquidation 
        of holding company (sec. 452 of the bill and sec. 332 of the 
        Code)

                              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. 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. 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.
    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. 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.
    Regulations under section 367(e) provide that the 
Commissioner may require a domestic liquidating corporation to 
recognize gain on distributions in liquidation made to a 
foreign corporation if a principal purpose of the liquidation 
is the avoidance of U.S. tax. Avoidance of U.S. tax for this 
purpose includes, but is not limited to, the distribution of a 
liquidating corporation's earnings and profits with a principal 
purpose of avoiding U.S. tax.

                           REASONS FOR CHANGE

    The Committee is concerned that foreign corporations 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 taxes, and then reestablish another U.S. holding 
company, with the intention of escaping U.S. withholding taxes. 
The Committee believes that instances of such withholding tax 
abuse will be significantly restricted by imposing U.S. 
withholding taxes on a liquidating distribution to foreign 
corporate shareholders of earnings and profits of a U.S. 
holding company created within five years of the liquidation.

                        EXPLANATION OF PROVISION

    The provision treats as a dividend any distribution of 
earnings by a U.S. holding company to a foreign corporation in 
a complete liquidation, if the U.S. holding company was in 
existence for less than five years.

                             EFFECTIVE DATE

    The provision is effective for distributions occurring on 
or after the date of enactment.

3. Prevention of mismatching of interest and original issue discount 
        deductions and income inclusions in transactions with related 
        foreign persons (sec. 453 of the bill and secs. 163 and 267 of 
        the Code)

                              PRESENT LAW

    Income earned by a foreign corporation from its foreign 
operations generally is subject to U.S. tax only when such 
income is distributed to any U.S. person that holds stock in 
such corporation. Accordingly, a U.S. person that conducts 
foreign operations through a foreign corporation generally is 
subject to U.S. tax on the income from such operations when the 
income is repatriated to the United States through a dividend 
distribution to the U.S. person. The income is reported on the 
U.S. person's tax return for the year the distribution is 
received, and the United States imposes tax on such income at 
that time. However, certain anti-deferral regimes may cause the 
U.S. person to be taxed on a current basis in the United States 
with respect to certain categories of passive or highly mobile 
income earned by the foreign corporations in which the U.S. 
person holds stock. The main anti-deferral regimes are the 
controlled foreign corporation rules of subpart F (sections 
951-964), the passive foreign investment company rules 
(sections 1291-1298), and the foreign personal holding company 
rules (sections 551-558).
    As a general rule, there is allowed as a deduction all 
interest paid or accrued within the taxable year with respect 
to indebtedness, including the aggregate daily portions of 
original issue discount (``OID'') of the issuer for the days 
during such taxable year.\306\ However, if a debt instrument is 
held by a related foreign person, any portion of such OID is 
not allowable as a deduction to the payor of such instrument 
until paid (``related-foreign-person rule''). This related-
foreign-person rule does not apply 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).\307\ 
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.\308\
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    \306\ Section 163(e)(1).
    \307\ Section 163(e)(3).
    \308\ Treas. Reg. sec. 1.163-12(b)(3). In the case of a PFIC, the 
regulations further require that the person owing the amount at issue 
has in effect a qualified electing fund election pursuant to section 
1295 with respect to the PFIC.
---------------------------------------------------------------------------
    In the case of unpaid stated 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 are 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.\309\ With respect to stated interest 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).\310\ As in 
the case of OID, the Treasury regulations additionally provide 
that in the case of stated interest 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.\311\
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    \309\ Section 267(a)(2).
    \310\ Treas. Reg. sec. 1.267(a)-3(b)(1), (c).
    \311\ Treas. Reg. sec. 1.267(a)-3(c)(4).
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                           REASONS FOR CHANGE

    The special rules in the Treasury regulations for FPHCs, 
CFCs and PFICs are an exception to the general rule that OID 
and unpaid interest owed to a related foreign person are 
deductible when paid (i.e., under a cash method). These special 
rules were 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. The Committee believes that 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. Consequently, under the Treasury regulations, 
both the U.S. payors and U.S.-owned foreign payors may 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 could reduce a CFC's income that would be 
currently taxable to its U.S. shareholders under subpart F.

                        EXPLANATION OF PROVISION

    The provision provides that deductions for amounts accrued 
but unpaid (whether by U.S. or foreign persons) to related 
FPHCs, CFCs, or PFICs are allowable only to the extent that the 
amounts accrued by the payor are, for U.S. tax purposes, 
currently included in the income of all of the direct or 
indirect U.S. owners of the related foreign person under the 
relevant inclusion rules. Deductions that have accrued but are 
not allowable under this provision are allowed when the amounts 
are paid. The provision grants the Secretary regulatory 
authority to provide exceptions to these rules, including 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.

                             EFFECTIVE DATE

    The provision is effective for payments accrued on or after 
date of enactment.

4. Effectively connected income to include certain foreign source 
        income (sec. 454 of the bill and sec. 864 of the Code)

                              PRESENT LAW

    Nonresident alien individuals and 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.\312\ 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.
---------------------------------------------------------------------------
    \312\ Sections 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 (so-called ``U.S.-effectively connected 
income'').\313\ 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 U.S. 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 (sometimes referred to as the ``force of attraction 
rule'').
---------------------------------------------------------------------------
    \313\ Section 864(c).
---------------------------------------------------------------------------
    In general, foreign-source income is not treated as U.S.-
effectively connected income.\314\ However, foreign-source 
income, gain, deduction, or loss generally is considered to be 
effectively connected with a U.S. business only if the person 
has an office or other fixed place of business within the 
United States to which such income, gain, deduction, or loss is 
attributable and such income falls into one of three categories 
described below.\315\ For these purposes, 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.\316\
---------------------------------------------------------------------------
    \314\ Section 864(c)(4).
    \315\ Section 864(c)(4)(B).
    \316\ Section 864(c)(5).
---------------------------------------------------------------------------
    The first category consists of rents or royalties for the 
use of patents, copyrights, secret processes, or formulas, good 
will, trademarks, trade brands, franchises, or other similar 
intangible properties derived in the active conduct of the U.S. 
trade or business.\317\ The second category consists of 
interest or dividends derived in the active conduct of a 
banking, financing, or similar business within the United 
States, or received by a corporation whose principal business 
is trading in stocks or securities for its own account.\318\ 
Notwithstanding the foregoing, foreign-source income consisting 
of dividends, interest, or royalties is not treated as 
effectively connected 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.\319\ The third category consists of 
income, gain, deduction, or loss derived from the sale or 
exchange of inventory or property held by the taxpayer 
primarily for sale to customers in the ordinary course of the 
trade or business where the property is sold or exchanged 
outside the United States through the foreign person's U.S. 
office or other fixed place of business.\320\ Such amounts are 
not treated as effectively connected if the property is sold or 
exchanged for use, consumption, or disposition outside the 
United States and an office or other fixed place of business of 
the taxpayer in a foreign country materially participated in 
the sale or exchange.
---------------------------------------------------------------------------
    \317\ Section 864(c)(4)(B)(i).
    \318\ Section 864(c)(4)(B)(ii).
    \319\ Section 864(c)(4)(D)(i).
    \320\ Section 864(c)(4)(B)(iii).
---------------------------------------------------------------------------
    The Code provides sourcing rules for enumerated types of 
income, including interest, dividends, rents, royalties, and 
personal services income.\321\ 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.
---------------------------------------------------------------------------
    \321\ Sections 861 through 865.
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    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.\322\ 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 
with a U.S. trade or business.\323\ Moreover, income from 
notional principal contracts (such as interest rate swaps) 
generally is sourced based on the residence of the recipient of 
the income, but is treated as U.S.-source effectively connected 
income if it arises from the conduct of a United States trade 
or business.\324\
---------------------------------------------------------------------------
    \322\ See Bank of America v. United States, 680 F.2d 142 (Ct. Cl. 
1982).
    \323\ Treas. Reg. sec. 1.864-5(b)(2)(ii).
    \324\ Treas. Reg. sec. 1.863-7(b)(3).
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The Committee believes that present law creates arbitrary 
distinctions between economically similar transactions that are 
equally related to a U.S. trade of business. The Committee 
believes that the rules for determining whether foreign-source 
income (e.g., interest and dividends) is U.S.-effectively 
connected income should be the same as the rules for 
determining whether income that is economically equivalent to 
such foreign-source income is U.S.-effectively connected 
income.

                        EXPLANATION OF PROVISION

    Each category of foreign-source income that is treated as 
effectively connected with a U.S. trade or business is expanded 
to include economic equivalents of such income (i.e., economic 
equivalents of certain foreign-source: (1) rents and royalties; 
(2) dividends and interest; and (3) income on sales or 
exchanges of goods in the ordinary course of business). Thus, 
sucheconomic equivalents are treated as U.S.-effectively 
connected income in the same circumstances that foreign-source rents, 
royalties, dividends, interest, or certain inventory sales are treated 
as U.S.-effectively connected income. For example, foreign-source 
interest and dividend equivalents are 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.

                             EFFECTIVE DATE

    The provision is effective for taxable years beginning 
after the date of enactment.

5. Recapture of overall foreign losses on sale of controlled foreign 
        corporation stock (sec. 455 of the bill and sec. 904 of the 
        Code)

                              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 a portion of the taxpayer's 
U.S. tax which portion is calculated by multiplying the 
taxpayer's total U.S. tax by a fraction, the numerator of which 
is the taxpayer's foreign-source taxable income (i.e., foreign-
source gross income less allocable expenses or deductions) and 
the denominator of which is the taxpayer's worldwide taxable 
income for the year.\325\ Separate limitations are applied to 
specific categories of income.
---------------------------------------------------------------------------
    \325\ Section 904(a).
---------------------------------------------------------------------------
    Special recapture rules apply in the case of foreign losses 
for purposes of applying the foreign tax credit 
limitation.\326\ 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.\327\ 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.
---------------------------------------------------------------------------
    \326\ Section 904(f).
    \327\ Section 904(f)(1).
---------------------------------------------------------------------------
    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.\328\ In this regard, dispositions of trade or 
business property used predominantly outside the United States 
are treated as resulting in the recognition of 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.\329\
---------------------------------------------------------------------------
    \328\ Section 904(f)(3).
    \329\ Coordination rules apply in the case of losses recaptured 
under the branch loss recapture rules. Section 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).\330\ 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.
---------------------------------------------------------------------------
    \330\ Section 864(e) and Temp. Treas. Reg. sec. 1.861-9T.
---------------------------------------------------------------------------
    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, for purposes of the interest apportionment.

                           REASONS FOR CHANGE

    The Committee believes that dispositions of corporate stock 
should be subject to the special recapture rules for overall 
foreign losses. 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 Committee believes that overall 
foreign losses should be recapturedwhen stock of a controlled 
foreign corporation is disposed of regardless of whether such stock is 
disposed of a non-taxable transaction.

                        EXPLANATION OF PROVISION

    Under the provision, the special recapture rule for overall 
foreign losses that currently applies to dispositions of 
foreign trade or business assets applies to the disposition of 
controlled foreign corporation stock. Thus, dispositions of 
controlled foreign corporation stock result in the recognition 
of 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 is resourced as U.S.-source income for foreign tax 
credit limitation purposes without regard to the 50-percent 
limit.

                             EFFECTIVE DATE

    The provision applies to dispositions after the date of 
enactment.

6. Minimum holding period for foreign tax credit on withholding taxes 
        on income other than dividends (sec. 456 of the bill and sec. 
        901 of the Code)

                              PRESENT LAW

    In general, 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.
    As a consequence of the foreign tax credit limitations of 
the Code, certain taxpayers are unable to utilize their 
creditable foreign taxes to reduce their U.S. tax liability. 
U.S. taxpayers that are tax-exempt receive no U.S. tax benefit 
for foreign taxes paid on income that they receive.
    Present law denies a U.S. shareholder the foreign tax 
credits normally available with respect to a dividend from a 
corporation or a regulated investment company (``RIC'') if the 
shareholder has not held the stock for more than 15 days 
(within a 30-day testing period) in the case of common stock or 
more than 45 days (within a 90-day testing period) in the case 
of preferred stock (sec. 901(k)). The disallowance applies both 
to foreign tax credits for foreign withholding taxes that are 
paid on the dividend where the dividend-paying stock is held 
for less than these holding periods, and to indirect foreign 
tax credits for taxes paid by a lower-tier foreign corporation 
or a RIC where any of the required stock in the chain of 
ownership is held for less than these holding periods. Periods 
during which a taxpayer is protected from risk of loss (e.g., 
by purchasing a put option or entering into a short sale with 
respect to the stock) generally are not counted toward the 
holding period requirement. In the case of a bona fide contract 
to sell stock, a special rule applies for purposes of indirect 
foreign tax credits. The disallowance does not apply to foreign 
tax credits with respect to certain dividends received by 
active dealers in securities. If a taxpayer is denied foreign 
tax credits because the applicable holding period is not 
satisfied, the taxpayer is entitled to a deduction for the 
foreign taxes for which the credit is disallowed.

                           REASONS FOR CHANGE

    The Committee believes that the present-law holding period 
requirement for claiming foreign tax credits with respect to 
dividends is too narrow in scope and, in general, should be 
extended to apply to items of income or gain other than 
dividends, such as interest.

                        EXPLANATION OF PROVISION

    The provision expands the present-law disallowance of 
foreign tax credits to include credits for gross-basis foreign 
withholding taxes with respect to any item of income or gain 
from property if the taxpayer who receives the income or gain 
has not held the property for more than 15 days (within a 30-
day testing period), exclusive of periods during which the 
taxpayer is protected from risk of loss. The provision does not 
apply to foreign tax credits that are subject to the present-
law disallowance with respect to dividends. The provision also 
does not apply to certain income or gain that is received with 
respect to property held by active dealers. Rules similar to 
the present-law disallowance for foreign tax credits with 
respect to dividends apply to foreign tax credits that are 
subject to the provision. In addition, the provision authorizes 
the Treasury Department to issue regulations providing that the 
provision does not apply in appropriate cases.

                             EFFECTIVE DATE

    The provision is effective for amounts that are paid or 
accrued more than 30 days after the date of enactment.

                      F. Other Revenue Provisions


1. Treatment of stripped interests in bond and preferred stock funds, 
        etc. (sec. 461 of the bill and secs. 305 and 1286 of the Code)

                              PRESENT LAW

Assignment of income in general

    In general, an ``income stripping'' transaction involves a 
transaction in which the right to receive future income from 
income-producing property is separated from the property 
itself. In such transactions, it may be possible to generate 
artificial losses from the disposition of certain property or 
to defer the recognition of taxable income associated with such 
property.
    Common law has developed a rule (referred to as the 
``assignment of income'' doctrine) that income may not be 
transferred without also transferring the underlying property. 
A leading judicial decision relating to the assignment of 
income doctrine involved a case in which a taxpayer made a gift 
of detachable interest coupons before their due date while 
retaining the bearer bond. The U.S. Supreme Court ruled that 
the donor was taxable on the entire amount of interest when 
paid to the donee on the grounds that the transferor had 
``assigned'' to the donee the right to receive the income.\331\
---------------------------------------------------------------------------
    \331\ Helvering v. Horst, 311 U.S. 112 (1940).
---------------------------------------------------------------------------
    In addition to general common law assignment of income 
principles, specific statutory rules have been enacted to 
address certain specific types of stripping transactions, such 
as transactions involving stripped bonds and stripped preferred 
stock (which are discussed below).\332\ However, there are no 
specific statutory rules that address stripping transactions 
with respect to common stock or other equity interests (other 
than preferred stock).\333\
---------------------------------------------------------------------------
    \332\ Depending on the facts, the IRS also could determine that a 
variety of other Code-based and common law-based authorities could 
apply to income stripping transactions, including: (1) sections 269, 
382, 446(b), 482, 701, or 704 and the regulations thereunder; (2) 
authorities that recharacterize certain assignments or accelerations of 
future payments as financings; (3) business purpose, economic 
substance, and sham transaction doctrines; (4) the step transaction 
doctrine; and (5) the substance-over-form doctrine. See Notice 95-53, 
1995-2 C.B. 334 (accounting for lease strips and other stripping 
transactions).
    \333\ However, in Estate of Stranahan v. Commissioner, 472 F.2d 867 
(6th Cir. 1973), the court held that where a taxpayer sold a carved-out 
interest of stock dividends, with no personal obligation to produce the 
income, the transaction was treated as a sale of an income interest.
---------------------------------------------------------------------------

Stripped bonds

    Special rules are provided with respect to the purchaser 
and ``stripper'' of stripped bonds.\334\ A ``stripped bond'' is 
defined as a debt instrument in which there has been a 
separation in ownership between the underlying debt instrument 
and any interest coupon that has not yet become payable.\335\ 
In general, upon the disposition of either the stripped bond or 
the detached interest coupons each of the retained portion and 
the portion that is disposed is treated as a new bond that is 
purchased at a discount and is payable at a fixed amount on a 
future date. Accordingly, section 1286 treats both the stripped 
bond and the detached interest coupons as individual bonds that 
are newly issued with original issue discount (``OID'') on the 
date of disposition. Consequently, section 1286 effectively 
subjects the stripped bond and the detached interest coupons to 
the general OID periodic income inclusion rules.
---------------------------------------------------------------------------
    \334\ Sec. 1286.
    \335\ Sec. 1286(e).
---------------------------------------------------------------------------
    A taxpayer who purchases a stripped bond or one or more 
stripped coupons is treated as holding a new bond that is 
issued on the purchase date with OID in an amount that is equal 
to the excess of the stated redemption price at maturity (or in 
the case of a coupon, the amount payable on the due date) over 
the ratable share of the purchase price of the stripped bond or 
coupon, determined on the basis of the respective fair market 
values of the stripped bond and coupons on the purchase 
date.\336\ The OID on the stripped bond or coupon is includible 
in gross income under the general OID periodic income inclusion 
rules.
---------------------------------------------------------------------------
    \336\ Sec. 1286(a).
---------------------------------------------------------------------------
    A taxpayer who strips a bond and disposes of either the 
stripped bond or one or more stripped coupons must allocate his 
basis, immediately before the disposition, in the bond (with 
the coupons attached) between the retained and disposed 
items.\337\ Special rules apply to require that interest or 
market discount accrued on the bond prior to such disposition 
must be included in the taxpayer's gross income (to the extent 
that it had not been previously included in income) at the time 
the stripping occurs, and the taxpayer increases his basis in 
the bond by the amount of such accrued interest or market 
discount. The adjusted basis (as increased by any accrued 
interest or market discount) is then allocated between the 
stripped bond and the stripped interest coupons in relation to 
their respective fair market values. Amounts realized from the 
sale of stripped coupons or bonds constitute income to the 
taxpayer only to the extent such amounts exceed the basis 
allocated to the stripped coupons or bond. With respect to 
retained items (either the detached coupons or stripped bond), 
to the extent that the price payable on maturity, or on the due 
date of the coupons, exceeds the portion of the taxpayer's 
basis allocable to such retained items, the difference is 
treated as OID that is required to be included under the 
general OID periodic income inclusion rules.\338\
---------------------------------------------------------------------------
    \337\ Sec. 1286(b). Similar rules apply in the case of any person 
whose basis in any bond or coupon is determined by reference to the 
basis in the hands of a person who strips the bond.
    \338\ Special rules are provided with respect to stripping 
transactions involving tax-exempt obligations that treat OID (computed 
under the stripping rules) in excess of OID computed on the basis of 
the bond's coupon rate (or higher rate if originally issued at a 
discount) as income from a non-tax-exempt debt instrument (sec. 
1286(d)).
---------------------------------------------------------------------------

Stripped preferred stock

    ``Stripped preferred stock'' is defined as preferred stock 
in which there has been a separation in ownership between such 
stock and any dividend on such stock that has not become 
payable.\339\ A taxpayer who purchases stripped preferred stock 
is required to include in gross income, as ordinary income, the 
amounts that would have been includible if the stripped 
preferred stock was a bond issued on the purchase date with OID 
equal to the excess of the redemption price of the stock over 
the purchase price.\340\ This treatment is extended to any 
taxpayer whose basis in the stock is determined by reference to 
the basis in the hands of the purchaser. A taxpayer who strips 
and disposes the future dividends is treated as having 
purchased the stripped preferred stock on the date of such 
disposition for a purchase price equal to the taxpayer's 
adjusted basis in the stripped preferred stock.\341\
---------------------------------------------------------------------------
    \339\ Sec. 305(e)(5).
    \340\ Sec. 305(e)(1).
    \341\ Sec. 305(e)(3).
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The Committee is concerned that taxpayers are entering into 
tax avoidance transactions to generate artificial losses, or 
defer the recognition of ordinary income and convert such 
income into capital gains, by selling or purchasing stripped 
interests that are not subject to the present-law rules 
relating to stripped bonds and preferred stock but that 
represent interests in bonds or preferred stock. Therefore, the 
Committee believes that it is appropriate to provide Treasury 
with regulatory authority to apply such rules to interests that 
do not constitute bonds or preferred stock but nevertheless 
derive their economic value and characteristics exclusively 
from underlying bonds or preferred stock.

                        EXPLANATION OF PROVISION

    The provision authorizes the Treasury Department to 
promulgate regulations that, in appropriate cases, apply rules 
that are similar to the present-law rules for stripped bonds 
and stripped preferred stock to direct or indirect interests in 
an entity or account substantially all of the assets of which 
consist of bonds (as defined in section 1286(e)(1)), preferred 
stock (as defined in section 305(e)(5)(B)), or any combination 
thereof. The provision applies only to cases in which the 
present-law rules for stripped bonds and stripped preferred 
stock do not already apply to such interests.
    For example, such Treasury regulations could apply to a 
transaction in which a person effectively strips future 
dividends from shares in a money market mutual fund (and 
disposes either the stripped shares or stripped future 
dividends) by contributing the shares (with the future 
dividends) to a custodial account through which another person 
purchases rights to either the stripped shares or the stripped 
future dividends. However, it is intended that Treasury 
regulations issued under this provision would not apply to 
certain transactions involving direct or indirect interests in 
an entity or account substantially all the assets of which 
consist of tax-exempt obligations (as defined in section 
1275(a)(3)), such as a tax-exempt bond partnership described in 
Rev. Proc. 2002-68,\342\ modifying and superceding Rev. Proc. 
2002-16.\343\
---------------------------------------------------------------------------
    \342\ 2002-43 I.R.B. 753.
    \343\ 2002-9 I.R.B. 572.
---------------------------------------------------------------------------
    No inference is intended as to the treatment under the 
present-law rules for stripped bonds and stripped preferred 
stock, or under any other provisions or doctrines of present 
law, of interests in an entity or account substantially all of 
the assets of which consist of bonds, preferred stock, or any 
combination thereof. The Treasury regulations, when issued, 
would be applied prospectively, except in cases to prevent 
abuse.

                             EFFECTIVE DATE

    The provision is effective for purchases and dispositions 
occurring after the date of enactment.

2. Application of earnings-stripping rules to partnerships and S 
        corporations (sec. 462 of the bill and sec. 163 of the Code)

                              PRESENT LAW

    Present law provides rules to limit the ability of U.S. 
corporations to reduce the U.S. tax on their U.S.-source income 
through earnings stripping transactions. Section 163(j) 
specifically addresses earnings stripping involving interest 
payments, by limiting the deductibility of interest paid to 
certain related parties (``disqualified interest''),\344\ if 
the payor's debt-equity ratio exceeds 1.5 to 1 and the payor's 
net interest expense exceeds 50 percent of its ``adjusted 
taxable income'' (generally taxable income computed without 
regard to deductions for net interest expense, net operating 
losses, and depreciation, amortization, and depletion). 
Disallowed interest amounts can be carried forward 
indefinitely. In addition, excess limitation (i.e., any excess 
of the 50-percent limit over a company's net interest expense 
for a given year) can be carried forward three years.
---------------------------------------------------------------------------
    \344\ This interest also may include interest paid to unrelated 
parties in certain cases in which a related party guarantees the debt.
---------------------------------------------------------------------------
    The present-law earnings stripping provision does not apply 
to partnerships. Proposed Treasury regulations provide that a 
corporate partner's proportionate share of the liabilities of a 
partnership is treated as debt of the corporate partner for 
purposes of applying the earnings stripping limitation to its 
own interest payments.\345\ In addition, interest paid or 
accrued by a partnership is treated as interest expense of a 
corporate partner, with the result that a deduction for the 
interest expense may be disallowed if that expense would be 
disallowed under the earnings stripping rules if paid by the 
corporate partner itself.\346\ The proposed regulations also 
provide that the earnings stripping rules do not apply to 
subchapter S corporations.\347\ Thus, under present law and the 
proposed regulations, a partnership or S corporation generally 
is allowed a deduction for interest paid or accrued on 
indebtedness that it issues that otherwise would be disallowed 
under the earnings stripping rules in the case of a subchapter 
C corporation.
---------------------------------------------------------------------------
    \345\ Prop. Treas. reg. sec. 1.163(j)-3(b)(3).
    \346\ Prop. Treas. reg. sec. 1.163(j)-2(c)(5).
    \347\ Prop. Treas. reg. sec. 1.163(j)-1(a)(i).
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The Committee is concerned that the present-law earnings-
stripping rules do not prevent U.S. partnerships and S 
corporations from reducing their U.S.-source taxable income 
through earnings-stripping transactions. The Committee also is 
concerned that subchapter C corporations are avoiding the 
application of the present-law earnings-stripping rules through 
the use of partnerships. Although proposed Treasury regulations 
would address some of these concerns, the Committee believes 
that it is necessary to modify the statutory earnings-stripping 
rules to apply to U.S. partnerships and S corporations, as well 
as to corporate partners to the extent of their proportionate 
shares in partnership debt.

                        EXPLANATION OF PROVISION

    The provision provides that the deduction for interest paid 
or accrued by partnerships and S corporations is subject to 
disallowance under the earnings stripping rules if the 
partnership or S corporation meets the tests that would apply 
under present law if the partnership or S corporation were a C 
corporation. Thus, for example, the deduction for interest paid 
by a partnership to a related person that is exempt from tax 
would be disallowed if the debt-equity ratio of the partnership 
exceeds 1.5 to 1 and the interest expense of the partnership 
exceeds 50 percent of the partnership's adjusted taxable 
income. As a result, no deduction for this interest would be 
available to any of the partners. Although an S corporation 
cannot have foreign shareholders under present law, 
``disqualified interest'' subject to the earnings stripping 
rules would include interest paid to tax-exempt organizations 
that are shareholders of the S corporation and interest paid to 
other related parties as defined under present law.
    The provision incorporates a rule attributing partnership 
debt to a corporate partner for purposes of applying the 
earnings stripping rules to the corporation.\348\ The rule 
attributing partnership interest expense to corporate partners 
for potential disallowance under the earnings stripping rules 
\349\ apply under the provision only after the earnings 
stripping rules have been applied at the partnership level. If 
interest expense of the partnership is disallowed under the 
provision, there is no deduction allocated to the corporate 
partners. If the interest deduction is not disallowed at the 
partnership level, the amount allocated to a corporate partner 
would be subject again to disallowance under the proposed 
Treasury regulations based upon the attributes of the corporate 
partner.
---------------------------------------------------------------------------
    \348\ This rule currently is contained in Prop. Treas. reg. sec. 
1.163(j)-2(c)(5).
    \349\ This rule currently is contained in Prop. Treas. reg. sec. 
1.163(j)-2(c)(5).
---------------------------------------------------------------------------

                             EFFECTIVE DATE

    The provision generally is effective for taxable years 
beginning on or after the date of enactment.

