Segment 1 Of 2 Next Hearing Segment(2)
SPEAKERS CONTENTS INSERTS Tables
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41–197 CC
1998
REVENUE RAISING PROVISIONS IN THE ADMINISTRATION'S FISCAL YEAR 1998 BUDGET PROPOSAL
HEARING
before the
COMMITTEE ON WAYS AND MEANS
HOUSE OF REPRESENTATIVES
ONE HUNDRED FIFTH CONGRESS
FIRST SESSION
MARCH 12, 1997
Serial 105–8
Printed for the use of the Committee on Ways and Means
COMMITTEE ON WAYS AND MEANS
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BILL ARCHER, Texas, Chairman
PHILIP M. CRANE, Illinois
BILL THOMAS, California
E. CLAY SHAW, Jr., Florida
NANCY L. JOHNSON, Connecticut
JIM BUNNING, Kentucky
AMO HOUGHTON, New York
WALLY HERGER, California
JIM McCRERY, Louisiana
DAVE CAMP, Michigan
JIM RAMSTAD, Minnesota
JIM NUSSLE, Iowa
SAM JOHNSON, Texas
JENNIFER DUNN, Washington
MAC COLLINS, Georgia
ROB PORTMAN, Ohio
PHILIP S. ENGLISH, Pennsylvania
JOHN ENSIGN, Nevada
JON CHRISTENSEN, Nebraska
WES WATKINS, Oklahoma
J.D. HAYWORTH, Arizona
JERRY WELLER, Illinois
KENNY HULSHOF, Missouri
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CHARLES B. RANGEL, New York
FORTNEY PETE STARK, California
ROBERT T. MATSUI, California
BARBARA B. KENNELLY, Connecticut
WILLIAM J. COYNE, Pennsylvania
SANDER M. LEVIN, Michigan
BENJAMIN L. CARDIN, Maryland
JIM McDERMOTT, Washington
GERALD D. KLECZKA, Wisconsin
JOHN LEWIS, Georgia
RICHARD E. NEAL, Massachusetts
MICHAEL R. McNULTY, New York
WILLIAM J. JEFFERSON, Louisiana
JOHN S. TANNER, Tennessee
XAVIER BECERRA, California
KAREN L. THURMAN, Florida
A.L. Singleton, Chief of Staff
Janice Mays, Minority Chief Counsel
Pursuant to clause 2(e)(4) of Rule XI of the Rules of the House, public hearing records of the Committee on Ways and Means are published in electronic form. The printed hearing record remains the official version. Because electronic submissions are used to prepare both printed and electronic versions of the hearing record, the process of converting between various electronic formats may introduce unintentional errors or omissions. Such occurrences are inherent in the current publication process and should diminish as the process is further refined. The electronic version of the hearing record does not include materials which were not submitted in an electronic format. These materials are kept on file in the official Committee records.
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C O N T E N T S
Advisory of February 25, 1997, announcing the hearing
WITNESSES
Amacher, Richard C., Belk Stores Services, Inc., and National Retail Federation
American Automobile Manufacturers Association, C. Ellen MacNeil
American Bankers Association, Richard A. Hayes
American Petroleum Institute, Paul Sullivan
Applied Materials, Inc., and Export Source Coalition, William C. Barrett
Belk Stores Services, Inc., Richard C. Amacher
Caterpillar, Inc., Douglas R. Oberhelman
Crumrine, Donald F., Flaherty & Crumrine, Inc
Export Source Coalition:
William C. Barrett
Gary C. Hufbauer
Douglas R. Oberhelman
Exxon Corp., Paul Sullivan
Flaherty & Crumrine, Inc., Donald F. Crumrine
Goldberg, Hon. Fred T., Jr., Skadden, Arps, Slate, Meagher & Flom LLP
Gordon, Robert N., Twenty-First Securities Corp., and Securities Industry Association
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Hayes, Richard A., Wells Fargo & Co., and American Bankers Association
Hufbauer, Gary C., Institute for International Economics, and Export Source Coalition
Hyde, Arthur D., Salomon Brothers, Inc., and PSA The Bond Market Trade Association
Institute for International Economics, Gary C. Hufbauer
MacNeil, C. Ellen, Arthur Andersen LLP, and American Automobile Manufacturers Association
National Retail Federation, Richard C. Amacher
Oberhelman, Douglas R., Caterpillar, Inc., and Export Source Coalition
Parks, Linda, James, Parks, Tschopp & Whitcomb, P.A.