3. Recognition of cancellation of indebtedness income realized on 
        satisfaction of debt with partnership interest (sec. 463 of the 
        bill and sec. 108 of the Code)

                              PRESENT LAW

    Under present law, a corporation that transfers shares of 
its stock in satisfaction of its debt must recognize 
cancellation of indebtedness income in the amount that would be 
realized if the debt were satisfied with money equal to the 
fair market value of the stock.\350\ Prior to enactment of this 
present-law provision in 1993, case law provided that a 
corporation did not recognize cancellation of indebtedness 
income when it transferred stock to a creditor in satisfaction 
of debt (referred to as the ``stock-for-debt exception'').\351\
---------------------------------------------------------------------------
    \350\ Sec. 108(e)(8).
    \351\ E.g., Motor Mart Trust v. Commissioner, 4 T.C. 931 (1945), 
aff'd, 156 F.2d 122 (1st Cir. 1946), acq. 1947-1 C.B. 3; Capento Sec. 
Corp. v. Commissioner, 47 B.T.A. 691 (1942), nonacq. 1943 C.B. 28, 
aff'd, 140 F.2d 382 (1st Cir. 1944); Tower Bldg. Corp. v. Commissioner, 
6 T.C. 125 (1946), acq. 1947-1 C.B. 4; Alcazar Hotel, Inc. v. 
Commissioner, 1 T.C. 872 (1943), acq. 1943 C.B. 1.
---------------------------------------------------------------------------
    When cancellation of indebtedness income is realized by a 
partnership, it generally is allocated among the partners in 
accordance with the partnership agreement, provided the 
allocations under the agreement have substantial economic 
effect. A partner who is allocated cancellation of indebtedness 
income is entitled to exclude it if the partner qualifies for 
one of the various exceptions to recognition of such income, 
including the exception for insolvent taxpayers or that for 
qualified real property indebtedness of taxpayers other than 
subchapter C corporations.\352\ The availability of each of 
these exceptions is determined at the partner, rather than the 
partnership, level.
---------------------------------------------------------------------------
    \352\ Sec. 108(a).
---------------------------------------------------------------------------
    In the case of a partnership that transfers to a creditor a 
capital or profits interest in the partnership in satisfaction 
of its debt, no Code provision expressly requires the 
partnership to realize cancellation of indebtedness income. 
Thus, it is unclear whether the partnership is required to 
recognize cancellation of indebtedness income under either the 
case law that established the stock-for-debt exception or the 
present-law statutory repeal of the stock-for-debtexception. It 
also is unclear whether any requirement to recognize cancellation of 
indebtedness income is affected if the cancelled debt is nonrecourse 
indebtedness.\353\
---------------------------------------------------------------------------
    \353\ See, e.g., Fulton Gold Corp. v. Commissioner, 31 B.T.A. 519 
(1934); American Seating Co. v. Commissioner, 14 B.T.A. 328, aff'd in 
part and rev'd in part, 50 F.2d 681 (7th Cir. 1931); Hiatt v. 
Commissioner, 35 B.T.A. 292 (1937); Hotel Astoria, Inc. v. 
Commissioner, 42 B.T.A. 759 (1940); Rev. Rul. 91-31, 1991-1 C.B. 19.
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The Committee believes that further guidance is necessary 
with regard to the application of the stock-for-debt exception 
in the context of transfers of partnership interests in 
satisfaction of partnership debt. In particular, the Committee 
believes that it is necessary to clarify that the present-law 
treatment of corporate indebtedness that is satisfied with 
transfers of stock of the debtor corporation also applies to 
partnership indebtedness that is satisfied with transfers of 
capital or profits interests in the debtor partnership.

                        EXPLANATION OF PROVISION

    The provision provides that when a partnership transfers a 
capital or profits interest in the partnership to a creditor in 
satisfaction of partnership debt, the partnership generally 
recognizes cancellation of indebtedness income in the amount 
that would be recognized if the debt were satisfied with money 
equal to the fair market value of the partnership interest. The 
provision applies without regard to whether the cancelled debt 
is recourse or nonrecourse indebtedness. Any cancellation of 
indebtedness income recognized under the provision is allocated 
solely among the partners who held interests in the partnership 
immediately prior to the satisfaction of the debt.
    Under the provision, no inference is intended as to the 
treatment under present law of the transfer of a partnership 
interest in satisfaction of partnership debt.

                             EFFECTIVE DATE

    This provision is effective for cancellations of 
indebtedness occurring on or after the date of enactment.

4. Modification of straddle rules (sec. 464 of the bill and sec. 1092 
        of the Code)

                              PRESENT LAW

In general

    A ``straddle'' generally refers to offsetting positions 
(sometimes referred to as ``legs'' of the straddle) 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. A ``position'' is an 
interest (including a futures or forward contract or option) 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.\354\ 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.
---------------------------------------------------------------------------
    \354\ Sec. 1092.
---------------------------------------------------------------------------

Positions in stock

    The straddle rules also generally do not apply to positions 
in stock. However, the straddle rules apply where one of the 
positions is stock and at least one of the offsetting positions 
is: (1) an option with respect to the stock, (2) a securities 
futures contract (as defined in section 1234B) with respect to 
the stock, or (3) 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 that offset positions taken by any 
shareholder.
    Although the straddles rules apply to offsetting positions 
that consist of stock and an option with respect to stock, the 
straddle rules do not apply if the option is a ``qualified 
covered call option'' written by the taxpayer. In general, a 
qualified covered call option is defined as an exchange-listed 
option that is not deep-in-the-money and is written by a non-
dealer more than 30 days before expiration of the option.
    The stock exception from the straddle rules has been 
curtailed severely by legislative amendment and regulatory 
interpretation. Under proposed Treasury regulations, the 
application of the stock exception essentially would be limited 
to offsetting positions involving direct ownership of stock and 
short sales of stock.\355\
---------------------------------------------------------------------------
    \355\ Prop. Treas. Reg. sec. 1.1092(d)-2(c).
---------------------------------------------------------------------------

Unbalanced straddles

    When one position with respect to personal property offsets 
only a portion of one or more other positions (``unbalanced 
straddles''), the Treasury Secretary is directed to prescribe 
by regulations the method for determining the portion of such 
other positions that is to be taken into account for purposes 
of the straddle rules.\356\ To date, no such regulations have 
been promulgated.
---------------------------------------------------------------------------
    \356\ Sec. 1092(c)(2)(B).
---------------------------------------------------------------------------
    Unbalanced straddles can be illustrated with the following 
example: Assume the taxpayer holds two shares of stock (i.e., 
is long) in XYZ stock corporation--share A with a $30 basis and 
share B with a $40 basis. When the value of the XYZ stock is 
$45, the taxpayer pays a $5 premium to purchase a put option on 
one share of the XYZ stock with an exercise price of $40. The 
issue arises as to whether the purchase of the put option 
creates a straddle with respect to share A, share B, or both. 
Assume that, when the value of the XYZ stock is $100, the put 
option expires unexercised. Taxpayer incurs a loss of $5 on the 
expiration of the put option, andsells share B for a $60 gain. 
On a literal reading of the straddle rules, the $5 loss would be 
deferred because the loss ($5) does not exceed the unrecognized gain 
($70) in share A, which is also an offsetting position to the put 
option--notwithstanding that the taxpayer recognized more gain than the 
loss through the sale of share B. This problem is exacerbated when the 
taxpayer has a large portfolio of actively traded personal property 
that may be offsetting the loss leg of the straddle.
    Although Treasury has not issued regulations to address 
unbalanced straddles, the IRS issued a private letter ruling in 
1999 that addressed an unbalanced straddle situation.\357\ 
Under the facts of the ruling, a taxpayer entered into a 
costless collar with respect to a portion of the shares of a 
particular stock held by the taxpayer.\358\ Other shares were 
held in an account as collateral for a loan and still other 
shares were held in excess of the shares used as collateral and 
the number of shares specified in the collar. The ruling 
concluded that the collar offset only a portion of the stock--
i.e., the number of shares specified in the costless collar--
because that number of shares determined the payoff under each 
option comprising the collar. The ruling further concluded 
that:
---------------------------------------------------------------------------
    \357\ Priv. Ltr. Rul. 199925044 (Feb. 3, 1999).
    \358\ A costless collar generally is comprised of the purchase of a 
put option and the sale of a call option with the same trade dates and 
maturity dates and set such that the premium paid substantially equals 
the premium received. The collar can be considered as economically 
similar to a short position in the stock.

        In the absence of regulations under section 
        1092(c)(2)(B), we conclude that it is permissible for 
        Taxpayer to identify which shares of Corporation stock 
        are part of the straddles and which shares are used as 
        collateral for the loans using appropriately modified 
        versions of the methods of section 1.1012-1(c)(2) and 
        (3) [providing rules for adequate identification of 
        shares of stock sold or transferred by a taxpayer] or 
        section 1.1092(b)-3T(d)(4) [providing requirements and 
        methods for identification of positions that are part 
        of a section 1092(b)(2) identified mixed straddle].

                           REASONS FOR CHANGE

    The Committee believes that the straddle rules should be 
modified in several respects. While the present-law rules 
provide authority for the Treasury Secretary to issue guidance 
concerning unbalanced straddles, the Committee is of the view 
that such guidance is not forthcoming. Therefore, the Committee 
believes that it is necessary at this time to provide such 
guidance by statute. The Committee further believes that it is 
appropriate to repeal the exception from the straddle rules for 
positions in stock, particularly in light of statutory changes 
in the straddle rules and elsewhere in the Code that have 
significantly diminished the continuing utility of the 
exception. In addition, the Committee believes that the 
present-law treatment of physically settled positions under the 
straddle rules requires clarification.

                        EXPLANATION OF PROVISION

    The bill modifies the straddle rules in three respects: (1) 
permit taxpayers to identify offsetting positions of a 
straddle; (2) provide a special rule to clarify the present-law 
treatment of certain physically settled positions of a 
straddle; and (3) repeal the stock and qualified covered call 
exceptions from the straddle rules.
    Under the bill, taxpayers generally are permitted to 
identify the offsetting positions that are components of a 
straddle at the time the taxpayer enters into a transaction 
that creates a straddle, including an unbalanced straddle.\359\ 
If there is a loss with respect to any identified position that 
is part of an identified straddle, the general straddle loss 
deferral rules do not apply to such loss. Instead, the basis of 
each of the identified positions that offset the loss position 
in the identified straddle is increased by an amount that bears 
the same ratio to the loss as the unrecognized gain (if any) 
with respect to such offsetting position bears to the aggregate 
unrecognized gain with respect to all positions that offset the 
loss position in the identified straddle.\360\ Any loss with 
respect to an identified position that is part of an identified 
straddle cannot otherwise be taken into account by the taxpayer 
or any other person to the extent that the loss increases the 
basis of any identified positions that offset the loss position 
in the identified straddle.
---------------------------------------------------------------------------
    \359\ However, to the extent provided by Treasury regulations, 
taxpayers are not permitted to identify offsetting positions of a 
straddle if the fair market value of the straddle position already held 
by the taxpayer at the creation of the straddle is less than its 
adjusted basis in the hands of the taxpayer.
    \360\ For this purpose, ``unrecognized gain'' is the excess of the 
fair market value of an identified position that is part of an 
identified straddle at the time the taxpayer incurs a loss with respect 
to another identified position in the identified straddle, over the 
fair market value of such position when the taxpayer identified the 
position as a position in the identified straddle.
---------------------------------------------------------------------------
    In addition, the provision provides authority to issue 
Treasury regulations that would specify: (1) the proper methods 
for clearly identifying a straddle as an identified straddle 
(and identifying positions as positions in an identified 
straddle); (2) the application of the identified straddle rules 
for a taxpayer that fails to properly identify the positions of 
an identified straddle; \361\ and (3) provide an ordering rule 
for dispositions of less than an entire position that is part 
of an identified straddle.
---------------------------------------------------------------------------
    \361\ For example, although the provision does not require 
taxpayers to identify any positions of a straddle as an identified 
straddle, it may be necessary to provide rules requiring all balanced 
offsetting positions to be included in an identified straddle if a 
taxpayer elects to identify any of the offsetting positions as an 
identified straddle.
---------------------------------------------------------------------------
    The bill also clarifies the present-law straddle rules with 
respect to taxpayers that settle a position that is part of a 
straddle by delivering property to which the position relates. 
Specifically, the provision clarifies that the present-law 
straddle loss deferral rules treat as a two-step transaction 
the physical settlement of a straddle position that, if 
terminated, would result inthe realization of a loss. With 
respect to the physical settlement of such a position, the taxpayer is 
treated as having terminated the position for its fair market value 
immediately before the settlement. The taxpayer then is treated as 
having sold at fair market value the property used to physically settle 
the position.
    The bill also eliminates the exceptions from the straddle 
rules for stock and qualified covered call options. Thus, 
offsetting positions comprised of actively traded stock and a 
position with respect to substantially similar or related 
property generally constitute a straddle if holding one of the 
positions results in a substantial diminution of the taxpayer's 
risk of loss with respect to holding the other position.

                             EFFECTIVE DATE

    The provision is effective for positions established on or 
after the date of enactment.

5. Denial of installment sale treatment for all readily tradable debt 
        (sec. 465 of the bill and sec. 453 of the Code)

                              PRESENT LAW

    Under present law, taxpayers are permitted to recognize as 
gain on a disposition of property only that proportion of 
payments received in a taxable year which is the same as the 
proportion that the gross profit bears to the total contract 
price (the ``installment method'').\362\ However, the 
installment method is not available if the taxpayer sells 
property in exchange for a readily tradable evidence of 
indebtedness that is issued by a corporation or a government or 
political subdivision.\363\
---------------------------------------------------------------------------
    \362\ Sec. 453.
    \363\ Sec. 453(f)(3). Instead, the receipt of such indebtedness is 
treated as a receipt of payment.
---------------------------------------------------------------------------
    No similar provision under present law prohibits the use of 
the installment method where the taxpayer sells property in 
exchange for readily tradable indebtedness issued by a 
partnership or an individual.

                           REASONS FOR CHANGE

    The Committee believes that the present-law exception from 
the installment method for dispositions of property in exchange 
for readily tradable debt is too narrow in scope and, in 
general, should be extended to apply to all dispositions in 
exchange for readily tradable debt, regardless of the nature of 
the issuer of such debt.

                        EXPLANATION OF PROVISION

    The provision denies installment sale treatment with 
respect to all sales in which the taxpayer receives 
indebtedness that is readily tradable under present-law rules, 
regardless of the nature of the issuer. For example, if the 
taxpayer receives readily tradable debt of a partnership in a 
sale, the partnership debt is treated as payment on the 
installment note, and the installment method is unavailable to 
the taxpayer.

                             EFFECTIVE DATE

    The provision is effective for sales occurring on or after 
date of enactment.

6. Modify treatment of transfers to creditors in divisive 
        reorganizations (sec. 466 of the bill and secs. 357 and 361 of 
        the Code)

                              PRESENT LAW

    Section 355 of the Code permits a corporation 
(``distributing'') to separate its businesses by distributing a 
controlled subsidiary (``controlled'') tax-free, if certain 
conditions are met. In cases where the distributing corporation 
contributes property to the controlled corporation that is to 
be distributed, no gain or loss is recognized if the property 
is contributed solely in exchange for stock or securities of 
the controlled corporation (which are subsequently distributed 
to distributing's shareholders). The contribution of property 
to a controlled corporation that is followed by a distribution 
of its stock and securities may qualify as a reorganization 
described in section 368(a)(1)(D). That section also applies to 
certain transactions that do not involve a distribution under 
section 355 and that are considered ``acquisitive'' rather than 
``divisive'' reorganizations.
    The contribution in the course of a divisive section 
368(a)(1)(D) reorganization is also subject to the rules of 
section 357(c). That section provides that the transferor 
corporation will recognize gain if the amount of liabilities 
assumed by controlled exceeds the basis of the property 
transferred to it.
    Because the contribution transaction in connection with a 
section 355 distribution is a reorganization under section 
368(a)(1)(D), it is also subject to certain rules applicable to 
both divisive and acquisitive reorganizations. One such rule, 
in section 361(b), states that a transferor corporation will 
not recognize gain if it receives money or other property and 
distributes that money or other property to its shareholders or 
creditors. The amount of property that may be distributed to 
creditors without gain recognition is unlimited under this 
provision.

                           REASONS FOR CHANGE

    The Committee is concerned that taxpayers engaged in 
section 355 transactions can effectively avoid the rules that 
require gain recognition if the controlled corporation assumes 
liabilities of the transferor that exceed the basis of the 
assets transferred to such corporation. This could occur 
because of the rules of section 361(b), which state that the 
transferor can receive money or other property from the 
transferee without gain recognition, so long as the money or 
property is distributed to creditors of the transferor. For 
example, a transferor corporation could receive money from the 
transferee corporation (e.g., money obtained from a borrowing 
by the transferee) and use that money to pay the transferor's 
creditors, without gain recognition. Such a transaction is 
economically similar to the actual assumption by thetransferee 
of the transferor's liabilities, but is taxed differently under present 
law because section 361(b) does not contain a limitation on the amount 
that can be distributed to creditors.
    The Committee also believes that it is appropriate to 
liberalize the treatment of acquisitive reorganizations that 
are included under section 368(a)(1)(D). The Committee believes 
that in these cases, the transferor should be permitted to 
assume liabilities of the transferee without application of the 
rules of section 357(c). This is because in an acquisitive 
reorganization under section 368(a)(1)(D), the transferor must 
generally transfer substantially all its assets to the 
acquiring corporation and then go out of existence. Assumption 
of its liabilities by the acquiring corporation thus does not 
enrich the transferor corporation, which ceases to exist and 
whose liability was limited to its assets in any event, by 
corporate form. The Committee believes that it is appropriate 
to conform the treatment of acquisitive reorganizations under 
section 368(a)(1)(D) to that of other acquisitive 
reorganizations.

                        EXPLANATION OF PROVISION

    The bill limits the amount of money plus the fair market 
value of other property that a distributing corporation can 
distribute to its creditors without gain recognition under 
section 361(b) to the amount of the basis of the assets 
contributed to a controlled corporation in a divisive 
reorganization. In addition, the bill provides that acquisitive 
reorganizations under section 368(a)(1)(D) are no longer 
subject to the liabilities assumption rules of section 357(c).

                             EFFECTIVE DATE

    The bill is effective for transactions on or after the date 
of enactment.

7. Clarify definition of nonqualified preferred stock (sec. 467 of the 
        bill and sec. 351(g) of the Code)

                              PRESENT LAW

    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. 
For this purpose, preferred stock is defined as stock that is 
``limited and preferred as to dividends and does not 
participate in corporate growth to any significant extent.'' 
Nonqualified preferred stock is defined as any preferred stock 
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, (3) the 
issuer or a related person has the right to redeem or 
repurchase, and, as of the issue date, it is more likely than 
not that such right will be exercised, or (4) the dividend rate 
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 an adjustable 
rate stock) or as a practical result of other aspects of the 
stock (as in the case of auction 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.

                           REASONS FOR CHANGE

    The Committee is concerned that taxpayers may attempt to 
avoid characterization of an instrument as nonqualified 
preferred stock by including illusory participation rights or 
including terms that taxpayers argue create an ``unlimited'' 
dividend.
    Clarification is desirable to conserve IRS resources that 
otherwise might have to be devoted to this area.

                        EXPLANATION OF PROVISION

    The provision clarifies the definition of nonqualified 
preferred stock to ensure that stock for which there is not a 
real and meaningful likelihood of actually participating in the 
earnings and profits of the corporation is not considered to be 
outside the definition of stock that is limited and preferred 
as to dividends and does not participate in corporate growth to 
any significant extent.
    As one example, instruments that are preferred on 
liquidation and that are entitled to the same dividends as may 
be declared on common stock do not escape being nonqualified 
preferred stock by reason of that right if the corporation does 
not in fact pay dividends either to its common or preferred 
stockholders. As another example, stock that entitles the 
holder to a dividend that is the greater of 7 percent or the 
dividends common shareholders receive does not avoid being 
preferred stock if the common shareholders are not expected to 
receive dividends greater than 7 percent.
    No inference is intended as to the characterization of 
stock under present law that has terms providing for unlimited 
dividends or participation rights but, based on all the facts 
and circumstances, is limited and preferred as to dividends and 
does not participate in corporate growth to any significant 
extent.

                             EFFECTIVE DATE

    The provision is effective for transactions after May 14, 
2003.

8. Modify definition of controlled group of corporations (sec. 468 of 
        the bill and sec. 1563 of the Code)

                              PRESENT LAW

    Under present law, a tax is imposed on the taxable income 
of corporations. The rates are as follows:

          TABLE 2.--MARGINAL FEDERAL CORPORATE INCOME TAX RATES
------------------------------------------------------------------------
      If taxable income is:             Then the income tax rate is:
------------------------------------------------------------------------
$0-$50,000.......................  15 percent of taxable income.
$50,001-$75,000..................  25 percent of taxable income.
$75,001-$10,000,000..............  34 percent of taxable income.
Over $10,000,000.................  35 percent of taxable income.
------------------------------------------------------------------------

    The first two graduated rates described above are phased 
out by a five-percent surcharge for corporations with taxable 
income between $100,000 and $335,000. Also, the application of 
the 34-percent rate is phased out by a three-percent surcharge 
for corporations with taxable income between $15 million and 
$18,333,333.
    The component members of a controlled group of corporations 
are limited to one amount in each of the taxable income 
brackets shown above.\364\ For this purpose, a controlled group 
of corporations means a parent-subsidiary controlled group and 
a brother-sister controlled group.
---------------------------------------------------------------------------
    \364\ Component members are also limited to one alternative minimum 
tax exemption and one accumulated earnings credit.
---------------------------------------------------------------------------
    A brother-sister controlled group means two or more 
corporations if five or fewer persons who are individuals, 
estates or trusts own (or constructively own) stock possessing 
(1) 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 value of all stock, and (2) more than 50 percent 
of percent of the total combined voting power of all classes of 
stock entitled to vote or more than 50 percent of the total 
value of all stock, taking into account the stock ownership of 
each person only to the extent the stock ownership is identical 
with respect to each corporation.

                           REASONS FOR CHANGE

    The Committee is concerned that taxpayers may be able to 
obtain benefits, such as multiple lower-bracket corporate tax 
rates, through the use of corporations that are effectively 
under common control even though the 80-percent test of present 
law is not satisfied. The Committee believes it is appropriate 
to eliminate the 80-percent test for purposes of the currently 
effective provisions under section 1561 (corporate tax 
brackets, the accumulated earnings credit, and the minimum 
tax.)

                        EXPLANATION OF PROVISION

    Under the provision, a brother-sister controlled group 
means two or more corporations if five or fewer persons who are 
individuals, estates or trusts own (or constructively own) 
stock possessing more than 50 percent of the total combined 
voting power of all classes of stock entitled to vote, or more 
than 50 percent of the total value of all stock, taking into 
account the stock ownership of each person only to the extent 
the stock ownership is identical with respect to each 
corporation.
    The provision applies only for purposes of section 1561, 
currently relating to corporate tax brackets, the accumulated 
earnings credit, and the minimum tax. The provision does not 
affect other Code sections or other provisions that utilize or 
refer to the section 1563 brother-sister corporation controlled 
group test for other purposes.\365\
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    \365\ As one example, the provision does not change the present law 
standards relating to deferred compensation, contained in subchapter D 
of the Code, that refer to section 1563.
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                             EFFECTIVE DATE

    The provision applies to taxable years beginning after the 
date of enactment.

9. Mandatory basis adjustments in connection with partnership 
        distributions and transfers of partnership interests (sec. 469 
        of the bill and secs. 734, 743 and 754 of the Code)

                              PRESENT LAW

Transfers of partnership interests

    Under present law, a partnership does not adjust the basis 
of partnership property following the transfer of a partnership 
interest unless the partnership has made a one-time election 
under section 754 to make basis adjustments.\366\ If an 
election is in effect, adjustments are made with respect to the 
transferee partner to account for the difference between the 
transferee partner's proportionate share of the adjusted basis 
of the partnership property and the transferee's basis in its 
partnership interest.\367\ These adjustments are intended to 
adjust the basis of partnership property to approximate the 
result of a direct purchase of the property by the transferee 
partner. Under these rules, if a partner purchases an interest 
in a partnership with an existing built-in loss and no election 
under section 754 is in effect, the transferee partner may be 
allocated a share of the loss when the partnership disposes of 
the property (or depreciates the property).
---------------------------------------------------------------------------
    \366\ Sec. 743(a).
    \367\ Sec. 743(b).
---------------------------------------------------------------------------

Distributions of partnership property

    With certain exceptions, partners may receive distributions 
of partnership property without recognition of gain or loss by 
either the partner or the partnership.\368\ In the case of a 
distribution in liquidation of a partner's interest, the basis 
of the property distributed in the liquidation is equal to the 
partner's adjusted basis in its partnership interest (reduced 
by any money distributed in the transaction).\369\ In a 
distribution other than in liquidation of a partner's interest, 
the distributee partner's basis in the distributed 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 the partnership interest (reduced 
by any money distributed in the same transaction).\370\
---------------------------------------------------------------------------
    \368\ Sec. 731(a) and (b).
    \369\ Sec. 732(b).
    \370\ Sec. 732(a).
---------------------------------------------------------------------------
    The determination of the basis of individual properties 
distributed by a partnership is dependent on the adjusted basis 
of the properties in the hands of the partnership.\371\ If a 
partnership interest is transferred to a partner and the 
partnership has not elected to adjust the basis of partnership 
property, a special basis rule provides for the determination 
of the transferee partner's basis of properties that are later 
distributed by the partnership.\372\ Under this rule, in 
determining the basis of property distributed by a partnership 
within 2 years following the transfer of the partnership 
interest, the transferee may elect to determine its basis as if 
the partnership had adjusted the basis of the distributed 
property under section 743(b) on the transfer. The special 
basis rule also applies to distributed property if, at the time 
of the transfer, the fair market value of partnership property 
other than money exceeds 110 percent of the partnership's basis 
in such property and a liquidation of the partnership interest 
immediately after the transfer would have resulted in a shift 
of basis to property subject to an allowance of depreciation, 
depletion or amortization.\373\
---------------------------------------------------------------------------
    \371\ Sec. 732 (a)(1) and (c).
    \372\ Sec. 732(d).
    \373\ Treas. Reg. 1.732-1(d)(4).
---------------------------------------------------------------------------
    Adjustments to the basis of the partnership's undistributed 
properties are not required unless the partnership has made the 
election under section 754 to make basis adjustments.\374\ If 
an election is in effect under section 754, adjustments are 
made by a partnership to increase or decrease the remaining 
partnership assets to reflect any increase or decrease in the 
adjusted basis of the distributed properties in the hands of 
the distributee partner (or gain or loss recognized by the 
distributee partner).\375\ To the extent the adjusted basis of 
the distributed properties increases (or loss is recognized) 
the partnership's adjusted basis in its properties is decreased 
by a like amount; likewise, to the extent the adjusted basis of 
the distributed properties decrease (or gain is recognized), 
the partnership's adjusted basis in its properties is increased 
by a like amount. Under these rules, a partnership with no 
election in effect under section 754 may distribute property 
with an adjusted basis lower than the distributee partner's 
proportionate share of the adjusted basis of all partnership 
property and leave the remaining partners with a smaller net 
built-in gain or a larger net built-in loss than before the 
distribution.
---------------------------------------------------------------------------
    \374\ Sec. 734(a).
    \375\ Sec. 734(b).
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The Committee believes that the present-law electivity of 
partnership basis adjustments upon transfers and distributions 
leads to anomalous tax results, causes inaccurate income 
measurement, and gives rise to opportunities for tax 
sheltering. In particular, the failure to make partnership 
basis adjustments permits partners to duplicate losses and to 
transfer losses among partners, creating an inappropriate 
incentive to use partnerships as tax shelter vehicles. The 
electivity of these adjustments has become anachronistic and 
should be eliminated, the Committee believes. Therefore, this 
provision makes these partnership basis adjustments mandatory, 
addressing both loss and gain situations. The bill provides 
that the partnership basis adjustments remain elective in the 
limited case of transfers of a partnership interest by reason 
of the death of a partner because that situation may involve 
unsophisticated taxpayers and constitutes only a narrow, 
limited set of transfers.

                        EXPLANATION OF PROVISION

    Under the provision, adjustments to the basis of 
partnership property in the event of a partnership distribution 
or the transfer of a partnership interest are required, not 
elective as under present law. However, the basis adjustments 
are elective, as under present law, in the case of the transfer 
of a partnership interest by reason of the partner's death. Any 
election made by a partnership under section 754 that is in 
effect when the provision becomes effective is treated as an 
election to adjust the basis of partnership property with 
respect to the transferee partner in the case of a transfer of 
a partnership interest upon the death of a partner. The 
provision repeals the special rule of section 732(d) for 
determining the transferee partner's basis in property that is 
later distributed by the partnership in cases in which the 
partnership did not have a section 754 election in effect with 
respect to the transfer of the partnership interest.

                             EFFECTIVE DATE

    The provision requiring partnership basis adjustments 
applies to transfers and distributions after the date of 
enactment.
    The provision repealing section 732(d) applies generally to 
transfers after the date of enactment, except that it applies 
to distributions made after the date which is 2 years following 
the date of enactment in the case of any transfer to which 
section 732(d) applies that is made on or before the date of 
enactment.

10. Extend the present-law intangible amortization provisions to 
        acquisitions of sports franchises (sec. 471 of the bill and 
        sec. 197 of the Code)

                              PRESENT LAW

    The purchase price allocated to intangible assets 
(including franchise rights) acquired in connection with the 
acquisition of a trade or business generally must be 
capitalized and amortized over a 15-year period.\376\ These 
rules were enacted in 1993 to minimize disputes regarding the 
proper treatment of acquired intangible assets. The rules do 
not apply to a franchise to engage in professional sports and 
any intangible asset acquired in connection with such a 
franchise.\377\ However, other special rules apply to certain 
of these intangible assets.
---------------------------------------------------------------------------
    \376\ Sec. 197.
    \377\ Sec. 197(e)(6).
---------------------------------------------------------------------------
    Under section 1056, when a franchise to conduct a sports 
enterprise is sold or exchanged, the basis of a player contract 
acquired as part of the transaction is generally limited to the 
adjusted basis of such contract in the hands of the transferor, 
increased by the amount of gain, if any, recognized by the 
transferor on the transfer of the contract. Moreover, not more 
than 50 percent of the consideration from the transaction may 
be allocated to player contracts unless the transferee 
establishes to the satisfaction of the Commissioner that a 
specific allocation in excess of 50 percent is proper. However, 
these basis rules may not apply if a sale or exchange of a 
franchise to conduct a sports enterprise is effected through a 
partnership.\378\ Basis allocated to the franchise or to other 
valuable intangible assets acquired with the franchise may not 
be amortizable if these assets lack a determinable useful life.
---------------------------------------------------------------------------
    \378\ P.D.B. Sports, Ltd. v. Comm., 109 T.C. 423 (1997).
---------------------------------------------------------------------------
    In general, section 1245 provides that gain from the sale 
of certain property is treated as ordinary income to the extent 
depreciation or amortization was allowed on such property. 
Section 1245(a)(4) provides special rules for recapture of 
depreciation and deductions for losses taken with respect to 
player contracts. The special recapture rules apply in the case 
of the sale, exchange, or other disposition of a sports 
franchise. Under the special recapture rules, the amount 
recaptured as ordinary income is the amount of gain not to 
exceed the greater of (1) the sum of the depreciation taken 
plus any deductions taken for losses (i.e., abandonment losses) 
with respect to those player contracts which are initially 
acquired as a part of the original acquisition of the franchise 
or (2) the amount of depreciation taken with respect to those 
player contracts which are owned by the seller at the time of 
the sale of the sports franchise.

                           REASONS FOR CHANGE

    The present-law rules under section 197 were enacted to 
minimize disputes regarding the measurement of acquired 
intangible assets. Prior to the enactment of the rules, there 
were many disputes regarding the value and useful life of 
various intangible assets acquired together in a business 
acquisition. Furthermore, in the absence of a showing of a 
reasonably determinable useful life, an asset could not be 
amortized. Taxpayers tended to identify and allocate large 
amounts of purchase price to assets said to have short useful 
lives, while the IRS would allocate a large amount of value to 
intangible value for which no determinable useful life could be 
shown (e.g., goodwill), and would deny amortization for that 
amount of purchase price.
    The present-law rules for acquisitions of sports franchises 
do not eliminate the potential for disputes, because they 
address only player contracts, while a sports franchise 
acquisition can involve many intangibles other than player 
contracts. In addition, disputes may arise regarding the 
appropriate period for amortization of particular player 
contracts. The Committee believes expending taxpayer and 
government resources disputing these items is an unproductive 
use ofeconomic resources. The Committee further believes that 
the section 197 rules should apply to all types of businesses 
regardless of the nature of their assets.

                        EXPLANATION OF PROVISION

    The provision extends the 15-year recovery period for 
intangible assets to franchises to engage in professional 
sports and any intangible asset acquired in connection with the 
acquisition of such a franchise (including player contracts). 
Thus, the same rules for amortization of intangibles that apply 
to other acquisitions under present law will apply to 
acquisitions of sports franchises. The provision also repeals 
the special rules under section 1245(a)(4) and makes other 
conforming changes.

                             EFFECTIVE DATE

    The provision is effective for property acquired after the 
date of enactment. The amendment to section 1245(a)(4) applies 
to franchises acquired after the date of enactment.

11. Lease term to include certain service contracts (sec. 472 of the 
        bill and sec. 168 of the Code)

                              PRESENT LAW

    Under present law, ``tax-exempt use property'' must be 
depreciated on a straight-line basis over a recovery period 
equal to the longer of the property's class life or 125 percent 
of the lease term.\379\ For purposes of this rule, ``tax-exempt 
use property'' is property that is leased (other than under a 
short-term lease) to a tax-exempt entity.\380\ For this 
purpose, the term ``tax-exempt entity'' includes Federal, state 
and local governmental units, charities, and, foreign entities 
or persons.\381\
---------------------------------------------------------------------------
    \379\ Sec. 168(g)(3)(A).
    \380\ Sec. 168(h)(1).
    \381\ Sec. 168(h)(2).
---------------------------------------------------------------------------
    In determining the length of the lease term for purposes of 
the 125 percent calculation, a number of special rules apply. 
In addition to the stated term of the lease, the lease term 
includes: (1) any additional period of time in the realistic 
contemplation of the parties at the time the property is first 
put in service; (2) any additional period of time for which 
either the lessor or lessee has the option to renew the lease 
(whether or not it is expected that the option will be 
exercised); (3) any additional period of any successive leases 
which are part of the same transaction (or series of related 
transactions) with respect to the same or substantially similar 
property; and (4) any additional period of time (even if the 
lessee may not continue to be the lessee during that period), 
if the lessee (a) has agreed to make a payment in the nature of 
rent with respect to such period or (b) has assumed or retained 
any risk of loss with respect to such property for such period.
    Tax-exempt use property does not include property that is 
used by a taxpayer to provide a service to a tax-exempt entity. 
So long as the relationship between the parties is a bona fide 
service contract, the taxpayer will be allowed to depreciate 
the property used in satisfying the contract under normal MACRS 
rules, rather than the rules applicable to tax-exempt use 
property.

                           REASONS FOR CHANGE

    The special rules applicable to the depreciation of tax-
exempt use property were enacted to prevent tax-exempt entities 
from using leasing arrangements to transfer the tax benefits of 
accelerated depreciation on property they used to a taxable 
entity. The Committee is concerned that some taxpayers are 
attempting to circumvent this policy through the creative use 
of service contracts with the tax-exempt entities.

                        EXPLANATION OF PROVISION

    The provision expands the definition of a lease to include 
service contracts and other similar arrangements and requires 
lessors of tax-exempt use property to include the term of 
service contracts and other similar arrangements in the lease 
term for purposes of determining the recovery period.

                             EFFECTIVE DATE

    The proposal is effective for leases and other similar 
arrangements entered into after the date of enactment. No 
inference is intended with respect to the tax treatment of 
leases and other similar arrangements entered into before such 
date.

12. Establish specific class lives for utility grading costs (sec. 473 
        of the bill and sec. 168 of the Code)

                              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. The class lives of assets placed 
in service after 1986 are generally set forth in Revenue 
Procedure 87-56.\382\ If no class life is provided, the asset 
is allowed a 7-year recovery period under MACRS.
---------------------------------------------------------------------------
    \382\ 1987-2 C.B. 674 (as clarified and modified by Rev. Proc. 88-
22, 1988-1 C.B. 785).
---------------------------------------------------------------------------
    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 recovery period of 20 
years. Assets class 00.3 provides a class life of 20 years and 
a MACRS recovery period of 15 years for land improvements. The 
cost of initially clearing and grading land improvements 
arespecifically excluded from asset classes 00.3 and 49.14. Prior to 
the adoption of the accelerated cost recovery system, 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. 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 
recovery period under MACRS as section 1245 real property for which no 
class life is provided.
    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 recovery period of 15 years. Initial clearing and 
grade improvements are specifically excluded from this asset 
class as well as asset class 00.3, and no separate asset class 
is provided for such costs. Accordingly, such costs are 
depreciated over a 7-year recovery period under MACRS as 
section 1245 real property for which no class life is provided.

                           REASONS FOR CHANGE

    The Committee believes the clearing and grading costs in 
question are incurred for the purpose of installing the 
transmission lines or pipelines and are properly seen as part 
of the cost of installing such lines or pipelines and their 
cost should be recovered in the same manner. The clearing and 
grading costs are not expected to have a useful life other than 
the useful life of the transmission line or pipeline to which 
they relate.

                        EXPLANATION OF PROVISION

    The provision assigns a class life to depreciable electric 
and gas utility clearing and grading costs incurred to locate 
transmission and distribution lines and pipelines. The 
provision includes 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 provision is effective for property placed in service 
after the date of enactment.

13. Expansion of limitation on expensing of certain passenger 
        automobiles (sec. 474 of the bill and sec. 179 of the Code)

                              PRESENT LAW

    A taxpayer is allowed to recover, through annual 
depreciation deductions, the cost of certain property used in a 
trade or business or for the production of income. The amount 
of the depreciation deduction allowed with respect to tangible 
property for a taxable year is determined under the modified 
accelerated cost recovery system (``MACRS''). Under MACRS, 
passenger automobiles generally are recovered over five years. 
However, section 280F limits the annual depreciation deduction 
with respect to certain passenger automobiles.\383\
---------------------------------------------------------------------------
    \383\ The limitation is commonly referred to as the ``luxury 
automobile depreciation limitation.'' For passenger automobiles 
(subject to such limitation) placed in service in 2002, the maximum 
amount of allowable depreciation is $7,660 for the year in which the 
vehicle was placed in service, $4,900 for the second year, $2,950 for 
the third year, and $1,775 for the fourth and later years. This 
limitation applies to the combined depreciation deduction provided 
under present law for depreciation, including section 179 expensing and 
the temporary 30 percent additional first year depreciation allowance. 
For luxury automobiles eligible for the 50% additional first 
depreciation allowance, the first year limitation is increased by an 
additional $3,050.
---------------------------------------------------------------------------
    For purposes of the depreciation limitation, passenger 
automobiles are defined broadly to include any 4-wheeled 
vehicles that are manufactured primarily for use on public 
streets, roads, and highways and which are rated at 6,000 
pounds unloaded gross vehicle weight or less.\384\ In the case 
of a truck or a van, the depreciation limitation applies to 
vehicles that are rated at 6,000 pounds gross vehicle weight or 
less. Sports utility vehicles are treated as a truck for the 
purpose of applying the section 280F limitation.
---------------------------------------------------------------------------
    \384\ Sec. 280F(d)(5). Exceptions are provided for any ambulance, 
hearse, or any vehicle used by the taxpayer directly in the trade or 
business of transporting persons or property for compensation or hire.
---------------------------------------------------------------------------
    In lieu of depreciation, a taxpayer with a sufficiently 
small amount of annual investment may elect to expense such 
investment (sec. 179). The Jobs and Growth Tax Relief 
Reconciliation Act (JGTRRA) of 2003 \385\ increased the amount 
a taxpayer may deduct, for taxable years beginning in 2003 
through 2005, to $100,000 of the cost of qualifying property 
placed in service for the taxable year.\386\ In general, 
qualifying property is defined as depreciable tangible personal 
property that is purchased for use in the active conduct of a 
trade or business. The $100,000 amount is reduced (but not 
below zero) by the amount by which the cost of qualifying 
property placed in service during the taxable year exceeds 
$400,000. Prior to the enactment of JGTRRA (and for taxable 
years beginning in 2006 and thereafter) a taxpayer with a 
sufficiently small amount of annual investment may elect to 
deduct up to $25,000 of the cost of qualifying property placed 
in service for the taxable year. The $25,000 amount is reduced 
(but not below zero) by the amount by which the cost of 
qualifying property placed in service during the taxable year 
exceeds $200,000. Passenger automobiles subject to section 280F 
are eligible for section 179 expensing only to the extent of 
the applicable limits contained in section 280F.
---------------------------------------------------------------------------
    \385\ Pub. Law No. 108-27, sec. 202 (2003).
    \386\ Additional section 179 incentives are provided with respect 
to a qualified property used by a business in the New York Liberty Zone 
(sec. 1400L(f)), an empowerment zone (sec. 1397A), or a renewal 
community (sec. 1400J).
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The Committee believes that section 179 expensing provides 
two important benefits for small business. First, it lowers the 
cost of capital for property used in a trade or business. With 
a lower cost of capital, the Committee believes small business 
will invest in more equipment and employ more workers. Second, 
it eliminates depreciation recordkeeping requirements with 
respect to expensed property. However, the Committee 
understands that some taxpayers are using section 179 to lower 
the cost of purchasing certain types of vehicles (1) that are 
not subject to the luxury automobile limitations imposed by 
Congress and (2) for which the specific features of such 
vehicle are not necessary for purposes of conducting the 
taxpayer's business. The Committee is concerned about such 
market distortions and does not believe that the United States 
taxpayers should subsidize a portion of such purchase. The 
Committee's provision places new restrictions on the ability of 
certain vehicles to qualify for the expensing provisions of 
section 179.

                        EXPLANATION OF PROVISION

    The provision limits the ability of taxpayers to claim 
deductions under section 179 for certain vehicles not subject 
to section 280F to $25,000. The provision applies to sport 
utility vehicles rated at 14,000 pounds gross vehicle weight or 
less (in place of the present law 6,000 pound rating). For this 
purpose, a sport utility vehicle is defined to exclude any 
vehicle that: (1) does not have a primary load device or 
container attached; (2) has a seating capacity of more than 12 
individuals; (3) is designed for more than nine individuals in 
seating rearward of the driver's seat; (4) is equipped with an 
open cargo area, or a covered box not readily accessible from 
the passenger compartment, of at least 72.0 inches in interior 
length; or (5) has an integral enclosure, fully enclosing the 
driver compartment and load carrying device, does not have 
seating rearward of the driver's seat, and has no body section 
protruding more than 30 inches ahead of the leading edge of the 
windshield.
    The following example illustrates the operation of the 
provision.
    Example.--Assume that during 2004, a calendar year taxpayer 
acquires and places in service a sport utility vehicle subject 
to the provision that costs $70,000. In addition, assume that 
the property otherwise qualifies for the expensing election 
under section 179. Under the provision, the taxpayer is first 
allowed a $25,000 deduction under section 179. The taxpayer is 
also allowed an additional first-year depreciation deduction 
(sec. 168(k)) of $22,500 based on $45,000 ($70,000 original 
cost less the section 179 deduction of $25,000) of adjusted 
basis. Finally, the remaining adjusted basis of $22,500 
($45,000 adjusted basis less $22,500 additional first-year 
depreciation) is eligible for an additional depreciation 
deduction of $4,500 under the general depreciation rules 
(automobiles are five-year recovery property). The remaining 
$18,000 of cost ($70,000 original cost less $52,000 deductible 
currently) would be recovered in 2005 and subsequent years 
pursuant to the general depreciation rules.

                             EFFECTIVE DATE

    The proposal is effective for property placed in service 
after the date of enactment.

14. Provide consistent amortization period for intangibles (sec. 475 of 
        the bill and secs. 195, 248, and 709 of the Code)

                              PRESENT LAW

    At the election of the taxpayer, start-up expenditures 
\387\ and organizational expenditures \388\ 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 not been paid or incurred 
before business began. Organizational expenditures are 
expenditures that are incident to the creation of a corporation 
(sec. 248) or the organization of a partnership (sec. 709), 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 or partnership with a limited 
or ascertainable life.
---------------------------------------------------------------------------
    \387\ Sec. 195
    \388\ Secs. 248 and 709.
---------------------------------------------------------------------------
    Treasury regulations \389\ 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 and organizational 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.
---------------------------------------------------------------------------
    \389\ Treas. Reg. sec. 1.195-1.
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    Section 197 requires most acquired intangible assets (such 
as goodwill, trademarks, franchises, and patents) 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.

                           REASONS FOR CHANGE

    The Committee believes that 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. In addition, 
the Committee believes a consistent amortization period for 
intangibles is appropriate.

                        EXPLANATION OF PROVISION

    The provision modifies the treatment of start-up and 
organizational expenditures. A taxpayer would be allowed to 
elect to deduct up to $5,000 of start-up and $5,000 
oforganizational 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 provision is 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.

15. Limitation of tax benefits for leases to certain tax exempt 
        entities (sec. 476 of the bill and new sec. 470 of the Code)

                              PRESENT LAW

    Under present law, ``tax-exempt use property'' must be 
depreciated on a straight-line basis over a recovery period 
equal to the longer of the property's class life or 125 percent 
of the lease term.\390\ For purposes of this rule, ``tax-exempt 
use property'' is property that is leased (other than under a 
short-term lease) to a tax-exempt entity.\391\ For this 
purpose, the term ``tax-exempt entity'' includes Federal, state 
and local governmental units, charities, and, foreign entities 
or persons.\392\
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    \390\ Sec. 168(g)(3)(A).
    \391\ Sec. 168(h)(1).
    \392\ Sec. 168(h)(2).
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    In determining the length of the lease term for purposes of 
the 125 percent calculation, several special rules apply. In 
addition to the stated term of the lease, the lease term 
includes: (1) any additional period of time in the realistic 
contemplation of the parties at the time the property is first 
put in service; (2) any additional period of time for which 
either the lessor or lessee has the option to renew the lease 
(whether or not it is expected that the option will be 
exercised); (3) any additional period of any successive leases 
which are part of the same transaction (or series of related 
transactions) with respect to the same or substantially similar 
property; and (4) any additional period of time (even if the 
lessee may not continue to be the lessee during that period), 
if the lessee (a) has agreed to make a payment in the nature of 
rent with respect to such period or (b) has assumed or retained 
any risk of loss with respect to such property for such period.
    Tax-exempt use property does not include property that is 
used by a taxpayer to provide a service to a tax-exempt entity. 
So long as the relationship between the parties is a bona fide 
service contract, the taxpayer will be allowed to depreciate 
the property used in satisfying the contract under normal MACRS 
rules, rather than the rules applicable to tax-exempt use 
property.

                           REASONS FOR CHANGE

    The Committee believes that certain ongoing leasing 
activity with tax-exempt entities and foreign governments 
highlights the potential ineffectiveness of the present-law tax 
rules that are intended to limit the ability to transfer 
certain tax benefits from a tax exempt entity to a taxable 
entity. The Committee is concerned about this activity and the 
continual development of new structures by tax shelter 
promoters that purport to minimize or neutralize the effect of 
these rules. In addition, the Committee also is concerned by 
the increasing use of certain lease structures involving 
technological equipment that it does not view as appropriate. 
Although the Committee considers leasing to play a role in 
ensuring the availability of capital to businesses, many of the 
transactions it recently has become aware of are not the type 
of activity that it believes play this role. Rather these 
transactions may result in no accumulation of capital for 
financing or refinancing, but only a tax accommodation fee paid 
by a U.S. taxpayer to a tax indifferent party.
    In discussing the reasons for the enactment of rules in 
1984 that were intended to limit the transfer of tax benefits 
with respect to property used by tax-exempt entities to taxable 
entities, Congress indicated at that time that it: (1) believed 
tax benefits (in excess of tax exemption itself) available to 
tax-exempt entities through leasing should be eliminated; (2) 
was concerned about possible problems of accountability of 
governments to their citizens, and of tax-exempt organizations 
to their clientele, if substantial amounts of their property 
came under the control of outside parties solely because the 
Federal tax system made leasing more favorable than owning; (3) 
believed the tax system should not encourage tax-exempt 
entities to dispose of assets they own or to forego control 
over the assets they use; (4) was concerned about waste of 
Federal revenues because in some cases a substantial portion of 
the tax savings was retained by the lawyers, investment 
bankers, lessors, and investors, and thus, the Federal revenue 
loss became more of a gain to financial entities than to tax-
exempt entities; (5) was more efficient to provide aid to tax-
exempt entities through direct appropriations rather than 
through the tax code; (6) must sustain a popular confidence in 
the tax system by ensuring the system generally is working 
correctly, and that a system enticing Federal agencies not to 
own their own essential equipment, or colleges their campuses, 
or cities their city halls, and which also rewards taxpayers 
who participate in such transactions with a lighter tax burden, 
risked eroding that confidence.\393\
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    \393\ See, Joint Committee on Taxation, General Explanation of the 
Revenue Provisions of the Deficit Reduction Act of 1984 (JCS-41-84), 
pg. 43-46, December 31, 1984.
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    The Committee believes that the reasons stated above are as 
important today as they were in 1984 and that, unfortunately, 
the present law rules have not stopped taxpayers from engaging 
in transactions that purport to circumvent such rules. New 
legislation therefore is essential to ensure the attainment of 
the aforementioned Congressional intentions.

                        EXPLANATION OF PROVISION

    The provision limits the amount of allowable deductions or 
losses \394\ with respect to certain service contracts or 
leases to the amount of income reported with respect to each 
such service contract or lease in such taxable year.\395\ The 
provision applies to leases and certain service contracts and 
similar arrangements with a tax-exempt entity. For purposes of 
the provision a tax-exempt entity is defined as the United 
States, any State or political subdivision thereof, any 
possession of the United States, or any agency or 
instrumentality of any of the foregoing; an organization (other 
than a cooperative described in section 521) which is exempt 
from tax imposed by chapter one of the Code; and any foreign 
government, political subdivision thereof, or any agency or 
instrumentality of any of the foregoing.
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    \394\ The provision applies to any deduction directly allocable to 
any tax-exempt use property and a proper share of other deductions that 
are not directly allocable to such property (e.g., interest expense not 
directly allocable, general overhead, etc.).
    \395\ It is intended that the limitations would be similar in 
concept to the limitations imposed on passive activity losses under 
section 469 and, in particular, subsection (k) (e.g., each tax-exempt 
use property is treated separately). This provision applies to all 
taxpayers (including C corporations) and the limitation applies under 
all circumstances (e.g., material participation is not relevant).
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    Any deduction disallowed is carried forward and treated as 
a deduction with respect to such property in the next taxable 
year. If property ceases to be tax-exempt use property, any 
unused deduction is allowable as a deduction only to the extent 
of any net income allocable to such property. In addition, a 
taxpayer disposing of its entire interest in tax-exempt use 
property in a fully taxable transaction is generally entitled 
to deduct any items previously disallowed (and not subsequently 
allowed) in the year of such disposition.\396\ The provision 
also grants the Treasury Department authority to prescribe 
regulations as may be necessary or appropriate to carryout the 
provisions of this section.\397\
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    \396\ Rules similar to the rules of section 469(g) shall apply for 
this purpose.
    \397\ For example, regulations would be appropriate to ensure that 
the provision applies to a transaction in which a foreign government 
(or other tax exempt entity) transfers an interest in property to an 
accommodation party (e.g., non governmental foreign person) who 
subsequently enters into a sale/leaseback of such property with a U.S. 
taxpayer.
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                             EFFECTIVE DATE

    The provision is effective for leases and other similar 
arrangements entered into after the date of enactment.

16. Clarification of rules for payment of estimated tax for certain 
        deemed asset sales (sec. 481 of the bill and sec. 338 of the 
        Code)

                              PRESENT LAW

    In certain circumstances, taxpayers can make an election 
under section 338(h)(10) to treat a qualifying purchase of 80 
percent of the stock of a target corporation by a corporation 
from a corporation that is a member of an affiliated group (or 
a qualifying purchase of 80 percent of the stock of an S 
corporation by a corporation from S corporation shareholders) 
as a sale of the assets of the target corporation, rather than 
as a stock sale. The election must be made jointly by the buyer 
and seller of the stock and is due by the 15th day of the ninth 
month beginning after the month in which the acquisition date 
occurs. An agreement for the purchase and sale of stock often 
may contain an agreement of the parties to make a section 
338(h)(10) election.
    Section 338(a) also permits a unilateral election by a 
buyer corporation to treat a qualified stock purchase of a 
corporation as a deemed asset acquisition, whether or not the 
seller of the stock is a corporation (or an S corporation is 
the target). In such a case, the seller or sellers recognize 
gain or loss on the stock sale (including any estimated taxes 
with respect to the stock sale), and the target corporation 
recognizes gain or loss on the deemed asset sale.
    Section 338(h)(13) provides that, for purposes of section 
6655 (relating to additions to tax for failure by a corporation 
to pay estimated income tax), tax attributable to a deemed 
asset sale under section 338(a)(1) shall not be taken into 
account.

                           REASONS FOR CHANGE

    The Committee is concerned that some taxpayers may 
inappropriately be taking the position that estimated tax and 
the penalty (computed in the amount of an interest charge) 
under section 6655 applies neither to the stock sale nor to the 
asset sale in the case of a section 338(h)(10) election. The 
Committee believes that estimated tax should not be avoided 
merely because an election may be made under section 
338(h)(10). Furthermore, the Committee understands that parties 
typically negotiate a sale with an understanding as to whether 
or not an election under section 338(h)(10) will be made. In 
the event there is a contingency in this regard, the parties 
may provide for adjustments to the price to reflect the effect 
of the election.