PSA The Bond Market Trade Association, and Salomon Brothers, Inc., Arthur D. Hyde
Securities Industry Association, Robert N. Gordon
Solid Waste Association of North America, Bernard J. Zahren
Sullivan, Paul, Exxon Corp., and American Petroleum Institute
Twenty-First Securities Corp., Robert N. Gordon
Zahren Alternative Power Corp., and Solid Waste Association of North America, Bernard J. Zahren
Wells Fargo & Co., Richard A. Hayes
SUBMISSIONS FOR THE RECORD
Ad Hoc Coalition of Utilities for Capital Formation, statement
Ad Hoc Coalition on Intermarket Coordination, statement
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Alliance of American Insurers, statement
America's Community Bankers, statements and letter-..L 134, 258
American Electronics Association, Peter Levy, statement
American Financial Services Association, statements and attachment
American Land Title Association, statement
Bank of America, et al., John E. Chapoton, and Thomas A. Stout, Jr., joint statement
Bear, Stearns & Co. Inc., New York, NY, statement
Boudrias, Claude P., Chemical Manufacturers Association, Arlington, VA, statement
Bunning, Hon. Jim, a Representative in Congress from the State of Kentucky, joint letter (see listing under Hon. Phil English)
Business Roundtable, statement
Caterpillar, Inc., statement
Chapoton, John E., and Thomas A. Stout, Jr., Bank of America, et al., joint statement
Chemical Manufacturers Association, Arlington, VA, Claude P. Boudrias, statement
Christensen, Hon. Jon, a Representative in Congress from the State of Nebraska, joint letter (see listing under Hon. Phil English)
Coalition on Credit Card Interest, statement
Cooper, Milton, National Association of Real Estate Investment Trusts, and Kimco Realty Corp., New Hyde Park, NY, statement
Coopers & Lybrand L.L.P., letter and attachment
Covol Technologies, Inc., Lehi, UT, Asael T. Sorensen, Jr., statement
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Doherty, John J., New York City Department of Sanitation, statement
Dunn, Hon. Jennifer, a Representative in Congress from the State of Washington, joint letter (see listing under Hon. Phil English)
Edison Electric Institute, statement
English, Hon. Phil, a Representative in Congress from the State of Pennsylvania; Hon. Jon Christensen, a Representative in Congress from the State of Nebraska; Hon. Jim McCrery, a Representative in Congress from the State of Louisiana; Hon. Amo Houghton, a Representative in Congress from the State of New York; Hon. Jim Bunning, a Representative in Congress from the State of Kentucky; Hon. E. Clay Shaw, Jr., a Representative in Congress from the State of Florida; Hon. Wes Watkins, a Representative in Congress from the State of Oklahoma; Hon. Sam Johnson, a Representative in Congress from the State of Texas; Hon. John Ensign, a Representative in Congress from the State of Nevada; Hon Jerry Weller, a Representative in Congress from the State of Illinois; Hon. Jennifer Dunn, a Representative in Congress from the State of Washington; and Hon. J.D. Hayworth, a Representative in Congress from the State of Arizona, joint letter
ENSERCH Corp., Dallas, TX, statement
Ensign, Hon. John, a Representative in Congress from the State of Nevada, joint letter (see listing under Hon. Phil English)
Financial Executives Institute, statement
Financial Services Council, statement
Gateway 2000, David McKittrick, statement
General Motors Corp., statement
Government Finance Officers Association, et al., statement
Griffin, W.M., Texas Utilities Co., statement
Hartford Steam Boiler Inspection and Insurance Co., Hartford, CT, James C. Rowan, Jr., letter
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Hayworth, Hon. J.D., a Representative in Congress from the State of Arizona, joint letter (See listing under Hon. Phil English)
Houghton, Hon. Amo, a Representative in Congress from the State of New York, joint letter (see listing under Hon. Phil English)
Independent Bankers Association of America, joint statement (see listing under New York Clearing House Association)
Inland Steel Co., East Chicago, IN, joint statement (see listing under Sun Coal and Coke Co.)
International Mass Retail Association, Arlington, VA, Robert J. Verdisco, statement and attachment
Interstate Natural Gas Association of America, statement
Investment Company Institute, statement
Johnson, Hon. Sam, a Representative in Congress from the State of Texas, joint letter (see listing under Hon. Phil English)
Kimco Realty Corp., New Hyde Park, NY, Milton Cooper, statement
Levy, Peter, American Electronics Association, and Raychem Corp., statement
Mahar, Declan, Fairfield, CT, letter
McCrery, Hon. Jim, a Representative in Congress from the State of Louisiana, joint letter (see listing under Hon. Phil English)
McKittrick, David, Gateway 2000, statement
Merrill Lynch & Co., Inc., statement
Monsanto Co., statement
Murray, Fred F., National Foreign Trade Council, Inc., statement
National Apartment Association, and National Multi Housing Council, joint statement
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National Association of Manufacturers, statement
National Association of Real Estate Investment Trusts, Milton Cooper, statement
National Foreign Trade Council, Inc., Fred F. Murray, statement
National Mining Association, statement
National Multi Housing Council, and National Apartment Association, joint statement
New York City Department of Sanitation, John J. Doherty, statement
New York Clearing House Association, New York, NY; Independent Bankers Association of America; Securities Industry Association; and America's Community Bankers, joint statement
Northern Indiana Public Service, Merrillville, IN, joint statement (see listing under Sun Coal and Coke Co.)