                        EXPLANATION OF PROVISION

    The bill clarifies section 338(h)(13) to provide that the 
exception for estimated tax purposes with respect to tax 
attributable to a deemed asset sale does not apply with respect 
to a qualified stock purchase for which an election is made 
under section 338(h)(10).
    Under the bill if a qualified stock purchase transaction 
eligible for the election under section 338(h)(10) occurs, 
estimated tax would be determined based on the stock sale 
unless and until there is an agreement of the parties to make a 
section 338(h)(10) election.
    If at the time of the sale there is an agreement of the 
parties to make a section 338(h)(10) election, then estimated 
tax is computed based on an asset sale, computed from the date 
of the sale.
    If the agreement to make a section 338(h)(10) election is 
concluded after the stock sale, such that the original 
computation was based on the stock sale, estimated tax is 
recomputed based on the asset sale election.
    No inference is intended as to present law.

                             EFFECTIVE DATE

    The bill is effective for qualified stock purchase 
transactions that occur after the date of enactment.

17. Extension of IRS user fees (sec. 482 of the bill and sec. 7529 of 
        the Code)

                              PRESENT LAW

    The IRS provides written responses to questions of 
individuals, corporations, and organizations relating to their 
tax status or the effects of particular transactions for tax 
purposes. The IRS generally charges a fee for requests for a 
letter ruling, determination letter, opinion letter, or other 
similar ruling or determination.\398\ Public Law 108-89 \399\ 
extended the statutory authorization for these user fees 
through December 31, 2004, and moved the statutory 
authorization for these fees into the Code.\400\
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    \398\ These user fees were originally enacted in section 10511 of 
the Revenue Act of 1987 (Pub. Law No. 100-203, December 22, 1987). 
Public Law 104-117 (An Act to provide that members of the Armed Forces 
performing services for the peacekeeping efforts in Bosnia and 
Herzegovina, Croatia, and Macedonia shall be entitled to tax benefits 
in the same manner as if such services were performed in a combat zone, 
and for other purposes (March 20, 1996)) extended the statutory 
authorization for these user fees through September 30, 2003.
    \399\ 117 Stat. 1131; H.R. 3146, signed by the President on October 
1, 2003.
    \400\ That Public Law also moved into the Code the user fee 
provision relating to pension plans that was enacted in section 620 of 
the Economic Growth and Tax Relief Reconciliation Act of 2001 (Pub. L. 
107-16, June 7, 2001).
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The Committee believes that it is appropriate to provide a 
further extension of these user fees.

                        EXPLANATION OF PROVISION

    The bill extends the statutory authorization for these user 
fees through September 30, 2013.

                             EFFECTIVE DATE

    The provision is effective for requests made after the date 
of enactment.

18. Doubling of certain penalties, fines, and interest on underpayments 
        related to certain offshore financial arrangements (sec. 483 of 
        the bill)

                              PRESENT LAW

In general

    The Code contains numerous civil penalties, such as the 
delinquency, accuracy-related and fraud penalties. These civil 
penalties are in addition to any interest that may be due as a 
result of an underpayment of tax. If all or any part of a tax 
is not paid when due, the Code imposes interest on the 
underpayment, which is assessed and collected in the same 
manner as the underlying tax and is subject to the same statute 
of limitations.

Delinquency penalties

    Failure to file.--Under present law, a taxpayer who fails 
to file a tax return on a timely basis is generally subject to 
a penalty equal to 5 percent of the net amount of tax due for 
each month that the return is not filed, up to a maximum of 
five months or 25 percent. An exception from the penalty 
applies if the failure is due to reasonable cause. The net 
amount of tax due is the excess of the amount of the tax 
required to be shown on the return over the amount of any tax 
paid on or before the due date prescribed for the payment of 
tax.
    Failure to pay.--Taxpayers who fail to pay their taxes are 
subject to a penalty of 0.5 percent per month on the unpaid 
amount, up to a maximum of 25 percent. If a penalty for failure 
to file and a penalty for failure to pay tax shown on a return 
both apply for the same month, the amount of the penalty for 
failure to file for such month is reduced by the amount of the 
penalty for failure to pay tax shown on a return. If a return 
is filed more than 60 days after its due date, then the penalty 
for failure to pay tax shown on a return may not reduce the 
penalty for failure to file below the lesser of $100 or 100 
percent of the amount required to be shown on the return. For 
any month in which an installment payment agreement with the 
IRS is in effect, the rate of the penalty is half the usual 
rate (0.25 percent instead of 0.5 percent), provided that the 
taxpayer filed the tax return in a timely manner (including 
extensions).
    Failure to make timely deposits of tax.--The penalty for 
the failure to make timely deposits of tax consists of a four-
tiered structure in which the amount of the penalty varies with 
the length of time within which the taxpayer corrects the 
failure. A depositor is subject to a penalty equal to 2 percent 
of the amount of the underpayment if the failure is corrected 
on or before the date that is five days after the prescribed 
due date. A depositor is subject to a penalty equal to 5 
percent of the amount of the underpayment if the failure is 
corrected after the date that is five days after the prescribed 
due date but on or before the date that is 15 days after the 
prescribed due date. A depositor is subject to a penalty equal 
to 10 percent of the amount of the underpayment if the failure 
is corrected after the date that is 15 days after the due date 
but on or before the date that is 10 days after the date of the 
first delinquency notice to the taxpayer (under sec. 6303). 
Finally, a depositor is subject to a penalty equal to 15 
percent of the amount of theunderpayment if the failure is not 
corrected on or before the date that is 10 days after the date of the 
day on which notice and demand for immediate payment of tax is given in 
cases of jeopardy.
    An exception from the penalty applies if the failure is due 
to reasonable cause. In addition, the Secretary may waive the 
penalty for an inadvertent failure to deposit any tax by 
specified first-time depositors.

Accuracy-related penalties

    The accuracy-related penalty is imposed at a rate of 20 
percent of the portion of any underpayment that is 
attributable, in relevant part, to (1) negligence, (2) any 
substantial understatement of income tax and (3) any 
substantial valuation misstatement. In addition, the penalty is 
doubled for certain gross valuation misstatements. These 
consolidated penalties are also coordinated with the fraud 
penalty. This statutory structure operates to eliminate any 
stacking of the penalties.
    No penalty is to be imposed if it is shown that there was 
reasonable cause for an underpayment and the taxpayer acted in 
good faith. However, Treasury has issued proposed regulations 
that limit the defenses available to the imposition of an 
accuracy-related penalty in connection with a reportable 
transaction when the transaction is not disclosed.
    Negligence or disregard for the rules or regulations.--If 
an underpayment of tax is attributable to negligence, the 
negligence penalty applies only to the portion of the 
underpayment that is attributable to negligence. Negligence 
means any failure to make a reasonable attempt to comply with 
the provisions of the Code. Disregard includes any careless, 
reckless or intentional disregard of the rules or regulations.
    Substantial understatement of income tax.--Generally, an 
understatement is substantial if the understatement exceeds the 
greater of (1) 10 percent of the tax required to be shown on 
the return for the tax year or (2) $5,000. 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.
    Substantial valuation misstatement.--A penalty applies to 
the portion of an underpayment that is attributable to a 
substantial valuation misstatement. Generally, a substantial 
valuation misstatement exists if the value or adjusted basis of 
any property claimed on a return is 200 percent or more of the 
correct value or adjusted basis. The amount of the penalty for 
a substantial valuation misstatement is 20 percent of the 
amount of the underpayment if the value or adjusted basis 
claimed is 200 percent or more but less than 400 percent of the 
correct value or adjusted basis. If the value or adjusted basis 
claimed is 400 percent or more of the correct value or adjusted 
basis, then the overvaluation is a gross valuation 
misstatement.
    Gross valuation misstatements.--The rate of the accuracy-
related penalty is doubled (to 40 percent) in the case of gross 
valuation misstatements.

Fraud penalty

    The fraud penalty is imposed at a rate of 75 percent of the 
portion of any underpayment that is attributable to fraud. The 
accuracy-related penalty does not apply to any portion of an 
underpayment on which the fraud penalty is imposed.

Interest Provisions

    Taxpayers are required to pay interest to the IRS whenever 
there is an underpayment of tax. An underpayment of tax exists 
whenever the correct amount of tax is not paid by the last date 
prescribed for the payment of the tax. The last date prescribed 
for the payment of the income tax is the original due date of 
the return.
    Different interest rates are provided for the payment of 
interest depending upon the type of taxpayer, whether the 
interest relates to an underpayment or overpayment, and the 
size of the underpayment or overpayment. Interest on 
underpayments is compounded daily.

Offshore Voluntary Compliance Initiative

    In January 2003, Treasury announced the Offshore Voluntary 
Compliance Initiative (``OVCI'') to encourage the voluntary 
disclosure of previously unreported income placed by taxpayers 
in offshore accounts and accessed through credit card or other 
financial arrangements. A taxpayer had to comply with various 
requirements in order to participate in OVCI, including sending 
a written request to participate in the program by April 15, 
2003. This request had to include information about the 
taxpayer, the taxpayer's introduction to the credit card or 
other financial arrangements and the names of parties that 
promoted the transaction. Taxpayers eligible under OVCI will 
not be liable for civil fraud, the fraudulent failure to file 
penalty or the civil information return penalties. The taxpayer 
will pay back taxes, interest and certain accuracy-related and 
delinquency penalties.

Voluntary Disclosure Initiative

    A taxpayer's timely, voluntary disclosure of a substantial 
unreported tax liability has long been an important factor in 
deciding whether the taxpayer's case should ultimately be 
referred for criminal prosecution. The voluntary disclosure 
must be truthful, timely, and complete. The taxpayer must show 
a willingness to cooperate (as well as actual cooperation) with 
the IRS in determining the correct tax liability. The taxpayer 
must make good-faith arrangements with the IRS to pay in full 
the tax, interest, and any penalties determined by the IRS to 
be applicable. A voluntary disclosure does not guarantee 
immunity from prosecution. It creates no substantive or 
procedural rights for taxpayers.

                           REASONS FOR CHANGE

    The Committee is aware that individuals and corporations, 
through sophisticated transactions, are placing unreported 
income in offshore financial accounts accessed through credit 
or debit cards or other financial arrangements in order to 
avoid or evade Federal income tax. Such a phenomenon poses a 
serious threat to the efficacy of the tax system because of 
both the potential loss of revenue and the potential threat to 
the integrity of the self-assessmentsystem. The IRS estimates 
there may be several hundred thousand taxpayers using offshore 
financial arrangements to conceal taxable income from the IRS costing 
the government billions of dollars in lost revenue. Under the OVCI 
initiative, only 1,253 taxpayers from 46 states stepped forward to 
participate in the program. From these cases, the IRS expects to 
identify millions of dollars of uncollected tax. At the start of the 
program, the clear message to taxpayers was that those who failed to 
come forward would be pursued by the IRS and would be subject to more 
significant penalties and possible criminal sanctions. The Committee 
believes that doubling the civil penalties, fines and interest 
applicable to taxpayers who entered in to these arrangements and did 
not take advantage of OVCI will provide the IRS with the significant 
sanctions needed to stem the promotion of, and participation in, these 
abusive schemes.

                        EXPLANATION OF PROVISION

    The provision increases by a factor of two the total amount 
of civil penalties, interest and fines applicable for taxpayers 
who would have been eligible to participate in either the OVCI 
or the Treasury Department's voluntary disclosure initiative 
(which applies to the taxpayer by reason of the taxpayer's 
underpayment of U.S. income tax liability through certain 
financing arrangements) but did not participate in either 
program.

                             EFFECTIVE DATE

    The provision generally is effective with respect to a 
taxpayer's open tax years on or after date of enactment.

19. Authorize IRS to enter into installment agreements that provide for 
        partial payment (sec. 484 of the bill and sec. 6159 of the 
        Code)

                              PRESENT LAW

    The Code authorizes the IRS to enter into written 
agreements with any taxpayer under which the taxpayer is 
allowed to pay taxes owed, as well as interest and penalties, 
in installment payments if the IRS determines that doing so 
will facilitate collection of the amounts owed (sec. 6159). An 
installment agreement does not reduce the amount of taxes, 
interest, or penalties owed. Generally, during the period 
installment payments are being made, other IRS enforcement 
actions (such as levies or seizures) with respect to the taxes 
included in that agreement are held in abeyance.
    Prior to 1998, the IRS administratively entered into 
installment agreements that provided for partial payment 
(rather than full payment) of the total amount owed over the 
period of the agreement. In that year, the IRS Chief Counsel 
issued a memorandum concluding that partial payment installment 
agreements were not permitted.

                           REASONS FOR CHANGE

    The Committee believes that clarifying that the IRS is 
authorized to enter into installment agreements with taxpayers 
which do not provide for full payment of the taxpayer's 
liability over the life of the agreement will improve effective 
tax administration.
    The Committee recognizes that some taxpayers are unable or 
unwilling to enter into a realistic offer in compromise. The 
Committee believes that these taxpayers should be encouraged to 
make partial payments toward resolving their tax liability, and 
that providing for partial payment installment agreements will 
help facilitate this. The Committee also believes, however, 
that the offer in compromise program should remain the sole 
avenue via which taxpayers fully resolve their tax liabilities 
and attain a fresh start.

                        EXPLANATION OF PROVISION

    The provision clarifies that the IRS is authorized to enter 
into installment agreements with taxpayers which do not provide 
for full payment of the taxpayer's liability over the life of 
the agreement. The provision also requires the IRS to review 
partial payment installment agreements at least every two 
years. The primary purpose of this review is to determine 
whether the financial condition of the taxpayer has 
significantly changed so as to warrant an increase in the value 
of the payments being made.

                             EFFECTIVE DATE

    The provision is effective for installment agreements 
entered into on or after the date of enactment.

20. Extension of customs user fees (sec. 485 of the bill)

                              PRESENT LAW

    Section 13031 of the Consolidated Omnibus Budget 
Reconciliation Act of 1985 (COBRA) (P.L. 99-272), authorized 
the Secretary of the Treasury to collect certain service fees. 
Section 412 (P.L 107-296) of the Homeland Security Act of 2002 
authorized the Secretary of the Treasury to delegate such 
authority to the Secretary of Homeland Security. Provided for 
under 19 U.S.C. 58c, these fees include: processing fees for 
air and sea passengers, commercial trucks, rail cars, private 
aircraft and vessels, commercial vessels, dutiable mail 
packages, barges and bulk carriers, merchandise, and Customs 
broker permits. COBRA was amended on several occasions but most 
recently by P.L. 108-89 which extended authorization for the 
collection of these fees through March 31, 2004.\401\
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    \401\ Sec. 301; 117 Stat. 1131.
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                           REASONS FOR CHANGE

    The Committee believes it is important to extend these fees 
to cover the expenses of the services provided.

                        EXPLANATION OF PROVISION

    The bill extends the passenger and conveyance processing 
fees and the merchandise processing fees authorized under the 
Consolidated Omnibus Budget Reconciliation Act of 1985 through 
September 30, 2013.

                             EFFECTIVE DATE

    The provisions are effective upon the date of enactment.

21. Deposits made to suspend the running of interest on potential 
        underpayments (sec. 486 of the bill and new sec. 6603 of the 
        Code)

                              PRESENT LAW

    Generally, interest on underpayments and overpayments 
continues to accrue during the period that a taxpayer and the 
IRS dispute a liability. The accrual of interest on an 
underpayment is suspended if the IRS fails to notify an 
individual taxpayer in a timely manner, but interest will begin 
to accrue once the taxpayer is properly notified. No similar 
suspension is available for other taxpayers.
    A taxpayer that wants to limit its exposure to underpayment 
interest has a limited number of options. The taxpayer can 
continue to dispute the amount owed and risk paying a 
significant amount of interest. If the taxpayer continues to 
dispute the amount and ultimately loses, the taxpayer will be 
required to pay interest on the underpayment from the original 
due date of the return until the date of payment.
    In order to avoid the accrual of underpayment interest, the 
taxpayer may choose to pay the disputed amount and immediately 
file a claim for refund. Payment of the disputed amount will 
prevent further interest from accruing if the taxpayer loses 
(since there is no longer any underpayment) and the taxpayer 
will earn interest on the resultant overpayment if the taxpayer 
wins. However, the taxpayer will generally lose access to the 
Tax Court if it follows this alternative. Amounts paid 
generally cannot be recovered by the taxpayer on demand, but 
must await final determination of the taxpayer's liability. 
Even if an overpayment is ultimately determined, overpaid 
amounts may not be refunded if they are eligible to be offset 
against other liabilities of the taxpayer.
    The taxpayer may also make a deposit in the nature of a 
cash bond. The procedures for making a deposit in the nature of 
a cash bond are provided in Rev. Proc. 84-58.
    A deposit in the nature of a cash bond will stop the 
running of interest on an amount of underpayment equal to the 
deposit, but the deposit does not itself earn interest. A 
deposit in the nature of a cash bond is not a payment of tax 
and is not subject to a claim for credit or refund. A deposit 
in the nature of a cash bond may be made for all or part of the 
disputed liability and generally may be recovered by the 
taxpayer prior to a final determination. However, a deposit in 
the nature of a cash bond need not be refunded to the extent 
the Secretary determines that the assessment or collection of 
the tax determined would be in jeopardy, or that the deposit 
should be applied against another liability of the taxpayer in 
the same manner as an overpayment of tax. If the taxpayer 
recovers the deposit prior to final determination and a 
deficiency is later determined, the taxpayer will not receive 
credit for the period in which the funds were held as a 
deposit. The taxable year to which the deposit in the nature of 
a cash bond relates must be designated, but the taxpayer may 
request that the deposit be applied to a different year under 
certain circumstances.

                           REASONS FOR CHANGE

    The Committee believes that an improved deposit system that 
allows for the payment of interest on amounts that are not 
ultimately needed to offset tax liability when the taxpayer's 
position is upheld, as well as allowing for the offset of tax 
liability when the taxpayer's position fails, will provide an 
effective way for taxpayers to manage their exposure to 
underpayment interest. However, the Committee believes that 
such an improved deposit system should be reserved for the 
issues that are known to both parties, either through IRS 
examination or voluntary taxpayer disclosure.

                        EXPLANATION OF PROVISION

In general

    The bill allows a taxpayer to deposit cash with the IRS 
that may subsequently be used to pay an underpayment of income, 
gift, estate, generation-skipping, or certain excise taxes. 
Interest will not be charged on the portion of the underpayment 
that is deposited for the period that the amount is on deposit. 
Generally, deposited amounts that have not been used to pay a 
tax may be withdrawn at any time if the taxpayer so requests in 
writing. The withdrawn amounts will earn interest at the 
applicable Federal rate to the extent they are attributable to 
a disputable tax.
    The Secretary may issue rules relating to the making, use, 
and return of the deposits.

Use of a deposit to offset underpayments of tax

    Any amount on deposit may be used to pay an underpayment of 
tax that is ultimately assessed. If an underpayment is paid in 
this manner, the taxpayer will not be charged underpayment 
interest on the portion of the underpayment that is so paid for 
the period the funds were on deposit.
    For example, assume a calendar year individual taxpayer 
deposits $20,000 on May 15, 2005, with respect to a disputable 
item on its 2004 income tax return. On April 15, 2007, an 
examination of the taxpayer's year 2004 income tax return is 
completed, and the taxpayer and the IRS agree that the taxable 
year 2004 taxes were underpaid by $25,000. The $20,000 on 
deposit is used to pay $20,000 of the underpayment, and the 
taxpayer also pays the remaining $5,000. In this case, the 
taxpayer will owe underpayment interest from April 15, 2005 
(the original due date of the return) to the date of payment 
(April 15, 2007) only with respect to the $5,000 of the 
underpayment that is not paid by the deposit. The taxpayer will 
owe underpayment interest on the remaining $20,000 of the 
underpayment only from April 15, 2005, to May 15, 2005, the 
date the $20,000 was deposited.

Withdrawal of amounts

    A taxpayer may request the withdrawal of any amount of 
deposit at any time. The Secretary must comply with the 
withdrawal request unless the amount has already been used to 
pay tax or the Secretary properly determines that collection of 
tax is in jeopardy. Interest will be paid on deposited amounts 
that are withdrawn at a rate equal to the short-term applicable 
Federalrate for the period from the date of deposit to a date 
not more than 30 days preceding the date of the check paying the 
withdrawal. Interest is not payable to the extent the deposit was not 
attributable to a disputable tax.
    For example, assume a calendar year individual taxpayer 
receives a 30-day letter showing a deficiency of $20,000 for 
taxable year 2004 and deposits $20,000 on May 15, 2006. On 
April 15, 2007, an administrative appeal is completed, and the 
taxpayer and the IRS agree that the 2004 taxes were underpaid 
by $15,000. $15,000 of the deposit is used to pay the 
underpayment. In this case, the taxpayer will owe underpayment 
interest from April 15, 2005 (the original due date of the 
return) to May 15, 2006, the date the $20,000 was deposited. 
Simultaneously with the use of the $15,000 to offset the 
underpayment, the taxpayer requests the return of the remaining 
amount of the deposit (after reduction for the underpayment 
interest owed by the taxpayer from April 15, 2005, to May 15, 
2006). This amount must be returned to the taxpayer with 
interest determined at the short-term applicable Federal rate 
from the May 15, 2006, to a date not more than 30 days 
preceding the date of the check repaying the deposit to the 
taxpayer.

Limitation on amounts for which interest may be allowed

    Interest on a deposit that is returned to a taxpayer shall 
be allowed for any period only to the extent attributable to a 
disputable item for that period. A disputable item is any item 
for which the taxpayer (1) has a reasonable basis for the 
treatment used on its return and (2) reasonably believes that 
the Secretary also has a reasonable basis for disallowing the 
taxpayer's treatment of such item.
    All items included in a 30-day letter to a taxpayer are 
deemed disputable for this purpose. Thus, once a 30-day letter 
has been issued, the disputable amount cannot be less than the 
amount of the deficiency shown in the 30-day letter. A 30-day 
letter is the first letter of proposed deficiency that allows 
the taxpayer an opportunity for administrative review in the 
Internal Revenue Service Office of Appeals.

Deposits are not payments of tax

    A deposit is not a payment of tax prior to the time the 
deposited amount is used to pay a tax. Thus, the interest 
received on withdrawn deposits will not be eligible for the 
proposed exclusion from income of an individual. Similarly, 
withdrawal of a deposit will not establish a period for which 
interest was allowable at the short-term applicable Federal 
rate for the purpose of establishing a net zero interest rate 
on a similar amount of underpayment for the same period.

                             EFFECTIVE DATE

    The provision applies to deposits made after the date of 
enactment. Amounts already on deposit as of the date of 
enactment are treated as deposited (for purposes of applying 
this provision) on the date the taxpayer identifies the amount 
as a deposit made pursuant to this provision.

22. Qualified tax collection contracts (sec. 487 of the bill and new 
        sec. 6306 of the Code)

                              PRESENT LAW

    In fiscal years 1996 and 1997, the Congress earmarked $13 
million for IRS to test the use of private debt collection 
companies. There were several constraints on this pilot 
project. First, because both IRS and OMB considered the 
collection of taxes to be an inherently governmental function, 
only government employees were permitted to collect the 
taxes.\402\ The private debt collection companies were utilized 
to assist the IRS in locating and contacting taxpayers, 
reminding them of their outstanding tax liability, and 
suggesting payment options. If the taxpayer agreed at that 
point to make a payment, the taxpayer was transferred from the 
private debt collection company to the IRS. Second, the private 
debt collection companies were paid a flat fee for services 
rendered; the amount that was ultimately collected by the IRS 
was not taken into account in the payment mechanism.
---------------------------------------------------------------------------
    \402\ Sec. 7801(a).
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    The pilot program was discontinued because of disappointing 
results. GAO reported \403\ that IRS collected $3.1 million 
attributable to the private debt collection company efforts; 
expenses were also $3.1 million. In addition, there were lost 
opportunity costs of $17 million to the IRS because collection 
personnel were diverted from their usual collection 
responsibilities to work on the pilot. The pilot program 
results were disappointing because ``IRS' efforts to design and 
implement the private debt collection pilot program were 
hindered by limitations that affected the program's results.'' 
The limitations included the scope of work permitted to the 
private debt collection companies, the number and type of cases 
referred to the private debt collection companies, and the 
ability of IRS' computer systems to identify, select, and 
transmit collection cases to the private debt collectors.
---------------------------------------------------------------------------
    \403\ GAO/GGD-97-129R Issues Affecting IRS' Collection Pilot (July 
18, 1997).
---------------------------------------------------------------------------
    The IRS has in the last several years expressed renewed 
interest in the possible use of private debt collection 
companies; for example, IRS recently revised its extensive 
Request for Information concerning its possible use of private 
debt collection companies.\404\
---------------------------------------------------------------------------
    \404\ TIRNO-03-H-0001 (February 14, 2003), at 
www.procurement.irs.treas.gov. The basic request for information is 104 
pages, and there are 16 additional attachments.
---------------------------------------------------------------------------
    In general, Federal agencies are permitted to enter into 
contracts with private debt collection companies for collection 
services to recover indebtedness owed to the United 
States.\405\ That provision does not apply to the collection of 
debts under the Internal Revenue Code.\406\
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    \405\ 31 U.S.C. sec. 3718.
    \406\ 31 U.S.C. sec. 3718(f).
---------------------------------------------------------------------------
    On February 3, 2003, the President submitted to the 
Congress his fiscal year 2004 budget proposal,\407\ which 
proposed the use of private debt collection companies to 
collect Federal tax debts.
---------------------------------------------------------------------------
    \407\ See Office of Management and Budget, Budget of the United 
States Government, Fiscal Year 2004 (H. Doc. 108-3, Vol. I), p. 274.
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The Committee believes that the use of private debt 
collection agencies will help facilitate the collection of 
taxes that are owed to the Government. The Committee also 
believes that the safeguards it has incorporated will protect 
taxpayers' rights and privacy.

                        EXPLANATION OF PROVISION

    The bill permits the IRS to use private debt collection 
companies to locate and contact taxpayers owing outstanding tax 
liabilities \408\ of any type \409\ and to arrange payment of 
those taxes by the taxpayers. Several steps are involved. 
First, the private debt collection company contacts the 
taxpayer by letter.\410\ If the taxpayer's last known address 
is incorrect, the private debt collection company searches for 
the correct address. Second, the private debt collection 
company telephones the taxpayer to request full payment.\411\ 
If the taxpayer cannot pay in full immediately, the private 
debt collection company offers the taxpayer an installment 
agreement providing for full payment of the taxes over a period 
of as long as three years. If the taxpayer is unable to pay the 
outstanding tax liability in full over a three-year period, the 
private debt collection company obtains financial information 
from the taxpayer and will provide this information to the IRS 
for further processing and action by the IRS.
---------------------------------------------------------------------------
    \408\ There must be an assessment pursuant to section 6201 in order 
for there to be an outstanding tax liability.
    \409\ The bill generally applies to any type of tax imposed under 
the Internal Revenue Code. It is anticipated that the focus in 
implementing the provision will be: (a) taxpayers who have filed a 
return showing a balance due but who have failed to pay that balance in 
full; and (b) taxpayers who have been assessed additional tax by the 
IRS and who have made several voluntary payments toward satisfying 
their obligation but have not paid in full.
    \410\ Several portions of the provision require that the IRS 
disclose confidential taxpayer information to the private debt 
collection company. Section 6103(n) permits disclosure for ``the 
providing of other services * * * for purposes of tax administration.'' 
Accordingly, no amendment to 6103 is necessary to implement the 
provision. It is intended, however, that the IRS vigorously protect the 
privacy of confidential taxpayer information by disclosing the least 
amount of information possible to contractors consistent with the 
effective operation of the provision.
    \411\ The private debt collection company is not permitted to 
accept payment directly. Payments are required to be processed by IRS 
employees.
---------------------------------------------------------------------------
    The bill specifies several procedural conditions under 
which the provision would operate. First, provisions of the 
Fair Debt Collection Practices Act apply to the private debt 
collection company. Second, taxpayer protections that are 
statutorily applicable to the IRS are also made statutorily 
applicable to the private sector debt collection companies. In 
addition, taxpayer protections that are statutorily applicable 
to IRS employees are also made statutorily applicable to 
employees of private sector debt collection companies. Third, 
the private sector debt collection companies are required to 
inform taxpayers of the availability of assistance from the 
Taxpayer Advocate. Fourth, subcontractors are prohibited from 
having contact with taxpayers, providing quality assurance 
services, and composing debt collection notices; any other 
service provided by a subcontractor must receive prior approval 
from the IRS.
    The bill creates a revolving fund from the amounts 
collected by the private debt collection companies. The private 
debt collection companies will be paid out of this fund. The 
bill prohibits the payment of fees for all services in excess 
of 25 percent of the amount collected under a tax collection 
contract.\412\
---------------------------------------------------------------------------
    \412\ It is assumed that there will be competitive bidding for 
these contracts by private sector tax collection agencies and that 
vigorous bidding will drive the overhead costs down.
---------------------------------------------------------------------------

                             EFFECTIVE DATE

    The provision is effective on the date of enactment.

23. Add vaccines against hepatitis A to the list of taxable vaccines 
        (sec. 491 of the bill and sec. 4132 of the Code)

                              PRESENT LAW

    A manufacturer's excise tax is imposed at the rate of 75 
cents per dose \413\ on the following vaccines routinely 
recommended for administration to children: diphtheria, 
pertussis, tetanus, measles, mumps, rubella, polio, HIB 
(haemophilus influenza type B), hepatitis B, varicella (chicken 
pox), rotavirus gastroenteritis, and streptococcus pneumoniae. 
The tax applied to any vaccine that is a combination of vaccine 
components equals 75 cents times the number of components in 
the combined vaccine.
---------------------------------------------------------------------------
    \413\ Sec. 4131.
---------------------------------------------------------------------------
    Amounts equal to net revenues from this excise tax are 
deposited in the Vaccine Injury Compensation Trust Fund to 
finance compensation awards under the Federal Vaccine Injury 
Compensation Program for individuals who suffer certain 
injuries following administration of the taxable vaccines. This 
program provides a substitute Federal, ``no fault'' insurance 
system for the State-law tort and private liability insurance 
systems otherwise applicable to vaccine manufacturers. All 
persons immunized after September 30, 1988, with covered 
vaccines must pursue compensation under this Federal program 
before bringing civil tort actions under State law.

                           REASONS FOR CHANGE

    The Committee is aware that the Centers for Disease Control 
and Prevention have recommended that children in 17 highly 
endemic States be inoculated with a hepatitis A vaccine. The 
population of children in the affected States exceeds 20 
million. Several of the affected States mandate childhood 
vaccination against hepatitis A. The Committee is aware that 
the Advisory Commission on Childhood Vaccines has recommended 
that the vaccine excise tax be extended to cover vaccines 
against hepatitis A. For these reasons, the Committee believes 
it is appropriate to include vaccines against hepatitis A as 
part of the Vaccine Injury Compensation Program. Making the 
hepatitis A vaccine taxable is a first step.\414\ In the 
unfortunate event of an injury related to this vaccine, 
families of injured children are eligible for the no-fault 
arbitration system established under the Vaccine Injury 
Compensation Program rather than going to Federal Court to seek 
compensatory redress.
---------------------------------------------------------------------------
    \414\ The Committee recognizes that, to become covered under the 
Vaccine Injury Compensation Program, the Secretary of Health and Human 
Services also must list the hepatitis A vaccine on the Vaccine Injury 
Table.
---------------------------------------------------------------------------

                        EXPLANATION OF PROVISION

    The bill adds any vaccine against hepatitis A to the list 
of taxable vaccines. The bill also makes a conforming amendment 
to the trust fund expenditure purposes.

                             EFFECTIVE DATE

    The provision is effective for vaccines sold and used 
beginning on the first day of the first month beginning more 
than four weeks after the date of enactment.

24. Exclusion of like-kind exchange property from nonrecognition 
        treatment on the sale or exchange of a principal residence 
        (sec. 492 of the bill and sec. 121 of the Code)

                              PRESENT LAW

    Under present law, a taxpayer may exclude up to $250,000 
($500,000 if married filing a joint return) of gain realized on 
the sale or exchange of a principal residence.\415\ To be 
eligible for the exclusion, the taxpayer must have owned and 
used the residence as a principal residence for at least two of 
the five years prior to the sale or exchange. A taxpayer who 
fails to meet these requirements by reason of a change of place 
of employment, health, or, to the extent provided under 
regulations, unforeseen circumstances is able to exclude an 
amount equal to the fraction of the $250,000 ($500,000 if 
married filing a joint return) that is equal to the fraction of 
the two years that the ownership and use requirements are met. 
There are no special rules relating to the sale or exchange of 
a principal residence that was acquired in a like-kind exchange 
within the prior five years.
---------------------------------------------------------------------------
    \415\ Sec. 121.
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The Committee strongly believes that the present-law 
exclusion of gain allowable upon the sale or exchange of 
principal residences serves an important role in encouraging 
home ownership. The Committee does not believe that this 
exclusion is appropriate for properties that were recently 
acquired in like-kind exchanges. Under the like-kind exchange 
rules, a taxpayer that exchanges property that was held for 
productive use or investment for like-kind property may acquire 
the replacement property on a tax-free basis. Because the 
replacement property generally has a low carry-over tax basis, 
the taxpayer will have taxable gain upon the sale or exchange 
of the replacement property. However, when the taxpayer 
converts the replacement property into the taxpayer's principal 
residence, the taxpayer may shelter some or all of this gain 
from income taxation. The Committee believes that this proposal 
balances the concerns associated with these provisions to 
reduce this tax shelter concern without unduly limiting the 
exclusion on sales or exchanges of principal residences.

                        EXPLANATION OF PROVISION

    The bill provides that the exclusion for gain on the sale 
or exchange of a principal residence does not apply if the 
principal residence was acquired in a like-kind exchange in 
which any gain was not recognized within the prior five years.

                             EFFECTIVE DATE

    The provision is effective for sales or exchanges of 
principal residences after the date of enactment.

25. Modify qualification rules for tax-exempt property and casualty 
        insurance companies (sec. 493 of the bill and secs. 501(c)(15) 
        and 831(b) of the Code)

                              PRESENT LAW

    A property and casualty insurance company is eligible to be 
exempt from Federal income tax if its net written premiums or 
direct written premiums (whichever is greater) for the taxable 
year do not exceed $350,000 (sec. 501(c)(15)).
    A property and casualty insurance company may elect to be 
taxed only on taxable investment income if its net written 
premiums or direct written premiums (whichever is greater) for 
the taxable year exceed $350,000, but do not exceed $1.2 
million (sec. 831(b)).
    For purposes of determining the amount of a company's net 
written premiums or direct written premiums under these rules, 
premiums received by all members of a controlled group of 
corporations of which the company is a part are taken into 
account. For this purpose, a more-than-50-percent threshhold 
applies under the vote and value requirements with respect to 
stock ownership for determining a controlled group, and rules 
treating a life insurance company as part of a separate 
controlled group or as an excluded member of a group do not 
apply (secs. 501(c)(15), 831(b)(2)(B) and 1563).

                           REASONS FOR CHANGE

    The Committee has become aware of abuses in the area of 
tax-exempt insurance companies. Considerable media attention 
has focused on the inappropriate use of tax-exempt insurance 
companies to shelter investment income.\416\ The Committee 
believes that the use of these organizations as vehicles for 
sheltering income was never contemplated by Congress. The 
proliferation of these organizations as a means to avoid tax on 
income, sometimes on large investment portfolios, is 
inconsistent with the original narrow scope of the provision, 
which has been in the tax law for decades. The Committee 
believes it is necessary to limit the availability of tax-
exempt status under the provision so that it cannot be abused 
as a tax shelter. To that end, the bill applies a gross 
receipts test and requires that premiums received for the 
taxable year be greater than 50 percent of gross receipts.
---------------------------------------------------------------------------
    \416\ See David Cay Johnston, Insurance Loophole Helps Rich, N.Y. 
Times, April 1, 2003; David Cay Johnston, Tiny Insurers Face Scrutiny 
as Tax Shields, N.Y. Times, April 4, 2003, at C1; Janet Novack, Are You 
a Chump?, Forbes, Mar. 5, 2001.
---------------------------------------------------------------------------
    The bill correspondingly expands the availability of the 
present-law election of a property and casualty insurer to be 
taxed only on taxable investment income to companies with 
premiums below $350,000. This provision of present law provides 
a relatively simple tax calculation for small property and 
casualty insurers, and because the election results in the 
taxation of investment income, the Committee does not believe 
that it is abused to avoid tax on investment income. Thus, the 
bill provides that a company whose net written premiums (or if 
greater, direct written premiums) do not exceed $1.2 million 
(without regard to the $350,000 threshold of present law) is 
eligible for the simplification benefit of this election.

                        EXPLANATION OF PROVISION

    The provision modifies the requirements for a property and 
casualty insurance company to be eligible for tax-exempt 
status, and to elect to be taxed only on taxable investment 
income.
    Under the provision, a property and casualty insurance 
company is eligible to be exempt from Federal income tax if (a) 
its gross receipts for the taxable year do not exceed $600,000, 
and (b) the premiums received for the taxable year are greater 
than 50 percent of its gross receipts. For purposes of 
determining gross receipts, the gross receipts of all members 
of a controlled group of corporations of which the company is a 
part are taken into account. The provision expands the present-
law controlled group rule so that it also takes into account 
gross receipts of foreign and tax-exempt corporations.
    A company that does not meet the definition of an insurance 
company is not eligible to be exempt from Federal income tax 
under the bill. For this purpose, the term ``insurance 
company'' means any company, more than half of the business of 
which during the taxable year is the issuing of insurance or 
annuity contracts or the reinsuring of risks underwritten by 
insurance companies (sec. 816(a) and new sec. 831(c)). A 
company whose investment activities outweigh its insurance 
activities is not considered to be an insurance company for 
this purpose.\417\ It is intended that IRS enforcement 
activities address the misuse of present-law section 
501(c)(15).
---------------------------------------------------------------------------
    \417\ See, e.g., Inter-American Life Insurance Co. v. Comm'r, 56 
T.C. 497, aff'd per curiam, 469 F.2d 697 (9th Cir. 1972).
---------------------------------------------------------------------------
    The provision also provides that a property and casualty 
insurance company may elect to be taxed only on taxable 
investment income if its net written premiums or direct written 
premiums (whichever is greater) do not exceed $1.2 million 
(without regard to whether such premiums exceed $350,000) (sec. 
831(b)). As under present law, for purposes of determining the 
amount of a company's net written premiums or direct written 
premiums under this rule, premiums received by all members of a 
controlled group of corporations (as defined in section 831(b)) 
of which the company is a part are taken into account.
    It is intended that regulations or other Treasury guidance 
provide for anti-abuse rules so as to prevent improper use of 
the provision, including, for example, by attempts to 
characterize as premiums any income that is other than premium 
income.

                             EFFECTIVE DATE

    The provisions are effective for taxable years beginning 
after December 31, 2003.

26. Definition of insurance company for property and casualty insurance 
        company tax rules (sec. 494 of the bill and sec. 831(c) of the 
        Code)

                              PRESENT LAW

    Present law provides specific rules for taxation of the 
life insurance company taxable income of a life insurance 
company (sec. 801), and for taxation of the taxable income of a 
company other than a life insurance company (sec. 831) 
(generally referred to as a property and casualty insurance 
company). For Federal income tax purposes, a life insurance 
company means an insurance company that is engaged in the 
business of issuing life insurance and annuity contracts, or 
noncancellable health and accident insurance contracts, and 
that meets a 50-percent test with respect to its reserves (sec. 
816(a)). This statutory provision applicable to life insurance 
companies explicitly defines the term ``insurance company'' to 
mean any company, more than half of the business of which 
during the taxable year is the issuing of insurance or annuity 
contracts or the reinsuring of risks underwritten by insurance 
companies (sec. 816(a)).
    The life insurance company statutory definition of an 
insurance company does not explicitly apply to property and 
casualty insurance companies, although a long-standing Treasury 
regulation \418\ that is applied to property and casualty 
companies provides a somewhat similar definition of an 
``insurance company'' based on the company's ``primary and 
predominant business activity.'' \419\
---------------------------------------------------------------------------
    \418\ The Treasury regulation provides that ``the term 'insurance 
company' means a company whose primary and predominant business 
activity during the taxable year is the issuing of insurance or annuity 
contracts or the reinsuring of risks underwritten by insurance 
companies. Thus, though its name, charter powers, and subjection to 
State insurance laws are significant in determining the business which 
a company is authorized and intends to carry on, it is the character of 
the business actually done in the taxable year which determines whether 
a company is taxable as an insurance company under the Internal Revenue 
Code.'' Treas. Reg. section 1.801-3(a)(1).
    \419\ Court cases involving a determination of whether a company is 
an insurance company for Federal tax purposes have examined all of the 
business and other activities of the company. In considering whether a 
company is an insurance company for such purposes, courts have 
considered, among other factors, the amount and source of income 
received by the company from its different activities. See Bowers v. 
Lawyers Mortgage Co., 285 U.S. 182 (1932); United States v. Home Title 
Insurance Co., 285 U.S. 191 (1932). See also Inter-American Life 
Insurance Co. v. Comm'r, 56 T.C. 497, aff'd per curiam, 469 F.2d 697 
(9th Cir. 1972), in which the court concluded that the company was not 
an insurance company: ``The * * * financial data clearly indicates that 
petitioner's primary and predominant source of income was from its 
investments and not from issuing insurance contracts or reinsuring 
risks underwritten by insurance companies. During each of the years in 
issue, petitioner's investment income far exceeded its premiums and the 
amounts of earned premiums were de minimis during those years. It is 
equally as clear that petitioner's primary and predominant efforts were 
not expended in issuing insurance contracts or in reinsurance. Of the 
relatively few policies directly written by petitioner, nearly all were 
issued to [family members]. Also, Investment Life, in which [family 
members] each owned a substantial stock interest, was the source of 
nearly all of the policies reinsured by petitioner. These facts, 
coupled with the fact that petitioner did not maintain an active sales 
staff soliciting or selling insurance policies * * *, indicate a lack 
of concentrated effort on petitioner's behalf toward its chartered 
purpose of engaging in the insurance business. * * * For the above 
reasons, we hold that during the years in issue, petitioner was not 'an 
insurance company * * * engaged in the business of issuing life 
insurance' and hence, that petitioner was not a life insurance company 
within the meaning of section 801.'' 56 T.C. 497, 507-508.
---------------------------------------------------------------------------
    When enacting the statutory definition of an insurance 
company in 1984, Congress stated, ``[b]y requiring [that] more 
than half rather than the 'primary and predominant business 
activity' be insurance activity, the bill adopts a stricter and 
more precise standard for a company to be taxed as a life 
insurance company than does the general regulatory definition 
of an insurance company applicable for both life and nonlife 
insurance companies * * * Whether more than half of the 
business activity is related to the issuing of insurance or 
annuity contracts will depend on the facts and circumstances 
and factors to be considered will include the relative 
distribution of the number of employees assigned to, the amount 
of space allocated to, and the net income derived from, the 
various business activities.'' \420\
---------------------------------------------------------------------------
    \420\ H.R. Rep. 98-432, part 2, at 1402-1403 (1984); S. Prt. No. 
98-169, vol. I, at 525-526 (1984); see also H.R. Rep. No. 98-861 at 
1043-1044 (1985) (Conference Report).
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The Committee believes that the law will be made clearer 
and more exact and tax administration will be improved by 
conforming the definition of an insurance company forpurposes 
of the property and casualty insurance tax rules to the existing 
statutory definition of an insurance company under the life insurance 
company tax rules. Further, the Committee expects that IRS enforcement 
activities to prevent abuse of the provision relating to tax-exempt 
insurance companies will be simplified and improved by this provision 
of the bill.

                        EXPLANATION OF PROVISION

    The bill provides that, for purposes of determining whether 
a company is a property and casualty insurance company, the 
term ``insurance company'' is defined to mean any company, more 
than half of the business of which during the taxable year is 
the issuing of insurance or annuity contracts or the reinsuring 
of risks underwritten by insurance companies. Thus, the bill 
conforms the definition of an insurance company for purposes of 
the rules taxing property and casualty insurance companies to 
the rules taxing life insurance companies, so that the 
definition is uniform. The provision adopts a stricter and more 
precise standard than the ``primary and predominant business 
activity'' test contained in Treasury Regulations. A company 
whose investment activities outweigh its insurance activities 
is not considered to be an insurance company under the 
provision.\421\ It is not intended that a company whose sole 
activity is the run-off of risks under the company's insurance 
contracts be treated as a company other than an insurance 
company, even if the company has little or no premium income.
---------------------------------------------------------------------------
    \421\ See Inter-American Life Insurance Co. v. Comm'r, supra.
---------------------------------------------------------------------------

                             EFFECTIVE DATE

    The provision applies to taxable years beginning after 
December 31, 2003.

27. Limit deduction for charitable contributions of patents and similar 
        property (sec. 495 of the bill and secs. 170 and 6050L of the 
        Code)

                              PRESENT LAW

    In general, a deduction is permitted for charitable 
contributions, subject to certain limitations that depend on 
the type of taxpayer, the property contributed, and the donee 
organization.\422\ The amount of the deduction generally equals 
the fair market value of the contributed property on the date 
of the contribution.
---------------------------------------------------------------------------
    \422\ Charitable deductions are provided for income, estate, and 
gift tax purposes. Secs. 170, 2055, and 2522, respectively.
---------------------------------------------------------------------------
    For certain contributions of property, the taxpayer is 
required to reduce the deduction amount by any gain, generally 
resulting in a deduction equal to the taxpayer's basis. This 
rule applies to contributions of: (1) property that, at the 
time of contribution, would not have resulted in long-term 
capital gain if the property was sold by the taxpayer on the 
contribution date; (2) tangible personal property that is used 
by the donee in a manner unrelated to the donee's exempt (or 
governmental) purpose; and (3) property to or for the use of a 
private foundation (other than a foundation defined in section 
170(b)(1)(E)).
    Charitable contributions of capital gain property generally 
are deductible at fair market value. Capital gain property 
means any capital asset or property used in the taxpayer's 
trade or business the sale of which at its fair market value, 
at the time of contribution, would have resulted in gain that 
would have been long-term capital gain. Contributions of 
capital gain property are subject to different percentage 
limitations than other contributions of property. Under present 
law, certain copyrights are not considered capital assets.\423\
---------------------------------------------------------------------------
    \423\ See sec. 1221(a)(3), 1231(b)(1)(C).
---------------------------------------------------------------------------
    In general, a charitable contribution deduction is allowed 
only for contributions of the donor's entire interest in the 
contributed property, and not for contributions of a partial 
interest.\424\ If a taxpayer sells property to a charitable 
organization for less than the property's fair market value, 
the amount of any charitable contribution deduction is 
determined in accordance with the bargain sale rules.\425\ In 
general, if a donor receives a benefit or quid pro quo in 
return for a contribution, any charitable contribution 
deduction is reduced by the amount of the benefit received. For 
contributions of $250 or more, no charitable contribution 
deduction is allowed unless the donee organization provides a 
contemporaneous written acknowledgement of the contribution 
that describes and provides a good faith estimate of the value 
of any goods or services provided by the donee organization in 
exchange for the contribution.\426\
---------------------------------------------------------------------------
    \424\ Sec. 170(f)(3).
    \425\ Sec. 1011(b) and Treas. Reg. sec. 1.1011-2.
    \426\ 426 Sec. 170(f)(8).
---------------------------------------------------------------------------
    In general, charitable organizations must be organized and 
operated exclusively for exempt purposes and no part of the net 
earnings of such organization may inure to the benefit of any 
private shareholder or individual. An organization is not 
organized or operated exclusively for one or more exempt 
purposes unless the organization serves a public rather than a 
private interest. In general, an excess benefit transaction 
between a public charity and a disqualified person is subject 
to intermediate sanctions.\427\
---------------------------------------------------------------------------
    \427\ Sec. 4958.
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The Committee believes that in the context of charitable 
contributions the valuation of patents, copyrights, trademarks, 
trade names, trade secrets, know-how, software, similar 
property, or applications or registrations of such property is 
highly speculative. In theory, such intellectual property may 
promise significant monetary benefits, but the benefits will 
not materialize if the charity does not make the appropriate 
investments, have the right personnel and equipment, or even 
have sufficient sustained interest to exploit the intellectual 
property. In addition, some donated intellectual property may 
prove to be worthless, or the initial promise of worth may be 
diminished by future inventions and marketplace competition. 
The Committee understands that valuation is made yet more 
difficult in the charitable contribution contextbecause the 
transferee does not provide full, if any, consideration in exchange for 
the transferred property pursuant to arm's length negotiations.
    The Committee is concerned that taxpayers with patents or 
similar property are taking advantage of the inherent 
difficulties in valuing such property and are preparing or 
obtaining erroneous valuations. In such cases, the charity 
receives an asset of questionable value, while the taxpayer 
receives a significant tax benefit. The Committee believes that 
the excessive charitable contribution deductions enabled by 
inflated valuations is best addressed by ensuring that the 
amount of the deduction for charitable contributions of such 
property may not exceed the taxpayer's basis in the property. 
The Committee notes that for other types of charitable 
contributions for which valuation is especially problematic--
charitable contributions of property created by the personal 
efforts of the taxpayer and charitable contributions to certain 
private foundations--a basis deduction generally is the result 
under present law.
    Although the Committee believes that a deduction of basis 
is appropriate in this context, the Committee recognizes that 
some contributions of patents or similar property are valuable 
and that donors may need an economic incentive to continue to 
make such contributions. Accordingly, the Committee believes 
that it is appropriate to permit donors of patents and similar 
property, upon negotiation with the donee, to make a charitable 
contribution (relinquishing ownership of the property) and have 
a right to receive certain payments attributable to the 
contributed property.

                        EXPLANATION OF PROVISION

In general

    The provision provides that the amount of the deduction for 
charitable contributions of patents, copyrights, trademarks, 
trade names, trade secrets, know-how, software, similar 
property, or applications or registrations of such property 
(``intellectual property'') may not exceed the taxpayer's basis 
in the contributed property. The provision permits a taxpayer 
to take such a deduction and have the right to receive certain 
payments (a ``qualified interest'') from the donee 
organization, provided that the donor relinquishes ownership of 
the entire property. A deduction of the taxpayer's basis in the 
contributed property is permitted notwithstanding the amount of 
any benefit or quid pro quo received by the taxpayer in the 
form of a qualified interest. In cases where the donor has a 
qualified interest, the provision overrides present-law rules 
regarding contributions of partial interests and bargain sales 
to the extent that they otherwise apply. If after a 
contribution of intellectual property, a taxpayer has any 
interest other than a qualified interest, no deduction is 
allowed and any payments received by the donor are taxed under 
the generally applicable law.
    The provision does not change present law rules regarding 
private inurement, private benefit, or intermediate sanctions. 
The fact that a right to receive payments meets the statutory 
standard of a qualified interest does not immunize the 
contribution from such present-law rules. Accordingly, under 
the provision, a donor's contribution of intellectual property 
and right to receive certain payments could, depending on the 
facts and circumstances, result in impermissible private 
inurement or private benefit, or be treated as an excess 
benefit transaction for purposes of intermediate sanctions.
    Present law rules regarding substantiation of charitable 
contributions apply, except that, for contributions of 
intellectual property by C corporations for which a deduction 
in excess of $500 is claimed, it is intended that the C 
corporation state on any return required by the Secretary with 
respect to the reporting of the contribution whether the fair 
market value of the contribution exceeds the C corporation's 
basis in the contributed property, and, in addition, state the 
fair market value of the contribution but only if such value is 
less than the C corporation's basis in the contributed 
property. For purposes of substantiation required of the donee 
organization for gifts of $250 or more, a qualified interest is 
not considered the provision of goods or services.
    The provision does not change the rules for charitable 
contributions of intellectual property that under present law 
generally provide the donor a basis deduction (for example, 
copyrights described in sections 1221(a)(3) and 1231(b)(1)(C)).

Donor's qualified interest

    A qualified interest of a donor is a right to receive 
payments from the donee organization that are attributable to 
royalties received by the donee organization with respect to 
the contributed property. No single payment to the donor by the 
donee organization may exceed 50 percent of the amount of the 
correlating royalty received by the donee organization from a 
third party with respect to the contributed property. The 
Secretary of the Treasury is authorized to treat as a qualified 
interest the right to receive other payments from the donee, 
but only if the donee does not possess a right to receive any 
payment (whether royalties or otherwise) from a third party 
with respect to the contributed property. In such a case, the 
Secretary may not treat as a qualified interest the right to 
receive any payment that provides a benefit to the donor that 
is greater than the benefit retained by the donee.\428\ In any 
case, an interest is not a qualified interest if the donor has 
a right to receive payments after the earlier of the expiration 
of the legal life of the contributed property or the date that 
is twenty years after the date of the contribution.\429\ A 
qualified interest does not include a right to receive any 
portion of proceeds from a sale of the contributed property by 
the donee.
---------------------------------------------------------------------------
    \428\ For example, in general, if the donee organization uses the 
contributed property in furtherance of the donee's exempt purposes, the 
Secretary may determine that it is appropriate to provide guidance that 
treats as a qualifying interest the right to receive from the donee 
payments that do not exceed 50 percent of the royalties that could be 
obtained by the donee if the donee granted a license of the contributed 
property pursuant to arm's length principles.
    \429\ The time (the earlier of twenty years or the legal life of 
the property) and amount (50 percent of royalty payments) limitations 
are intended as upper limits. It is expected that the donee 
organization will negotiate with the donor time and percentage 
limitations that are reasonable with respect to the property 
contributed, based on factors such as the likelihood of successful 
development, the maturity of the contributed property at the time of 
the contribution, and the effort and time likely to be invested by the 
donee organization in the contributed property.
---------------------------------------------------------------------------
    The provision provides that payments pursuant to a 
qualified interest will constitute ordinary income recognized 
by the donor when received, regardless of the donor's method of 
accounting.

Reporting requirements

    Under the provision, the donee organization must file a 
return with the Secretary for any calendar year during which 
the donee organization makes a payment pursuant to a qualified 
interest. The return must show: (1) the name, address, and 
taxpayer identification number of the payor and the payee with 
respect to a payment; (2) a description, and date of 
contribution, of the property to which the qualified interest 
relates; (3) the dates and amounts of any royalty payments 
received by the donee with respect to such property; (4) the 
date and the amount of the payment pursuant to the qualified 
interest; (5) a description of the terms of the qualified 
interest; and (6) such other information as the Secretary may 
prescribe. The donee organization is required to furnish a copy 
of any such return to the donor of the contributed property to 
which the qualified interest relates. Generally applicable 
penalties apply to failures to file such a return or furnish 
the required information.\430\
---------------------------------------------------------------------------
    \430\ Secs. 6721-6724.
---------------------------------------------------------------------------

Treasury guidance regarding abusive situations

    The provision provides the Secretary of the Treasury with 
the authority to issue regulations or other guidance to prevent 
avoidance of the purposes of the provision. In general, the 
provision is intended to prevent taxpayers from claiming a 
deduction in excess of basis with respect to charitable 
contributions of intellectual property. A taxpayer would 
contravene the purposes of the provision, for example, by 
engaging in transactions or other activity that manipulated the 
basis of the contributed property or changed the form of the 
contributed property in order to increase the amount of the 
deduction. This might occur, for instance, if a taxpayer, for 
the purpose of claiming a larger deduction, engaged in activity 
that increased the basis of the contributed property by using 
related parties, pass-thru entities, or other intermediaries or 
means. The purpose of the provision also would be abused if a 
taxpayer changed the form of the property in order to claim a 
larger deduction by, for example, embedding the property into a 
product, contributing the product, and claiming a fair market 
value deduction based in part on the fair market value of the 
embedded property. In such abusive cases, any guidance issued 
by the Secretary of the Treasury shall provide that the 
taxpayer is required to separate the embedded property from the 
related product and treat the charitable contribution as 
contributions of distinct properties, with each property 
subject to the applicable deduction rules.

                             EFFECTIVE DATE

    The provision is effective for contributions made after 
October 1, 2003.

28. Repeal of ten-percent rehabilitation tax credit (sec. 496 of the 
        bill and sec. 47(a)(1) of the Code)

                              PRESENT LAW

    Present law provides a two-tier tax credit for 
rehabilitation expenditures (sec. 47).
    A 20-percent credit is provided for rehabilitation 
expenditures with respect to a certified historic structure. 
For this purpose, a certified historic structure means any 
building that is listed in the National Register, or that is 
located in a registered historic district and is certified by 
the Secretary of the Interior to the Secretary of the Treasury 
as being of historic significance to the district.
    A 10-percent credit is provided for rehabilitation 
expenditures with respect to buildings first placed in service 
before 1936. The pre-1936 building must meet certain 
requirements in order for expenditures with respect to it to 
qualify for the rehabilitation tax credit. In the 
rehabilitation process, certain walls and structures must have 
been retained. Specifically, (1) 50 percent or more of the 
existing external walls must be retained in place as external 
walls, (2) 75 percent or more of the existing external walls of 
the building must be retained in place as internal or external 
walls, and (3) 75 percent or more of the existing internal 
structural framework of the building must be retained in place. 
Further, the building must have been substantially 
rehabilitated, and it must have been placed in service before 
the beginning of the rehabilitation. A building is treated as 
having been substantially rehabilitated only if the 
rehabilitation expenditures during the 24-month period selected 
by the taxpayer and ending with or within the taxable year 
exceed the greater of (1) the adjusted basis of the building 
(and its structural components), or $5,000.

                           REASONS FOR CHANGE

    The Committee believes that the rehabilitation credit would 
be simplified by repealing the 10-percent credit while 
retaining the 20-percent credit. The category of non-historic 
structures under the 10-percent credit has an increasing 
potential overlap with the category of certified historic 
structures under the 20-percent credit, and the two-tier format 
of the credit creates needless complexity. Therefore, the 
Committee bill repeals the 10-percent rehabilitation credit 
with respect to buildings first placed in service before 1936.

                        EXPLANATION OF PROVISION

    The provision repeals the 10-percent credit for 
rehabilitation expenditures with respect to buildings first 
placed in service before 1936. The provision retains the 
present-law 20-percent credit for rehabilitation expenditures 
with respect to a certified historic structure.

                             EFFECTIVE DATE

    The provision is effective for expenditures incurred in 
taxable years beginning after December 31, 2003.

29. Increase age limit under section 1(g) (sec. 497 of the bill and 
        sec. 1 of the Code)

                              PRESENT LAW

Filing requirements for children

    A single unmarried individual eligible to be claimed as a 
dependent on another taxpayer's return generally must file an 
individual income tax return if he or she has: (1) earned 
income only over $4,750 (for 2003); (2) unearned income only 
over the minimum standard deduction amount for dependents ($750 
in 2003); or (3) both earned income and unearned income 
totaling more than the smaller of (a) $4,750 (for 2003) or (b) 
the larger of (i) $750 (for 2003), or (ii) earned income plus 
$250.\431\ Thus, if a dependent child has less than $750 in 
gross income, the child does not have to file an individual 
income tax return for 2003.
---------------------------------------------------------------------------
    \431\ Sec. 6012(a)(1)(C). Other filing requirements apply to 
dependents who are married, elderly, or blind. See, Internal Revenue 
Service, Publication 929, Tax Rules for Children and Dependents, at 3, 
Table 1 (2002).
---------------------------------------------------------------------------
    A child who cannot be claimed as a dependent on another 
person's tax return (e.g., because the support test is not 
satisfied by any other person) is subject to the generally 
applicable filing requirements. That is, such an individual 
generally must file a return if the individual's gross income 
exceeds the sum of the standard deduction and the personal 
exemption amounts applicable to the individual.

Taxation of unearned income under section 1(g)

    Special rules apply to the unearned income of a child under 
age 14. These rules, generally referred to as the ``kiddie 
tax,'' tax certain unearned income of a child at the parent's 
rate, regardless of whether the child can be claimed as a 
dependent on the parent's return.\432\ The kiddie tax applies 
if: (1) the child has not reached the age of 14 by the close of 
the taxable year; (2) the child's investment income was more 
than $1,500 (for 2003); and (3) the child is required to file a 
return for the year. The kiddie tax applies regardless of the 
source of the property generating the income or when the 
property giving rise to the income was transferred to or 
otherwise acquired by the child. Thus, for example, the kiddie 
tax may apply to income from property acquired by the child 
with compensation derived from the child's personal services or 
from property given to the child by someone other than the 
child's parent.
---------------------------------------------------------------------------
    \432\ Sec. 1(g).
---------------------------------------------------------------------------
    The kiddie tax is calculated by computing the ``allocable 
parental tax.'' This involves adding the net unearned income of 
the child to the parent's income and then applying the parent's 
tax rate. A child's ``net unearned income'' is the child's 
unearned income less the sum of (1) the minimum standard 
deduction allowed to dependents ($750 for 2003), and (2) the 
greater of (a) such minimum standard deduction amount or (b) 
the amount of allowable itemized deductions that are directly 
connected with the production of the unearned income.\433\ A 
child's net unearned income cannot exceed the child's taxable 
income.
---------------------------------------------------------------------------
    \433\ Sec. 1(g)(4).
---------------------------------------------------------------------------
    The allocable parental tax equals the hypothetical increase 
in tax to the parent that results from adding the child's net 
unearned income to the parent's taxable income. If a parent has 
more than one child subject to the kiddie tax, the net unearned 
income of all children is combined, and a single kiddie tax is 
calculated. Each child is then allocated a proportionate share 
of the hypothetical increase.
    If the parents file a joint return, the allocable parental 
tax is calculated using the income reported on the joint 
return. In the case of parents who are married but file 
separate returns, the allocable parental tax is calculated 
using the income of the parent with the greater amount of 
taxable income. In the case of unmarried parents, the child's 
custodial parent is the parent whose taxable income is taken 
into account in determining the child's liability. If the 
custodial parent has remarried, the stepparent is treated as 
the child's other parent. Thus, if the custodial parent and 
stepparent file a joint return, the kiddie tax is calculated 
using that joint return. If the custodial parent and stepparent 
file separate returns, the return of the one with the greater 
taxable income is used. If the parents are unmarried but lived 
together all year, the return of the parent with the greater 
taxable income is used.\434\
---------------------------------------------------------------------------
    \434\ Sec. 1(g)(5); Internal Revenue Service, Publication 929, Tax 
Rules for Children and Dependents, at 6 (2002).
---------------------------------------------------------------------------
    Unless the parent elects to include the child's income on 
the parent's return (as described below) the child files a 
separate return. In this case, items on the parent's return are 
not affected by the child's income. The total tax due from a 
child is the greater of:
          (1) The sum of (a) the tax payable by the child on 
        the child's earned income plus (b) the allocable 
        parental tax or;
          (2) the tax on the child's income without regard to 
        the kiddie tax provisions.

Parental election to include child's unearned income

    Under certain circumstances, a parent may elect to report a 
child's unearned income on the parent's return. If the election 
is made, the child is treated as having no income for the year 
and the child does not have to file a return. The requirements 
for the election are that:
          (1) The child has gross income only from interest and 
        dividends (including capital gains distributions and 
        Alaska Permanent Fund Dividends); \435\
---------------------------------------------------------------------------
    \435\ Internal Revenue Service, Publication 929, Tax Rules for 
Children and Dependents, at 7 (2002).
---------------------------------------------------------------------------
          (2) Such income is more than the minimum standard 
        deduction amount for dependents ($750 in 2003) and less 
        than 10 times that amount;
          (3) No estimated tax payments for the year were made 
        in the child's name and taxpayer identification number;
          (4) No backup withholding occurred; and
          (5) The child is required to file a return if the 
        parent does not make the election.
    Only the parent whose return must be used when calculating 
the kiddie tax may make the election. The parent includes in 
income the child's gross income in excess of twice the minimum 
standard deduction amount for dependents (i.e., the child's 
gross income in excess of $1,500 for 2003). This amount is 
taxed at the parent's rate. The parent also must report an 
additional tax liability equal to the lesser of: (1) $75 (in 
2003), or (2) 10 percent of the child's gross income exceeding 
the child's standard deduction ($750 in 2003).
    Including the child's income on the parent's return can 
affect the parent's deductions and credits that are based on 
adjusted gross income, as well as income-based phaseouts, 
limitations, and floors.\436\ In addition, certain deductions 
that the child would have been entitled to take on his or her 
own return are lost.\437\ Further, if the child received tax-
exempt interest from a private activity bond, that item is 
considered a tax preference of the parent for alternative 
minimum tax purposes.\438\
---------------------------------------------------------------------------
    \436\ Internal Revenue Service, Publication 929, Tax Rules for 
Children and Dependents, at 8 (2002).
    \437\ Internal Revenue Service, Publication 929, Tax Rules for 
Children and Dependents, at 7 (2002).
    \438\ Sec. 1(g)(7)(B).
---------------------------------------------------------------------------

Taxation of compensation for services under section 1(g)

    Compensation for a child's services is considered the gross 
income of the child, not the parent, even if the compensation 
is not received or retained by the child (e.g. is the parent's 
income under local law).\439\ If the child's income tax is not 
paid, however, an assessment against the child will be 
considered as also made against the parent to the extent the 
assessment is attributable to amounts received for the child's 
services.\440\
---------------------------------------------------------------------------
    \439\ Sec. 73(a).
    \440\ Sec. 6201(c).
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The ``kiddie tax'' was enacted to restrict the practice of 
high-income individuals transferring income-producing property 
to their children so that the income would be taxed at lower 
rates. The Committee believes that this rationale for applying 
the kiddie tax rules to children under 14 also applies to older 
children who have not yet attained the age of majority.

                        EXPLANATION OF PROVISION

    The provision increases the age of minors to which the 
kiddie tax provisions apply from under 14 to under 18.

                             EFFECTIVE DATE

    The provision is effective for taxable years beginning 
after December 31, 2003.

                     II. BUDGET EFFECTS OF THE BILL


                         A. Committee Estimates

    In compliance with paragraph 11(a) of Rule XXVI of the 
Standing Rules of the Senate, the following statement is made 
concerning the estimated budget effects of the revenue 
provisions of the ``Jumpstart Our Business Strength (JOBS) Act 
of 2003'' as reported.
    The bill, as reported, is estimated to have the following 
budget effects for fiscal years 2003-2013.

                               ESTIMATED BUDGET EFFECTS OF S. 1637, THE ``JUMPSTART OUR BUSINESS STRENGTH (`JOBS') ACT,'' AS REPORTED BY THE COMMITTEE ON FINANCE
                                                                        [Fiscal years 2004-2013, in millions of dollars]
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
            Provision                     Effective            2004       2005        2006        2007       2008       2009       2010       2011       2012       2013     2004-08    2004-13
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Provisions Relating to Repeal of
 Exclusion for Extraterritorial
 Income:
    1. Repeal of exclusion for                    toa DOE       3,710      4,780        5,093      5,312      5,508      5,727      5,993      6,258      6,518      6,789     24,403     55,688
     extraterritorial income \1\
    2. Deduction relating to                     tyea DOE        -378     -1,006       -2,022     -4,328     -5,431     -6,311     -8,241     -9,517    -10,762    -12,171    -13,165    -60,167
     income attributable to
     United States production
     activities.................
                                                           -------------------------------------------------------------------------------------------------------------------------------------
      Total of Provisions         ........................      3,332      3,774        3,071        984         77       -584     -2,248     -3,259     -4,244     -5,382     11,238     -4,479
       Relating to Repeal of
       Exclusion for
       Extraterritorial Income..
                                                           =====================================================================================================================================
General Transition for Repeal of                toa DOE &      -3,105     -3,234       -2,682       -765  .........  .........  .........  .........  .........  .........     -9,786     -9,786
 Exclusion for Extraterritorial               before 2007
 Income.........................
                                                           =====================================================================================================================================
International Tax Provisions:
    A. International Tax Reform.
        1. 20-year foreign tax                      (\2\)        -165       -214         -271       -338       -500       -686       -858       -995     -1,166     -1,363     -1,488     -6,556
         credit carryover; 1-
         year foreign tax credit
         carryback..............
        2. Apply look-through               tyba 12/31/02        -585        -77          -51        -23         -6         -1      (\3\)      (\3\)      (\3\)      (\3\)       -742       -743
         rules for dividends
         from noncontrolled
         section 902
         corporations...........
        3. Repeal the 90%                   tyba 12/31/04   .........       -236         -355       -338       -334       -333       -334       -338       -344       -352     -1,263     -2,964
         limitation on the use
         of foreign tax credits
         against the AMT........
        4. Recharacterize                If tyba 12/31/06   .........  .........  ...........        -57       -680       -713       -756       -793       -829       -862       -737     -4,690
         overall domestic loss..
        5. Interest expense                 tyba 12/31/08   .........  .........  ...........  .........  .........       -908     -2,487     -2,586     -2,689     -2,797  .........    -11,467
         allocation rules.......
        6. Determination of                 teia 12/31/04   .........         -4          -10        -10        -10        -10        -11        -11        -11        -11        -34        -88
         foreign personal
         holding company income
         with respect to
         transactions in
         commodities............
    B. International Tax
     Simplification.............
        1. Repeal of rules                          (\4\)   .........        -25          -65        -73        -81        -91       -102       -114       -128       -143       -244       -822
         applicable to foreign
         personal holding
         companies and foreign
         investment companies,
         personal holding
         company rules as they
         apply to foreign
         corporations, and
         include in subpart F
         personal service
         contract income, as
         defined under the
         foreign personal
         holding company rules..
        2. Expand the subpart F                     (\4\)   .........        -15         -143       -157       -173       -190       -209       -230       -253       -279       -488     -1,649
         de minimis rule to the
         lesser of 5% of gross
         income or $5 million...
        3. Attribution of stock                  tyba DOE      (\13\)         -1           -3         -3         -3         -3         -3         -3         -3         -3        -10        -25
         ownership through
         partnerships in
         determining section 902
         and 960 credits........
        4. Limit application of             tyba 12/31/04   .........       -125         -278        -79        -27         -8        -12        -14        -16        -18       -509       -577
         uniform capitalization
         rules in the case of
         foreign persons........
        5. Eliminate secondary               pma 12/31/04   .........         -2           -3         -3         -3         -3          -         -3          3         -3        -11        -26
         withholding tax with
         respect to dividends
         paid by certain foreign
         corporations...........
        6. Eliminate 30% tax on             tyba 11/31/03          -1         -2           -2         -2         -3         -3         -3         -3         -3         -3        -10        -25
         certain U.S.-source
         capital gains of
         nonresident individuals
    C. Additional International   ........................  .........  .........  ...........  .........  .........  .........  .........  .........  .........  .........  .........  .........
     Tax Provisions.............
        1. Subpart F exception                      (\5\)   .........  .........  ...........        -46       -187       -237       -289       -333       -382       -440       -233     -1,914
         for active aircraft and
         vessel leasing income..
        2. Look-through                             (\4\)   .........        -72         -203       -219       -239       -245       -272       -292       -314       -337       -733     -2,193
         treatment of payments
         between related CFCs
         under foreign personal
         holding company income
         rules..................
        3. Look-through                             (\4\)   .........        -39          -91        -96       -101       -106       -111       -116       -122       -129       -327       -911
         treatment under subpart
         F for sales of
         partnership interests..
        4. Election not to use              tyba 12/31/04                                                         Negligible Revenue Effect
         average exchange rate
         for foreign tax paid
         other than in
         functional currency....
        5. Revision of foreign                   tyea DOE          -4        -14          -15        -17        -19        -21        -24        -27        -30        -34        -69       -205
         tax credit rules with
         respect to ``base
         differences''..........
        6. Modification of                          (\4\)                                                         Negligible Revenue Effect
         exceptions under
         subpart F for active
         financing income.......
        7. United States                            (\4\)   .........         -3          -20        -21        -22        -23        -24         25        -27        -29        -66       -194
         property not to include
         certain assets of
         controlled foreign
         corporation............
        8. Provide equal                    tyba 12/31/03          -1         -2           -2         -2         -2         -2         -2         -2         -3         -3         -9        -21
         treatment for interest
         paid by foreign
         partnerships and
         foreign corporations
         doing business in the
         U.S....................
        9. Foreign tax credit                 atar 8/5/97         -22         -4           -5         -5         -5         -5         -5         -5         -5         -5        -41        -66
         treatment of deemed
         payments under section
         367(d).................
        10. Modify FIRPTA rules                  tyba DOE          -3         -5           -7        -10        -12        -14        -15        -17        -19        -21        -38       -124
         for REITs..............
        11. Temporary rate                          (\6\)       2,713        146       -2,511     -1,376       -903       -599       -413       -327       -288       -211     -1,931     -3,769
         deduction for certain
         dividends received from
         controlled foreign
         corporations...........
        12. Exclusion of certain                  wma DOE          -1         -2           -3         -3         -3         -3         -3         -3         -3         -3        -12        -26
         horse-racing and dog-
         racing gambling
         winnings from the
         income of nonresident
         alien individuals......
        13. Reduce withholding                    Dpa DOE          -2         -5           -7         -8         -9        -10        -10        -11        -12        -13        -31        -87
         tax applicable to
         dividends paid to
         Puerto Rico companies
         to 10%.................
        14. Require Commerce                          DOE                                                             No Revenue Effect
         Department report on
         adverse decisions of
         the World Trade
         Organization...........
        15. Study of impact of                        DOE                                                             No revenue Effect
         international tax law
         on taxpayers other than
         large corporations.....
        16. Consultative role                         DOE                                                             No revenue Effect
         for the Commerce on
         Finance in connection
         with the review of
         proposed tax treaties..
          Total of International  ........................      1,929       -701       -4,045     -2,886     -3,322     -4,214     -5,946     -6,248     -6,650     -7,059     -9,026    -39,142
           Tax Provisions.......
                                                           -------------------------------------------------------------------------------------------------------------------------------------
Interaction.....................  ........................         13         14           16         17         19         21        245        620        646        674         79      2,285
                                 ===============================================================================================================================================================
Domestic Manufacturing and
 Business Provisions:
    A General Provisions........
        1. Modifications to                       bia DOE          -3         -9          -16        -22        -29        -35        -42        -48        -54        -60        -78       -317
         qualified small issue
         bonds--increase capital
         expenditure limit from
         $10 to $20 million
         (maximum bond limit
         remains at $10 million)
        2. Expensing of                      eia 12/31/03        -157        -65           27         23         20         18         17         15         13         13       -151        -75
         investment in broadband
         equipment (sunset 12/31/
         04)....................
        3. Change the definition                 ppba DOE         -25        -50          -44        -32        -20         -7         -1         -1         -1         -1       -169       -181
         of ``production
         period'' with regard to
         natural aging process
         for distilled liquors
         for purposes of the
         capitalization rules
         under section 263A.....
        4. Section 355 ``active            general da DOE          -6         -7           -7         -7         -8         -8         -9         -9        -10        -11        -35        -82
         business test'' applied
         to chains of affiliated
         corporations...........
        5. Exclusion of certain                       (7)          -1         -1           -1         -1         -1         -1         -1         -1         -1         -1         -5        -11
         indebtedness of small
         business investment
         companies from
         acquisition
         indebtedness...........
        6. Modified taxation of         asbmpoia 12/31/02          -1         -1           -1         -1         -1         -1         -1         -1         -1         -1         -3         -7
         imported archery
         products...............
        7. Modify cooperative                    tyba DOE          -1         -3           -4         -5         -6         -7         -9        -10        -11        -13        -19        -69
         marketing to include
         value-added processing
         involving animals......
        8. Extend declaratory                     pfa DOE                                                   Revenue Effects Included in Line Above
         judgment relief to farm
         cooperatives...........
        9. Repeal personal                  tyba 12/31/03         -87       -164         -171       -174       -178        -81  .........  .........  .........  .........       -774       -855
         holding company tax
         (sunset 12/31/08)......
        10. Extend phaseout of              tyba 12/31/02         -99        -54          -47        -16          8          2         -2         -5         -8        -10       -208       -231
         section 179............
        11. 3-year carryback of                 tyei 2003      -9,438      1,956        1,599      1,210        749        538        380        274        179        115     -3,924     -2,437
         net operating losses
         and waive AMT 90%
         limitation on the
         allowance of losses
         (including losses
         carried forward into
         tax years ending in
         2003)..................
    B. Manufacturing Relating to
     Films......................
        1. Special rules for                      pca DOE        -112       -264         -348       -326       -231         -7        239        349        306        157     -1,281       -237
         certain film and
         television production
         (sunset taxable years
         beginning after 12/31/
         08)....................
        2. Modification of                      ppisa DOE        -157       -132          -86        -43        -27        -23        -25        -28        -31        -35       -445       -587
         application of the
         income forecast method
         of accounting..........
    C. Manufacturing Relating to
     Timber.....................
        1. Deduction of the                     epoia DOE         -21        -51          -39        -27        -14         -2          3          9         14         22       -152       -106
         first $10,000 of
         qualified reforestation
         costs..................
        2. Election to treat                          DOE          -1         -2           -4         -8        -11        -12        -16        -19        -21        -24        -26       -120
         cutting of timber as
         sale or exchange.......
        3. Permit capital gain                   sota DOE                                                         Negligible Revenue Effect
         treatment for outright
         sales of timber by
         landowner..............
        4. Modified safe-harbor                  tyba DOE         (8)        (8)           -1         -1         -2         -3         -3         -4         -4         -5         -4        -23
         rules for timber REITs.
                                                           -------------------------------------------------------------------------------------------------------------------------------------
          Total of Domestic       ........................    -10,109      1,153          857        570        249        371        530        521        370        146     -7,274     -5,338
           Manufacturing and
           Business Provisions..
                                                           =====================================================================================================================================
Addition Provisions:
    A. Provisions Designed to
     Curtail Tax Shelters.......
        1. Clarification of the                  teia DOE       1,031      1,242        1,163      1,049      1,086      1,200      1,335      1,517      1,729      1,970      5,571     13,322
         economic substance
         doctrine and related
         penalty provisions.....
        2. Provisions relating                        (9)          92        115          119        120        124        131        139        150        164        179        570      1,333
         to reportable
         transactions and tax
         shelters...............
        3. Modification to the                   tyba DOE   .........          4           11         19         23         26         30         34         38         38         57        223
         substantial
         understatement penalty.
        4. Impose a civil                             DOE        (10)       (10)         (10)       (10)       (10)       (10)       (10)       (10)       (10)       (10)          1          3
         penalty (of up to
         $5,000) on failure to
         report interest in
         foreign financial
         accounts...............
        5. Actions to enjoin                          DOE                                                         Negligible Revenue Effect
         conduct with respect to
         tax shelters...........
        6. Understatement of                      dpa DOE                                                         Negligible Revenue Effect
         taxpayer's liability by
         income tax return
         preparer...............
        7. Frivolous tax                           (\11\)   .........          3            3          3          3          3          3          3          3          3         15         30
         submissions............
        8. Regulation of                          ata DOE                                                             No Revenue Effect
         individuals practicing
         before the Department
         of Treasury............
        9. Extend statute of                       (\12\)   .........  .........            1          1          1          1          1          1          1          3          8
         limitations for
         undisclosed listed
         transactions...........
        10. Deny deduction for                   tyba DOE   .........  .........            1          1          3          4          4          4          4          4          5         25
         interest paid to the
         IRS on underpayments
         involving certain tax
         motivated transactions.
        11. Authorize additional                      DOE                                                             No Revenue Effect
         $300 million per year
         to the IRS to combat
         abusive tax avoidance
         transactions \13\......
    B. Other Corporate
     Governance Provisions......
        1. Affirmation of                          (\14\)                                                         Negligible Revenue Effect
         consolidated return
         regulation authority...
        2. Chief executive                        rfa DOE                                                         Negligible Revenue Effect
         officer required to
         sign declaration as
         part of corporate
         income tax return......
        3. Denial of deduction    generally apoia 4/27/03         101         10           10         10         10         10         10         10         10         10        141        191
         for certain fines,
         penalties, and other
         amounts................
        4. Denial of deduction                  dpoia DOE          36         29           30         31         32         33         34         35         36         37        160        333
         for punitive damages...
        5. Criminal tax fraud                uaoataoa DOE   .........  .........       (\10\)     (\10\)     (\10\)     (\10\)     (\10\)     (\10\)     (\10\)     (\10\)     (\10\)          5
         package................
    C. Enron-Related Tax Shelter
     Provisons..................
        1. Limitation on                       ta 2/13/03         128        123          136        149        164        180        198        218        240        264        700      1,800
         transfer or importation
         of built-in losses.....
        2. No reduction of basis               da 2/13/03           9         13           20         28         36         44         51         54         56         57        105        368
         under section 734 in
         stock held by
         partnership in
         corporate partner......
        3. Repeal of special                   on 2/13/03                                                         Negligible Revenue Effect
         rules for FASITs.......
        4. Expanded disallowance             diia 2/13/03           6         88           90         94         96         98        101        103        106        109        374        891
         of deduction for
         interest on convertible
         debt...................
        5. Expanded authority to               aa 2/13/03          10          9            9         10         10         11         11         12         12         13         48        108
         disallow tax benefits
         under section 269......
        6. Modification of CFC-                    (\15\)          23         15            8          4          5          6          8         10         12         15         55        106
         PFIC coordination rules
    D. Provisions to Discourage
     Expatriation...............
        1. Tax treatment of                        (\16\)         172        137          140        168        202        242        290        348        418        493        819      2,610
         inversion transactions.
        2. Impose mark-to-market                   (\17\)         101         84           80         74         71         67         61         57         54         51        410        700
         on individuals who
         expatriate.............
        3. Excise tax on stock          generally 7/11/02           8          6            6          6          6          7          7          7          7          7         32         68
         compensation of
         insiders in inverted
         corporations...........
        4. Reinsurance                        rra 4/11/02      (\10\)     (\10\)       (\10\)     (\10\)     (\10\)     (\10\)     (\10\)     (\10\)     (\10\)     (\10\)          2          5
         agreements.............
        5. Reporting of taxable                    aa DOE           1          2            3          3          3          3          3          3          3          3         12         27
         mergers and
         acquisitions...........
    E. International Tax........
        1. Clarification of                           DOE   .........          9           17         17         18         19         20         21         22         23         61        166
         banking business for
         determining investment
         of earnings in U.S.
         property...............
        2. Prohibition on                       doo/a DOE      (\10\)         13           15         17         19         21         23         25         27         29         64        189
         nonrecognition of gain
         through complete
         liquidation of holding
         company................
        3. Prevent mismatching                  pao/a DOE          12         41           84         79         33         35         37         39         41         43        249        444
         of deductions and
         income inclusions in
         transactions with
         related foreign persons
        4. Effectively connected                 tyba DOE           3          5            7          8          9         10         10         10         10         11         32         83
         income to include
         economic equivalents of
         certain categories of
         foreign-source income..
        5. Recapture of overall                    DA DOE      (\10\)          3            7          8          9          9          9         10         10         10         27         75
         foreign losses on sale
         of controlled foreign
         corporation stock......
        6. Minimum holding                 apoamt30da DOE      (\10\)          3            3          3          3          4          4          4          4          5         12         33
         period for foreign tax
         credit on withholding
         tax on income other
         than dividends.........
    F. Other Revenue Provisions.
        1. Treatment of stripped                padoa DOE           2         13           11          8          5          3     (\10\)     (\10\)     (\10\)     (\10\)         39         42
         bonds to apply to
         stripped interests in
         bond and preferred
         stock funds............
        2. Apply earnings-                     tybo/a DOE           3         18           21         22         25         27         29         31         33         35         89        244
         stripping rules to
         partnerships and S
         corporations...........
        3. Recognize                           coio/a DOE           3          4            4          4          4          5          5          5          5          6         19         45
         cancellation of
         indebtedness income
         realized on
         satisfaction of debt
         with partnership
         interest \18\..........
        4. Modification of the                  peo/a DOE           5         17           19         21         24         26         28         29         30         31         86        230
         straddle rules.........
        5. Deny installment sale                soo/a DOE          13         51           57          8         11         12         13         15         17         18        140        215
         treatment for all
         readily tradable debt..
        6. Modify treatment of                   to/a DOE      (\10\)          8            9         10         10         10         11         11         12         12         37         93
         transfers to creditors
         in divisive
         reorganizations........
        7. Clarify definition of               ta 5/14/03      (\10\)          5            8          8          8          8          8          8          7          7         29         67
         nonqualified preferred
         stock..................
        8. Definition of                         tyba DOE           3          6            5          4          3          2          2          2          1          1         21         29
         controlled group of
         corporations...........
        9. Mandatory basis                       tata DOE          15         40           59         73         83         88         91         93         96         99        270        737
         adjustment of
         partnership property in
         the case of partnership
         distributions and
         transfers of
         partnership interests
         except for transfers by
         reason of death........
        10. Extend present-law                    aoa DOE          13         61           94         68         36         23         21         19         22         24        272        381
         intangibles
         amortization provisions
         to acquisitions of
         sports franchises......
        11. Lease term to                    laosaeia DOE          14         26           41         57         74         92        110        129        150        171        212        864
         include certain service
         contracts..............
        12. Establish specific                  ppisa DOE           3         14           34         56         73         86         96        107        114        117        182        701
         class lives for utility
         grading costs..........
        13. Expansion of                        ppisa DOE          43         75           76         38        -46       -102        -57        -25         -3  .........        187  .........
         limitation on
         depreciation of certain
         passenger automobiles..
        14. Provide consistent                     (\19\)        -112        214          442        518        552        443        398        342        282        212      1,614      3,291
         amortization periods
         for intangibles........
        15. Limitation of tax                laosaeia DOE           8         16           25         34         44         55         66         78         90        103        127        519
         benefits for lease to
         certain tax exempt
         entities...............
        16. Clarification of                      toa DOE          51         37           10          3          3          3          3          4          4          5        104        123
         rules for payment of
         estimated tax for
         certain deemed asset
         sales..................
        17. Extension of IRS                      rma DOE   .........         25           35         36         38         39         41         42         44         45         93        345
         user fees (through 9/30/
         13) \13\...............
        18. Double certain                      oyo/a DOE           2          1            1     (\20\)     (\20\)     (\20\)     (\20\)     (\20\)     (\20\)     (\20\)          4          6
         penalties, fines, and
         interest on
         underpayments related
         to certain offshore
         financial arrangements.
        19. Authorize IRS to                  iaeio/a DOE          48         14            5     (\20\)     (\20\)     (\20\)     (\20\)     (\20\)     (\20\)     (\20\)         67         67
         enter into installment
         agreements that provide
         for partial payment....
        20. Extension of Customs
         User Fees..............
            a. Extend passenger                       DOE          75        314          329        346        363        381        400        420        441        464      1,427      3,534
             and conveyance
             processing fee
             through 9/30/13
             \13\...............
            b. Extend                                 DOE         544      1,151        1,216      1,286      1,359      1,436      1,518      1,605      1,696      1,793      5,556     13,605
             merchandise
             processing fee
             through 9/30/12
             \13\...............
        21. Deposits to stop the                  dma DOE         157         -5           -6         -6         -6         -6         -7         -7         -7         -7       -134        101
         running of interest on
         potential underpayments
        22. Private debt                              DOE   .........         70          129        131        116        106        106        106        106        106        445        973
         collection (net of
         outlays) \21\..........
        23. Add vaccines against                   (\23\)           6          9            9          9          9          9          9          9          9          9         42         87
         Hepatitis A to the list
         of taxable vaccines
         \22\...................
        24. Exclusion of like-                  sopra DOE      (\10\)         11           13         15         17         19         21         23         25         27         56        171
         kind exchange property
         from nonrecognition
         treatment on the sale
         or exchange of a
         principal residence....
        25. Modify qualification            tyba 12/31/03          49        107          120        126        131        137        142        148        154        160        534      1,273
         rules for tax-exempt
         property and casualty
         insurance companies and
         definition of insurance
         company................
        26. Provide that                      cma 10/1/03         236        356          366        377        389        400        412        425        438        451      1,725      3,851
         deductions for
         charitable
         contributions of
         patents or similar
         property may not exceed
         the donor's basis;
         provide that donor may
         receive a right to
         certain payments by the
         donee..................
        27. Repeal the 10%              eii tyba 12/31/03          54         74           79         89         97        106        116        123        134        144        390      1,013
         rehabilitation credit
         for non-historic
         buildings..............
        28. Increase age limit              tyba 12/31/03          34         88           97        109        117        120        123        139        168        185        445      1,180
         under section 1(g).....
                                                           -------------------------------------------------------------------------------------------------------------------------------------
          Total of Additional     ........................      3,007      4,774        5,271      5,352      5,505      5,692      6,094      6,556      7,075      7,593     23,871     56,933
           Provisions...........
                                                           =====================================================================================================================================
          Net Total.............  ........................     -4,933      5,780        2,488      3,272      2,528      1,286     -1,325     -1,810     -2,803     -4,028      9,102       473
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
\1\ Includes estimate for binding contract relief.
\2\ Effective for excess foreign taxes that may be carried forward to any taxable year ending after the date of enactment. Carryback period effective for credits arising in taxable years
  beginning after the date of enactment.
\3\ Loss of less than $1 million.
\4\ Effective for taxable years of foreign corporations beginning after December 31, 2004, and for taxable years of U.S. shareholders with or within which such taxable years of such foreign
  corporations end.
\5\ Effective for taxable years of foreign corporations beginning after December 31, 2006, and for taxable years of U.S. shareholders with or within which such taxable years of such foreign
  corporations end.
\6\ Effective for the first taxable year of an electing taxpayer ending 120 days or more after the date of enactment.
\7\ Effective for debt incurred by a small business investment company after December 31, 2003, with respect to property acquired after such date.
\8\ Loss of less than $500,000.
\9\ Effective dates for provisions relating to reportable transactions and tax shelters: the penalty for failure to disclose reportable transactions is effective for returns and statements the
  due date of which is after the date of enactment; the modification to the accuracy-related penalty for listed or reportable transactions is effective for taxable years ending after the date
  of enactment; the tax shelter exception to confidentiality privileges is effective for communications made on or after the date of enactment; the material advisor and investor list
  disclosure provisions applies to transactions with respect to which material aid, assistance or advice is provided after the date of enactment; the failure to register tax shelter penalty
  applies to returns the due date for which is after the date of enactment; the investor list penalty applies to requests made after the date of enactment; and the penalty on promoters of tax
  shelters is effective for activities after the date of enactment.
\10\ Gain of less than $1 million.
\11\ Effective for submissions made and issues raised after the first list is prescribed under section 6702(c).
\12\ Effective for taxable years with respect to which the period for assessing deficiencies did not expire before October 1, 2003.
\13\ Estimate is subject to review by the Congressional Budget Office.
\14\ Effective for all taxable years, whether beginning before, on, or after the date of enactment.
\15\ Effective for taxable years of foreign corporations beginning after February 13, 2003, and for taxable years of U.S. shareholders with or within which such taxable years of such foreign
  corporations end.
\16\ Effective for certain transactions completed after March 20, 2002, and would also affect certain taxpayers who completed transactions before March 21, 2002.
\17\ Generally effective for U.S. citizens who expatriate or long-term residents who terminate their residency on or after February 5, 2003.
\18\ Estimate is preliminary and subject to change pursuant to the receipt of additional information.
\19\ Generally effective for start-up and organizational expenditures incurred after the date of enactment.
\20\ Gain of less than $500,000.


                                            2004         2005         2006         2007         2008         2009         2010         2011         2012         2013      2004-08      2004-13
                                     -----------------------------------------------------------------------------------------------------------------------------------------------------------
  \21\ Breakout of Outlay effects     ...........         -22          -43          -43          -38          -34          -34          -34          -34          -34         -148        -323
 Net of Offsetting Receipts: Private
 sector debt collection.............

\22\ Estimate contains outlay effects that will be provided by the Congressional Budget Office.
\23\ Effective for vaccines sold and used beginning on the first day of the first month beginning more than four weeks after the date of enactment.

Legend for ``Effective'' column: aa = acquisitions after; aoa = acquisitions occurring after; apoamt30da = amounts paid or accrued more than 30 days after; apoia = amounts paid or incurred
  after; asbmpoia = articles sold by the manufacturer, producer, or importer after; ata = actions taken after; atar = amounts treated as received; bia = bonds issued after; cma = contributions
  made after; coio/a = cancellations of indebtedness on or after; da = distributions after; DA = dispositions after; diia = debt instrument issued after; dma = deposits made after; DOE = date
  of enactment; doo/a = distributions occurring on or after; dpa = documents prepared after; Dpa = dividends paid after; dpoia = damages paid or incurred after; eia = expenses incurred after;
  eii = expenses incurred in; epoia = expenditures paid or incurred after; iaeio/a = installment agreements entered into on or after; laosaeia = leases and other similar arrangements entered
  into after; lf = losses for; oyo/a = open years on or after; padoa = purchases and dispositions occurring after; pao/a = payments accrued on or after; pca = productions commencing after; peo/
  a = positions established on or after; pfa = pleadings filed after; pma = payments made after; ppba = production periods beginning after; ppisa = property placed in service after; rfa =
  returns filed after; rma = requests made after; rra = risk reinsured after; sota = sales of timber after; soo/a = sales occurring on or after; sopra = sales of principal residences after;
  tada = transfers and distributions after; ta = transactions after; teia = transactions entered into after; toa = transactions occurring after; to/a = transactions on or after; tyba = taxable
  years beginning after; tybo/a = taxable years beginning on or after; tyea = table years ending after; tyei = taxable years ending in; uaoataoa = underpayments and overpayments attributable
  to actions occurring after; and wma = wagers made after.

Note.--Details may not add to totals due to rounding.
Source: Joint Committee on Taxation.

                B. Budget Authority and Tax Expenditures


Budget authority

    In compliance with section 308(a)(1) of the Budget Act, the 
Committee states that the revenue provisions of the bill as 
reported involve new or increased budget authority with respect 
to section 418 of the bill, relating to the authorization of 
appropriations for tax law enforcement.

Tax expenditures

    In compliance with section 308(a)(2) of the Budget Act, the 
Committee states that the revenue-reducing provisions of the 
bill involve increased tax expenditures (see revenue table in 
Part III. A., above). The revenue increasing provisions of the 
bill involve reduced tax expenditures (see revenue table in 
Part II. A., above).

            C. Consultation with Congressional Budget Office

    In accordance with section 403 of the Budget Act, the 
Committee advises that the Congressional Budget Office 
submitted the following statement on this bill:

                                     U.S. Congress,
                               Congressional Budget Office,
                                  Washington, DC, November 6, 2003.
Hon. Charles E. Grassley,
Chairman, Committee on Finance,
U.S. Senate, Washington, DC.
    Dear Mr. Chairman: The Congressional Budget Office has 
prepared the enclosed cost estimate for S. 1637, the Jumpstart 
Our Business Strength (JOBS) Act.
    If you wish further details on this estimate, we will be 
pleased to provide them. The CBO staff contact is Annabelle 
Bartsch.
            Sincerely,
                                       Douglas Holtz-Eakin,
                                                          Director.
    Enclosure.

S. 1637--Jumpstart Our Business Strength (JOBS) Act

    Summary: S. 1637 would repeal the exclusion for 
extraterritorial income, allow a deduction for income 
attributable to U.S. production activities, and make numerous 
other changes to existing tax law for corporations. In 
addition, the bill would extend IRS and customs user fees. The 
tax provisions of the bill would generally take effect upon 
enactment of the legislation.
    The Congressional Budget Office (CBO) and the Joint 
Committee on Taxation (JCT) estimate the provisions of the bill 
would decrease federal revenues by about $5.6 billion in 2004. 
Enacting the bill would increase revenues by about $2.3 billion 
over the 2004-2008 period, but would decrease revenues by about 
$16.4 billion over the 2004-2013 period. CBO estimates that the 
bill would reduce direct spending by $614 million in 2004, 
about $6.8 billion over the 2004-2008 period, and about $16.7 
billion over the 2004-2013 period.
    JCT has determined that several tax provisions of S. 1637 
contain private-sector mandates as defined in the Unfunded 
Mandates Reform Act (UMRA). CBO has reviewed the non-tax 
provisions and determined that the extension of the customs 
user fees is a private-sector mandate as defined in UMRA. In 
aggregate, the costs of those mandates would greatly exceed the 
annual threshold established by UMRA for private-sector 
mandates ($120 million in 2004, adjusted annually for 
inflation) in each of the first five years the mandates are in 
effect. JCT and CBO have determined that S. 1637 contains no 
intergovernmental mandates as defined in UMRA, and would not 
affect the budgets of state, local, or tribal governments.
    Estimated cost to the Federal Government: The estimated 
budgetary impact of S. 1637 is shown in the following table. 
The costs of the legislation fall within budget functions 550 
(health), 750 (administration of justice), and 800 (general 
government).


--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                  By fiscal year, in millions of dollars--
                                                   -----------------------------------------------------------------------------------------------------
                                                      2004      2005      2006      2007      2008      2009      2010      2011       2012       2013
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                   CHANGES IN REVENUES
Repeal Exclusion for Extraterritorial Income and         605     1,546     2,411     4,547     5,508     5,727     5,993     6,258      6,518      6,789
 Provide Transition Relief........................
IRS Contracting for Tax Collections...............         0        92       172       174       154       140       140       140        140        140
Extend IRS User Fees..............................         0        25        35        36        38        39        41        42         44         45
Other Provisions Increasing Revenues..............     2,401     3,228     3,578     3,570     3,648     3,751     4,274     5,003      5,434      5,859
Modify Carryback Rules for Losses.................    -9,438     1,956     1,599     1,210       749       538       380       274        179        115
Reduce Tax Rate on Dividends from Controlled           2,713       146    -2,511    -1,376      -903      -599      -413      -327       -288       -211
 Foreign Corporations.............................
Allow a Deduction for Income: Attributable to U.S.      -378    -1,006    -2,022    -4,328    -5,431    -6,311    -8,241    -9,517    -10,762    -12,171
 Production Activities............................
Other Provisions Reducing Revenues................    -1,455    -1,650    -2,276    -2,150    -2,919    -3,782    -5,383    -5,674     -6,171     -6,817
                                                   -----------------------------------------------------------------------------------------------------
      Estimated Revenues..........................    -5,552     4,337       986     1,683       844      -497    -3,209    -3,801     -4,906     -6,251

                                                               CHANGES IN DIRECT SPENDING
Installment Agreements for Tax Payments:
    Estimated Budget Authority....................         1         *         *         0         0         0         0         0          0          0
    Estimated Outlays.............................         1         *         *         0         0         0         0         0          0          0
IRS Contracting for Tax Collections:
    Estimated Budget Authority....................         0        23        43        43        39        35        35        35         35         35
    Estimated Outlays.............................         0        23        43        43        39        35        35        35         35         35
Extension of Customs User Fees:
    Estimated Budget Authority....................      -619    -1,464    -1,546    -1,632    -1,722    -1,818    -1.919    -2,025     -2,137     -2,257
    Estimated Outlays.............................      -619    -1,464    -1,546    -1,632    -1,722    -1,818    -1,919    -2,025     -2,137     -2,257
Taxing Hepatitis A Vaccine:
    Estimated Budget Authority....................         5         7         7         7         7         7         7         7          7          7
    Estimated Outlays.............................         5         7         7         7         7         7         7         7          7          7
Total Changes:
    Estimated Budget Authority....................      -614    -1,434    -1,496    -1,582    -1,676     1,776    -1,877    -1,983     -2,096     -2,215
    Estimated Outlays.............................      -614    -1,434    -1,496    -1,582    -1,676     1,776    -1,877    -1,983     -2,096     -2,215

Tax Law Enforcement:
    Authorization Level...........................       300       300       300       300       300       300       300       300        300        300
    Estimated Outlays.............................       278       297       299       299       299       299       299       299        299        299
Extension of IRS User Fees:
    Estimated Authorization Level.................         0         3         4         4         4         4         4         4          4          5
    Estimated Outlays.............................         0         3         4         4         4         4         4         4          4          5
Total Changes:
    Estimated Authorization Level.................       300       303       304       304       304       304       304       304        304        305
    Estimated Outlays.............................       278       300       303       303       303       303       303       303        303       304
--------------------------------------------------------------------------------------------------------------------------------------------------------
Notes.--Postive (negative) changes in revenues correspond to decreases (increases) in budget deficits. Positive (negative) changes in direct spending
  correspond to increases (decreases) in budget deficits *= Increase of less than $500,000.
Sources: CBO and the Joint Committee on Taxation.

Basis of Estimate

            Revenues
    JCT provided all the revenue estimates, with the exception 
of the extension of IRS user fees. A little more than half of 
the provisions contained in S. 1637 that would affect federal 
revenues would increase receipts over the 2004-2013 period. The 
remaining provisions would reduce governmental receipts. On 
net, CBO and JCT estimate the provisions of the bill would 
decrease federal revenues by about $5.6 billion in 2004. 
Enacting the bill would increase revenues by about $2.3 billion 
over the 2004-2008 period and decrease revenues by about $16.4 
billion over the 2004-2013 period.
    The largest increase in revenues would come from repealing 
the exclusion for extraterritorial income (ETI). In conjunction 
with the repeal, the bill also would provide transition relief 
for certain corporations through January 1, 2007. JCT estimates 
enacting these provisions would increase federal revenues by 
$605 million in 2004, about $14.6 billion over the 2004-2008 
period, and about $45.9 billion over the 2004-2013 period.
    The bill also would allow the IRS to enter into qualified 
tax collection contracts with private collection agencies 
(PCAs) to collect delinquent tax liabilities. Such agents would 
be given specific, limited information regarding a taxpayer's 
outstanding tax liability. JCT estimates this provision would 
result in an increase in revenues of $592 million over the 
2005-2008 period and about $1.3 billion over the 2005-2013 
period.
    In addition, S. 1637 would make many other changes to tax 
law that would raise revenues over the 2004-2013 period. Some 
of these changes include:
           Clarifying the economic substance doctrine 
        and other related penalty provisions;
           Altering the tax treatment of tax shelters;
           Providing consistent amortization periods 
        for intangibles;
           Repealing the 10 percent rehabilitation 
        credit for non-historic buildings;
           Modifying rules relating to deductions for 
        charitable contributions of patents and other similar 
        property;
           Adding Hepatitis A to the list of taxable 
        vaccines; and
           Allowing the IRS to enter into installment 
        agreements for certain tax payments.
    All together, JCT estimates that the additional revenue-
raising provisions would increase governmental receipts by 
about $2.4 billion in 2004, $16.4 billion over the 2004-2008 
period, and $40.7 billion over the 2004-2013 period. This total 
does not include extending IRS user fees, which currently are 
set to expire on December 31, 2004. The bill would extend the 
fees through September 30, 2013. CBO estimates this would 
increase revenues by $135 million over the 2005-2008 period and 
$345 million over the 2005-2013 period. In addition, the 
provisions adding Hepatitis A to the list of taxable vaccines, 
allowing the IRS to contract with private debt collectors, and 
authorizing the IRS to enter into installment agreements all 
would affect direct spending (see ``Direct Spending'' section).
    Two provisions would increase receipts in some years but 
decrease receipts over the 2004-2013 period. JCT estimates that 
changing tax law relating to the carryback of net operating 
losses would reduce revenues by about $9.4 billion in 2004, and 
then increase revenues by about $7 billion over the 2005-2013 
period. JCT estimates that temporarily reducing the tax rate 
for certain dividends from controlled foreign corporations 
would increase receipts by about $2.9 billion over the 2004-
2005 period, and then decrease receipts by about $6.6 billion 
over the 2006-2013 period.
    The largest reduction in revenues would come from allowing 
firms to deduct a portion of income attributable to certain 
production activities within the United States. The deduction 
would be phased in over five years. JCT estimates that this 
provision would reducegovernmental receipts by $378 million in 
2004, about $13.2 billion over the 2004-2008 period, and about $60.2 
billion over the 2004-2013 period.
    JCT estimates that, together, the remaining revenue-
reducing provisions contained in S. 1637 would decrease 
governmental receipts by about $1.5 billion in 2004, $10.4 
billion over the 2004-2008 period, and $38.3 billion over the 
2004-2013 period. These other provisions include modifying 
interest expense allocation rules used in computing the foreign 
tax credit limitation and altering the existing manufacturing 
deduction to include softwood timber, oil refining, 
partnerships and sole proprietors, and possessions.
            Direct spending
    In total, CBO estimates that the bill would decrease direct 
spending by $614 million 2004, about $6.8 billion over the 
2004-2008 period, and about $16.7 billion over the 2004-2013 
period.
    Installment Agreements for Tax Payments. Section 484 would 
allow the IRS to enter into agreements for the partial payment 
of tax liabilities. Under current law, taxpayers can elect to 
pay their full tax liability through installments. The IRS 
charges a fee of $43 for each installment agreement, which it 
can retain and spend without further appropriation action. CBO 
estimates that allowing for the partial payment of tax 
liabilities would increase direct spending by about $1 million 
over the 2004-2013 period.
    IRS Contracting for Tax Collections. As discussed in the 
Revenues section, section 487 would allow the IRS to contract 
with PCAs for the partial payment of tax liabilities. The IRS 
would be allowed to retain and spend up to 25 percent of the 
amount collected by the PCAs for the cost of services provided 
under the contracts. CBO estimates that allowing the IRS to 
retain and spend 25 percent of the amounts collected would 
increase direct spending by about $323 million over the 2004-
2013 period.
    Extension of Customs User Fees. Under current law, customs 
user fees expire on March 31, 2004. Section 485 of S. 1637 
would extend these fees through September 30, 2013. CBO 
estimates that would increase offsetting receipts by about $17 
billion over the 2004-2013 period.
    Taxation of Hepatitis A Vaccine. The Hepatitis A vaccine 
tax provision (section 491) would require vaccine buyers to pay 
an excise tax on each dose purchased. Medicaid is a major 
purchaser of vaccines through the Vaccines for Children 
program, administered through the Centers for Disease Control 
and Prevention (CDC). CBO assumes that Medicaid purchases 
approximately half of the Hepatitis A vaccines sold annually. 
Basedon estimates provided by JCT, CBO expects that 
implementing section 491 would cost the Medicaid program about $47 
million over the 2004-2013 period.
    Receipts from the tax would go to the Vaccine Injury 
Compensation Fund (VICF), which is administered by the Health 
Resources and Services Administration (HRSA). The fund uses tax 
revenues to pay compensation to claimants injured by vaccines. 
Once a vaccine becomes taxable, injuries attributed to its use 
become compensable through this fund. Based on information 
provided by HRSA and CDC, we assume there will be a few 
compensable claims related to the Hepatitis A vaccine. CBO 
estimates the provision would increase outlays from the VICF by 
$21 million over the 2004-2013 period.
            Spending subject to appropriation
    CBO estimates that implementing H.R. 2896 would cost about 
$1.5 billion over the 2004-2008 period and $3 billion over the 
2004-2013 period, subject to the appropriation of the estimated 
amounts.
    Tax Law Enforcement. Section 418 would authorize the 
appropriation of $300 million annually for tax law enforcement 
activities to combat tax avoidance transactions, including tax 
shelters and offshore accounts. Assuming the appropriation of 
the specified amounts CBO estimates that implementing this 
provision would cost $278 million in 2004 and about $3 billion 
over the 2004-2013 period.
    Extension of IRS User Fees. Section 482 would extend the 
authority of the IRS to charge taxpayers fees for certain 
rulings, opinion letters, and determinations through September 
30, 2013. The bill would authorize the IRS to retain and spend 
a portion of the fees collected, subject to appropriation. 
Based on the historical level of fees spent, CBO estimates that 
implementing this provision would cost $15 million over the 
2005-2008 period and $36 million over the 2005-2013 period, 
subject to the appropriation of the necessary amounts.
    Estimated impact on state, local, and tribal governments: 
JCT and CBO have reviewed the provisions of S. 1637 and have 
determined that the bill contains no intergovernmental mandates 
as defined in UMRA and would not affect the budgets of state, 
local, or tribal governments.
    Estimated impact on the private sector: JCT has determined 
that several tax provisions of S. 1637 contain private-sector 
mandates as defined in UMRA. Those are the provisions which:
          1. Repeal the exclusion for extraterritorial income;
          2. Alter tax law relating to tax shelters;
          3. Alter the limitation on transfer or importation of 
        built-in losses;
          4. Modify the tax treatment of inversion 
        transactions;
          5. Expand the lease term to include certain service 
        contracts;
          6. Provide special rules for certain film and 
        television productions;
          7. Modify the qualification rules for tax-exempt 
        property and casualty insurance companies;
          8. Alter the tax treatment of charitable 
        contributions of patents or similar property;
          9. Establish specific class lives for utility grading 
        costs;
          10. Repeal the rehabilitation credit in the case of 
        non-historic buildings;
          11. Increase the age limit regarding the taxation of 
        certain minors; and
          12. Provide consistent amortization periods for 
        intangibles.
    In aggregate, the costs of those mandates would greatly 
exceed the annual threshold established by UMRA for private-
sector mandates ($120 million in 2004, adjusted annually for 
inflation) in each of the first five years the mandates are in 
effect.
    CBO has reviewed the non-tax provisions of S. 1637 and 
determined that the extension of the customs user fees is a 
private-sector mandate as defined in UMRA. S. 1637 would extend 
through 2013 customs user fees that are scheduled to expire at 
the end of March 2004 under current law. CBO cannot determine 
the direct cost of this provision, however, because UMRA does 
not clearly specify how to calculate the cost associated with 
extending an existing mandate that has not yet expired. Under 
one interpretation, UMRA requires the direct cost to be 
measured relative to a case that assumes that the current 
mandate will not exist beyond its current expiration date. 
Under that interpretation, CBO estimates that the direct cost 
of the mandate would be more than $600 million in 2004 and 
larger in later years. Under the other interpretation, UMRA 
requires the direct cost to be measured relative to the mandate 
currently in effect. Under that interpretation, the direct cost 
of this provision would be zero.
    Previous CBO estimate: On November 5, 2003, CBO transmitted 
a cost estimate for H.R. 2896, the American Jobs Creation Act 
of 2003, as ordered reported by the House Committee on Ways and 
Means on October 28, 2003. CBO estimated that enacting H.R. 
2896 would decrease federal revenues by about $76.6 billion and 
direct spending by about $17.1 billion over the 2004-2013 
period. By comparison, CBO estimates that enacting S. 1637 
would decrease revenues by about $16.4 billion and direct 
spending by about $16.7 billion over the same period. Both 
bills would repeal the exclusion for extraterritorial income 
and provide some transition relief to corporations; however, 
H.R. 2896 would reduce the tax rate on certain corporate 
income, while S. 1637 would provide corporations with a 
deduction for certain U.S. production activity. Many of the 
other provisions of the bills also differ, and our cost 
estimates reflect those differences.
    Estimate prepared by: Federal Revenues: Annabelle Bartsch. 
Federal Spending: Installment Agreements and Private Debt 
Collection: Matthew Pickford; Extension of Customs User Fees: 
Mark Grabowicz; and Hepatitis A Vaccine: Tom Bradley. Impact on 
State, Local, and Tribal Governments: Melissa Merrell. Impact 
on the Private Sector: Patrice Gordon and Paige Piper/Bach.
    Estimate approved by: G. Thomas Woodward, Assistant 
Director for Tax Analysis; and Peter H. Fontaine, Deputy 
Assistant Director for Budget Analysis.

                      III. VOTES OF THE COMMITTEE

    In compliance with paragraph 7(b) of Rule XXVI of the 
standing rules of the Senate, the following statements are made 
concerning the roll call votes in the Committee's consideration 
of the ``Jumpstart Our Business Strength (JOBS) Act of 2003.''

Motion to report the bill

    An original bill, the ``Jumpstart our Business Strength 
Act,'' was ordered favorably reported, by a roll call vote on 
October 1, 2003:
          Ayes: Grassley, Hatch, Lott, Snowe, Thomas, Santorum, 
        Frist, Smith, Bunning (proxy), Baucus, Rockefeller, 
        Daschle, Breaux, Conrad, Graham (proxy), Jeffords 
        (proxy), Bingaman, Kerry (proxy), Lincoln.
          Nays: Nickles, Kyl.

Votes on other amendments

    The Committee rejected an amendment by Senator Breaux to 
add certain anti-abuse measures to the provision related to the 
repatriation of foreign earnings, by roll call vote.
          Ayes: Baucus (proxy), Rockefeller, Daschle (Proxy), 
        Breaux, Conrad (proxy), Graham (proxy), Jeffords 
        (proxy), Bingaman (proxy), Kerry (proxy), Lincoln.
          Nays: Grassley, Hatch (proxy), Nickles, Lott, Snowe, 
        Kyl, Thomas (proxy), Santorum, Frist (proxy), Smith, 
        Bunning.
    The Committee accepted an amendment by Senator Santorum to 
lower the U.S. withholding tax rate on dividends paid to a 
corporation created or organized in Puerto Rico from 30 percent 
to 10 percent.

                IV. REGULATORY IMPACT AND OTHER MATTERS


                          A. Regulatory Impact

    Pursuant to paragraph 11(b) of Rule XXVI of the Standing 
Rules of the Senate, the Committee makes the following 
statement concerning the regulatory impact that might be 
incurred in carrying out the provisions of the bill as 
reported.

Impact on individuals and businesses

    With respect to individuals and businesses, Title I of the 
bill repeals the present-law extraterritorial income regime. 
The repeal of this regime may increase the tax burden on 
domestic manufacturers. Title I also provides a deduction 
relating to income attributable to U.S. qualified production 
activities. This new deduction is available to partnerships, S 
corporations, and sole proprietorships. The provision may 
decrease the tax burden for businesses that have qualified 
production activities, but it will also increase administrative 
and compliance burdens by requiring businesses to keep detailed 
records in order to qualify for the provision.
    Title II of the bill reforms and simplifies the 
international tax rules related to the U.S. taxation of foreign 
source income. These modifications relate principally to the 
foreign tax credit and certain U.S. anti-deferral regimes, and 
tend to reduce the burden on taxpayers subject to these rules. 
Taxpayers that do not have operations overseas generally are 
not affected by these provisions of the bill.
    Title III of the bill contains provisions related to 
domestic manufacturing and general business operations. These 
provisions include the exclusion of certain indebtedness for 
small businesses investment companies, the repeal of the 
personal holding company tax, an increase in section 179 
expensing, the extension of the carryback period for net 
operating losses, and the modification of certain rules related 
to the film industry, the timber industry, and cooperatives. 
These rules, both individually and collectively, will reduce 
the tax burden on businesses.
    Title IV of the bill contains provisions to curtail tax 
shelters, including provisions arising from the investigative 
report by the staff of the Joint Committee on Taxation relating 
to Enron Corporation undertaken at the request of the 
Committee, corporate governance provisions, and provisions to 
address expatriation by corporations and individuals. In 
general, these provisions will have an impact on taxpayers that 
engage in certain tax avoidance transactions. Taxpayers that 
have not undertaken or planned to undertake such transactions 
generally are not affected by these provisions of the bill. 
Title IV of the bill also contains a variety of provisions that 
are generally designed to result in a better measurement of 
income.

Impact on personal privacy and paperwork

    The provisions of the bill do not impact personal privacy. 
Individuals will have to keep additional records in order to 
demonstrate that they qualify for certain tax benefits provided 
by the bill.

                     B. Unfunded Mandates Statement

    This information is provided in accordance with section 423 
of the Unfunded Mandates Reform Act of 1995 (Pub.L.No. 104-4).
    The Committee has determined that the following provisions 
of the bill contain Federal private sector mandates within the 
meaning of Public Law 104-4, the Unfunded Mandates Reform Act 
of 1995: (1) the provision relating to the repeal of the 
exclusion for extraterritorial income; (2) the provisions 
designed to curtail tax shelters; (3) the provision relating to 
the limitation on transfer or importation of built-in losses; 
(4) the provision relating to the tax treatment of inversion 
transactions; (5) the provision to expand the lease term to 
include certain service contracts; (6) the provision relating 
to special rules for certain film and television productions; 
(7) the provision to modify the qualification rules for tax-
exempt property and casualty insurance companies; (8) the 
provision relating to the tax treatment of charitable 
contributions of patents or similar property; (9) the provision 
to establish specific class lives for utility grading costs; 
(10) the provision to repeal the rehabilitation credit in the 
case of non-historic buildings; (11) the provision relating to 
the increase in the age limit regarding the taxation of certain 
minors; and (12) the provision to provide consistent 
amortization periods for intangibles.
    The costs required to comply with each Federal private 
sector mandate generally are no greater than the aggregate 
estimated budget effects of the provision. Benefits from the 
provisions include improved administration of the tax laws and 
a more accurate measurement of income for Federal income tax 
purposes.
    The tax provisions in the reported bill contain no 
intergovernmental mandates within the meaning of Public Law 
104-4, the Unfunded Mandates Reform Act of 1995.

                       C. Tax Complexity Analysis

    The following tax complexity analysis is provided pursuant 
to section 4022(b) of the Internal Revenue Service Reform and 
Restructuring Act of 1998, which requires the staff of the 
Joint Committee on Taxation (in consultation with the Internal 
Revenue Service (``IRS'') and the Treasury Department) to 
provide a complexity analysis of tax legislation reported by 
the House Committee on Ways and Means, the Senate Committee on 
Finance, or a Conference Report containing tax provisions. The 
complexity analysis is required to report on the complexity and 
administrative issues raised by provisions that directly or 
indirectly amend the Internal Revenue Code and that have 
widespread applicability to individuals or small businesses. 
For each such provision identified by the staff of the Joint 
Committee on Taxation, a summary description of the provision 
is provided along with an estimate of the number and type of 
affected taxpayers, and a discussion regarding the relevant 
complexity and administrative issues.
    Following the analysis of the staff of the Joint Committee 
on Taxation are the comments of the IRS and the Treasury 
Department regarding each of the provisions included in the 
complexity analysis, including a discussion of the likely 
effect on IRS forms and any expected impact on the IRS.

1. Deduction relating to income attributable to United States 
        production activities (sec. 102 of the bill)

Summary description of provision

    The bill provides a deduction attributable to the income 
from certain qualified production activities of a C 
corporation, S corporation, partnership or sole proprietorship. 
The term ``qualified production activities'' generally includes 
manufacturing, production, growth or extraction of certain 
tangible personal property, computer software, and property 
described in section 168(f)(3) or (4) of the Code.
    The amount of the deduction in taxable years beginning in 
2003, 2004, 2005, 2006, 2007, 2008, and 2009 and thereafter 
generally is one, one, two, three, six, six, and nine percent, 
respectively, of the income from qualified production 
activities. The deduction is limited for a taxable year to 50 
percent of the wages paid by the taxpayer during such taxable 
year. In addition, the deduction cannot exceed the lesser of 
the taxpayer's taxable income (computed without regard to the 
deduction) or the taxpayer's qualified production activities 
income.
    For purposes of determining the deduction, income from 
qualified production activities is reduced by virtue of a 
fraction, the numerator of which is the value of the domestic 
production of the taxpayer and the denominator of which is the 
value of the worldwide production of the taxpayer (the 
``domestic/worldwide fraction''). For taxable years beginning 
in 2010, 2011, and 2012, the reduction in qualified production 
activities income by virtue of this fraction is reduced by 25, 
50, and 75 percent, respectively. For taxable years beginning 
after 2012, there is no reduction in qualified production 
activities income by virtue of this fraction.
    The bill is effective for taxable years ending after the 
date of enactment.

Number of affected taxpayers

    It is estimated that the provision will affect more than 10 
percent of small businesses.

Discussion

    It is anticipated that small businesses engaged in 
qualified production activities will need to keep additional 
records due to this provision, and that extensive additional 
regulatory guidance will be necessary to effectively implement 
the provision. It is anticipated that the provision will result 
in an increase in disputes between small businesses and the 
IRS. Reasons for such disputes include the complexity of the 
provision and the inherent incentive for small businesses and 
other taxpayers to characterize their activities as qualified 
production activities to claim the deduction under the 
provision.
    The provision likely will increase the tax preparation 
costs for most small businesses that are, or may be, engaged in 
qualified production activities. Small businesses will have to 
perform additional analysis and make subjective determinations 
concerning whether their activities constitute qualified 
production activities and, thus, whether income attributable to 
such activities qualifies for the deduction allowed under the 
provision. In this regard, the provision does not provide 
detailed definitions of the activities that produce income 
eligible for the deduction, and itwill be difficult for the 
Treasury Secretary to define qualified production activities 
administratively. It should be noted that a similar provision in the 
Canadian tax laws was found to be highly complex and difficult to 
administer, which led to numerous disputes and litigation between 
affected taxpayers and the Canadian tax authorities. Canada recently 
repealed the provision and provided a general reduction in corporate 
tax rates.
    For income that is determined to be eligible for the 
deduction under the provision, small businesses will be 
required to perform additional and complex calculations to 
determine the amount of the deduction under the provision. 
Because the deduction is based upon modified taxable income 
rather than gross income, small businesses will be required to 
undertake complicated calculations to determine the amount of 
costs that are allocable to gross income from qualified 
production activities. In many cases, small businesses would 
not have been required otherwise to perform these calculations 
but for the provision.
    The wage limitation on the deduction is likely to impact 
small businesses disproportionately. After undertaking the 
calculations and analyses to determine the amount of their 
potential deduction, many small business will find that such 
amount is significantly reduced, or eliminated altogether, by 
the wage limitation.
    Under the provision, it may be necessary for small 
businesses to make certain allocations of income that are not 
required under present law, particularly with respect to 
businesses that have both income that is directly attributable 
to qualified production activities and income that is 
attributable to processes associated with qualified production 
activities (e.g., vertically integrated manufacturers that also 
engage in the selling, storage, and installation of 
manufactured goods). To the extent the deduction under the 
provision is not based upon income from processes associated 
with qualified production activities, taxpayers that engage in 
such processes will be required to allocate their aggregate 
income between qualified production activities and processes 
associated with qualified production activities. In general, it 
is expected that the multiple calculations and analyses 
required by this provision will lead to intentional or 
inadvertent noncompliance among small businesses, as well as 
other taxpayers.
    Due to the detailed calculations required by the provision, 
it is anticipated that the Secretary of the Treasury will have 
to make appropriate revisions to several types of income tax 
forms, schedules, spreadsheets and instructions.

                        Department of the Treasury,
                                  Internal Revenue Service,
                                                    Washington, DC.
Mr. George K. Yin,
Chief of Staff, Joint Committee on Taxation,
Washington, DC.
    Dear Mr. Yin: Enclosed are the combined comments of the 
Internal Revenue Service and the Treasury Department on the new 
deduction for U.S. production activities in the Senate Finance 
Committee markup of S. 1637, the ``Jumpstart Our Business 
Strength Act,'' that you identified for complexity analysis in 
your letter of October 8, 2003. Our comments are based solely 
on the description of that provision provided in your letter.
    Due to the short turnaround time, our comments are 
provisional and subject to change upon a more complete and in-
depth analysis of the provision.
            Sincerely,
                                           Mark W. Everson,
                                                      Commissioner.
    Enclosure.

   Complexity Analysis of Provision From S. 1367, the Jumpstart Our 
                      Business Strength (JOBS) Act


DEDUCTION RELATING TO INCOME ATTRIBUTABLE TO U.S. PRODUCTION ACTIVITIES

Provision

    The provision provides a deduction attributable to income 
from certain production activities. The amount of the deduction 
in taxable years beginning in 2004, 2005, 2006, 2007 and 2008, 
and 2009 and thereafter is one, two, three, six, and nine 
percent of the income for these activities, respectively. The 
deduction for any taxable year is limited to 50 percent of the 
wages paid by the taxpayer during such taxable year.
    For purposes of determining the deduction, qualified 
production activities income is reduced by virtue of a 
fraction, the numerator of which is the value of the domestic 
production of the taxpayer and the denominator of which is the 
value of the worldwide production of the taxpayer (the 
``domestic/worldwide fraction''). For taxable years beginning 
before 2010, the reduction in qualified production activities 
income by virtue of the domestic/worldwide fraction is 100 
percent. For taxable years beginning in 2010, 2011, and 2012, 
the reduction in qualified production activities income by 
virtue of this fraction is 75, 50, and 25 percent, 
respectively. For taxable years beginning after 2012, there is 
no reduction in qualified production activities income by 
virtue of this fraction.
    The provision is effective for taxable years ending after 
the date of enactment. (Because the above description provides 
no deduction percentage for taxable years beginning before 
2004, our comments are based on the assumption that the 
percentage is zero for 2003 and the provision could not be 
effective before 2004.)

IRS and Treasury Comments

            Administration, compliance and controversy
     The new deduction for domestic production 
activities will require the promulgation of extensive, detailed 
new guidance, particularly in the form of regulations. We 
anticipate that guidance will be required to address:
           Which activities constitute production 
        activities;
           The statutory exceptions to the definition 
        of production activity;
           The allocation of revenues between 
        production and non-production activities;
           The allocation of deductions between 
        production and non-production activities;
           The application of the limitation based on 
        worldwide production activities including the 
        allocation of revenues and expenses between domestic 
        and worldwide production activities;
           The application of the provisions when 
        related and unrelated taxpayers perform parts of the 
        production activity; and
           Numerous other issues.
     We expect that such guidance will be difficult to 
craft. By distinguishing ``production'' from other activities, 
the provision places considerable tension on defining terms and 
designing anti-abuse rules.
     Many businesses, particularly small businesses, 
will find it difficult to understand and comply with these 
complex new rules, which will affect not only the computation 
of a taxpayer's regular tax liability but also its alternative 
minimum tax liability. It will be difficult, if not impossible, 
for the IRS to craft simplified provisions tailored to small 
business or other taxpayers.
     Taxpayers will be required to devote substantial 
additional resources to meeting their tax responsibilities, 
including not only employees and outside tax advisers, but also 
recordkeeping and systems modification resources. The resulting 
costs will reduce significantly the benefits of the proposal. 
Some small businesses may find that the additional costs 
outweigh the benefits, particularly during the initial phase-in 
period.
     It will be necessary to devote significant audit 
resources to administering the new deduction. This will be due 
not only to the novelty of the rule but also to the benefits 
that are provided to ``production activities'' over other 
aspects of a taxpayer's business. Taxpayers naturally will 
classify everything possible as production activities. Audits, 
particularly those involving integrated businesses, will have 
to focus on classification and the allocation of income and 
costs. Significant additional IRS resources will be needed to 
administer the provision to avoid diverting resources from 
other compliance issues (such as tax shelters).
     Finally, for all of the reasons discussed above, 
we anticipate a significant increase in controversies between 
taxpayers and the IRS. This will increase the number of IRS 
appeals cases and litigated tax cases.
            Tax forms and publications
     In addition to the substantive issues noted above, 
compliance with the provision will require new forms and 
instructions to be developed by the IRS and used by taxpayers.
     The computation of the deduction relating to 
income attributable to United States Production Activities 
would most likely be figured on a new form of at least 10 
lines. The instructions for the new form would likely be at 
least 3 pages.
     Two additional lines would have to be added to 
each 2004 form or schedule on which the deduction figured on 
the new form could be claimed. The deduction would be claimed 
on the following forms and schedules, among others
          1. Schedule C (Form 1040) (sole proprietors).
          2. Schedule F (Form 1040) (farm businesses).
          3. Schedule E (Form 1040) (rental businesses).
          4. Form 1041 (estates and trusts).
          5. Form 1065 (partnerships).
          6. Form 1065-B (electing large partnerships).
          7. Form 1120 (corporations).
          8. Form 1120-A (short tax return for corporations).
          9. Form 1120-L (life insurance companies).
          10. Form 1120-PC (property and casualty insurance 
        companies).
          11. Other Form 1120 series returns.
          12. Form 1120S (S corporations).
     The instructions for all affected forms and 
schedules listed above would have to be revised to reflect the 
new deduction, adding one-half to one full page of instructions 
to each form and schedule listed above.
     The tax forms and publications for years after 
2004 would have to be updated to reflect the increasing 
percentage of qualified activities production income and the 
decreasing percentage of domestic/worldwide fraction taken into 
account until the provision is fully phased in 2013.
     Programming changes will be required to reflect 
the new 10 line form, the two additional lines on the above 
forms and schedules, and the changing percentages. Currently, 
the IRS tax computation programs are updated annually to 
incorporate mandated inflation adjustments. Any programming 
changes necessitated by the provision would be included during 
that process.
     The following 2004 publications, among others, 
would have to be revised to cover the new deduction, adding 3 
to 6 pages to each.
          1. Publication 541 (corporations).
          2. Publication 542 (partnerships).
          3. Publication 535 (business expenses--primarily 
        individuals).
          4. Publication 225 (farmers).
          5. Publication 334 (small business tax guide).
     Training materials and Internal Revenue Manuals 
will have to be revised to reflect the new deduction.

                   ADDITIONAL VIEWS OF SENATOR SMITH

    I write as a strong supporter of S. 1637--a balanced and 
bipartisan effort championed by Chairman Chuck Grassley. I do 
believe that his efforts on this bill will help most domestic 
manufacturers in the United States. I will continue to support 
the bill with the following reservation:
    The centerpiece of the JOBS Act is a benefit for 
manufacturers that has the effect of reducing the rate on 
manufacturing income over time by 3 percentage points.
    This rate cut, however, is not applied equally to all U.S. 
manufacturers. This bill includes a provision--a ``haircut''--
that provides less of a benefit to companies that ALSO 
manufacture abroad. For example, a company that has 55% of its 
manufacturing in the U.S. and 45% abroad will calculate its 
benefit under the bill and then reduce that benefit by a 
fraction--the numerator of which is the gross receipts from 
domestic manufacturing over the same derived from worldwide 
manufacturing.
    This company suffers twice. First, the manufacturing 
benefit in S. 1637 is less than the benefit currently provided 
under FSC/ETI. Secondly, this company's manufacturing benefit 
is further reduced by the ``haircut'' merely because it also 
has overseas manufacturing operations.
    While the Finance Committee passed the bill with this 
``haircut'' to save revenue, I and many of my colleagues would 
like to find a way to completely eliminate it for the following 
reasons:
     The ``haircut'' treats U.S. jobs created by 
multinational companies as ``less worthy'' than U.S. jobs 
created by strictly domestic manufacturers. Congress should be 
in the business of rewarding all well-paid, manufacturing jobs 
that are created in the U.S.--not just those created by 
strictly domestic manufacturers.
     The ``haircut'' makes the U.S. a less competitive 
location for current and future investment because 
multinational companies will believe they are being ``cheated'' 
and discriminated against.
     The ``haircut'' is inconsistent with historic tax 
and trade policies to encourage U.S. companies to open up 
facilities outside the U.S. In fact, there is an entire 
Department--the Department of Commerce--set up to assist U.S. 
companies going global and then to promote and facilitate those 
same companies' efforts once they have established themselves 
in-country.
     The ``haircut'' invites mirror legislation in 
other countries.
     The ``haircut'' could invite another WTO challenge 
to this legislation.

                                                      Gordon Smith.

       MINORITY VIEWS OF SENATOR DON NICKLES AND SENATOR JON KYL

    We respectfully file our dissenting views to the Jumpstart 
Our Business Strength (JOBS) Act, which was approved by the 
Senate Finance Committee on October 1, 2003. We appreciate the 
hard work of the chairman and the committee staff on this 
legislation to bring our tax laws into compliance with our 
World Trade Organization obligations and to address economic 
concerns of U.S. domestic manufacturers. Unfortunately, the 
committee-approved legislation deviates so greatly from sound 
tax policy that we voted against it and feel compelled to 
explain why.
    Our primary concern with the JOBS Act is the deduction it 
provides for manufacturing income. The chairman explained that 
the deduction is designed to effect a reduction in the 
corporate tax rate applied to manufacturing income. The tax cut 
was structured as a deduction for financial reporting purposes, 
but the end result is that it provides a lower tax rate for 
manufacturers than for other U.S. businesses. This is bad tax 
policy and is virtually without precedent in our history. While 
Congress has built into the tax code numerous preferences in 
the form of credits or deductions for favored activities, it 
has never before (to our knowledge) explicitly sought to 
provide a lower tax rate for one type of corporation over 
others.
    There is broad agreement among tax authorities that taxes 
should be neutral, fair and efficient. When the Finance 
Committee considered the JOBS Act, we offered an amendment to 
replace the manufacturing deduction and the miscellaneous 
international reforms with a reduction in the top corporate 
rate from the current 35 percent to 33 percent. Our proposal 
meets all of these tax policy goals, while the manufacturing 
deduction does not.
    A reduction in the top corporate tax rate for all 
corporations is neutral in that it will not influence a 
company's resource allocation or encourage unproductive, tax-
induced activity. It is fair in that it retains an equitable 
distribution of the tax burden; it does not favor one type of 
business over others. It is efficient in that it will not be 
costly for the government to administer or taxpayers to 
calculate and will not encourage gaming of the system by 
providing new loopholes.
    In contrast, the manufacturing deduction in the JOBS Act 
meets none of these standards.
    The manufacturing deduction is not neutral because it could 
cause companies with a variety of business operations to shift 
more resources to their manufacturing operations to take 
advantage of the lower rates, even if that is not the most 
productive use of their resources. We believe that the reported 
bill will lead us down the slippery slope of industries 
pressuring Congress to expand the definition of 
``manufacturing'' in the future to allow them to qualify for 
the deduction, regardless of whether the industry can properly 
be defined as a manufacturing industry. We see this already in 
the reported bill, which allows films to qualify for the 
manufacturing deduction. We know that special-interest tax 
provisions for favored industries lead to unproductive, tax-
driven economic activity; we should not add yet another such 
provision to our tax code.
    It is unfair in that the deduction is available only to 
U.S. manufacturers; it penalizes all other U.S. businesses, 
subjecting them to a 35 percent rate while manufacturers enjoy 
a 32 percent rate.
    It is inefficient in that companies will have to segregate 
their manufacturing income to take advantage of the relief. 
When asked, the Treasury Department suggested that the 
manufacturing deduction would be virtually unadministrable.
    Congress must recognize that our corporate income tax rate 
is too high for all U.S. companies, not just for manufacturers. 
Currently, the U.S. has the second highest corporate tax rate 
among the countries of the Organization for Economic 
Cooperation and Development. Only Japan has a higher rate. This 
puts all U.S. companies, not just manufacturers, at a 
competitive disadvantage. Our proposal to reduce the top 
corporate rate to 33 percent will begin to address this 
problem.
    Many will argue that we must do something to help U.S. 
manufacturers in particular. We believe that we must do 
something to help all U.S. companies. Our efforts to carve-out 
special tax breaks for manufacturers have not had a successful 
track-record. In the three decades that we have tried to 
provide tax incentives for U.S. exports, study after study has 
shown that the special tax provisions have done little to 
retain U.S. jobs. The time has come to try something new and to 
recognize that sound tax policy will be better for our 
country's economic growth than will more targeted tax breaks.
    We urge all members of the Senate to consider very 
carefully whether it is sensible tax policy to create a special 
tax rate for manufacturing income while continuing to tax other 
types of corporate income at the higher 35 percent rate.

                                   Don Nickles.
                                   Jon Kyl.

       VII. CHANGES IN EXISTING LAW MADE BY THE BILL, AS REPORTED

    In the opinion of the Committee, it is necessary in order 
to expedite the business of the Senate, to dispense with the 
requirements of paragraph 12 of Rule XXVI of the Standing Rules 
of the Senate (relating to the showing of changes in existing 
law made by the bill as reported by the Committee).

                                
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