Pace Carbon Fuels, L.L.C., Fairfax, VA, James R. Treptow, letter
Ramstad, Hon. Jim, a Representative in Congress from the State of Minneapolis, statement
Raychem Corp., Peter Levy, statement
Rowan, James C., Jr., Hartford Steam Boiler Inspection and Insurance Co., Hartford, CT, letter
Securities Industry Association, joint statement (see listing under New York Clearing House Association)
Shaw, Hon. E. Clay, Jr., a Representative in Congress from the State of Florida, joint letter (see listing under Hon. Phil English)
Sorensen, Asael T., Jr., Covol Technologies, Inc., Lehi, UT, statement
Stout, Thomas A., Jr., and John E. Chapoton, Bank of America, et al., joint statement
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Sun Coal and Coke Co., Philadelphia, PA; Inland Steel Co., East Chicago, IN; and Northern Indiana Public Service, Merrillville, IN, joint statement
Tax Council, statement
Texas Utilities Co., W.M. Griffin, statement
Treptow, James R., Pace Carbon Fuels, L.L.C., Fairfax, VA, letter
United States Council for International Business, New York, NY, statement
United States Telephone Association, statement
Valero Energy Corp., San Antonio, TX, statement
Verdisco, Robert J., International Mass Retail Association, Arlington, VA, statement and attachment
Washington Counsel, P.C., statements
Watkins, Hon. Wes, a Representative in Congress from the State of Oklahoma, joint letter (see listing under Hon. Phil English)
Weller, Hon. Jerry, a Representative in Congress from the State of Illinois, joint letter (see listing under Hon. Phil English)
REVENUE RAISING PROVISIONS IN THE ADMINISTRATION'S FISCAL YEAR 1998 BUDGET PROPOSAL
WEDNESDAY, MARCH 12, 1997
House of Representatives,
Committee on Ways and Means,
Washington, DC.
The Committee met, pursuant to notice, at 10:03 a.m., in room 1100, Longworth House Office Building, Hon. Bill Archer (Chairman of the Committee) presiding.
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[The advisory announcing the hearing follows:]
ADVISORY
FROM THE COMMITTEE ON WAYS AND MEANS
CONTACT: (202) 225–1721
IMMEDIATE RELEASE
February 25, 1997
No. FC–4
Archer Announces Hearing on
Revenue Raising Provisions
in the Administration's
Fiscal Year 1998 Budget Proposal
Congressman Bill Archer (R–TX), Chairman of the Committee on Ways and Means, today announced that the Committee will hold a hearing on revenue raising provisions in the Administration's fiscal year 1998 budget proposal. The hearing will take place on Wednesday, March 12, 1997, in the main Committee hearing room, 1100 Longworth House Office Building, beginning at 10:00 a.m. Oral testimony at the hearing will be heard from public witnesses.
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BACKGROUND:
The Administration's fiscal year 1998 budget proposal contains approximately $78 billion in revenue increases, according to Administration estimates. These provisions have not yet been estimated by the Joint Committee on Taxation.
In announcing the hearing, Chairman Archer stated: ''As part of his fiscal year 1998 budget, the President has sent to Congress a number of proposals which would increase Federal tax revenues. The Administration believes that many of these proposals will eliminate 'unwarranted tax benefits.' As the Ways and Means Committee and the Congress demonstrated during the 104th Congress, we will not permit anachronistic and unwarranted tax provisions to remain in the law. However, commentators have suggested that many of the proposals submitted by the Administration are simply tax increases by another name. The Ways and Means Committee will study carefully the revenue raising proposals submitted by the Clinton Administration in order to determine which are firmly grounded in tax policy.
I am pleased that the Administration has for the most part heeded the announcement Senator Roth and I issued last year regarding effective dates for its revenue proposals. However, I am concerned that several of the new proposals from the Administration still have retroactive effective dates or retroactive impact. I want to learn more about potential effective dates for the proposals as well as the rationale for those dates.''
FOCUS OF THE HEARING:
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The focus of the hearing will be the revenue raising provisions of the Administration's budget proposal for fiscal year 1998, other than the aviation, oil spill, Superfund, and Leaking Underground Storage Tank excise taxes and the corporate environmental tax extension proposals which will be considered later this year.
DETAILS FOR SUBMISSIONS OF REQUESTS TO BE HEARD:
Requests to be heard at the hearing must be made by telephone to Traci Altman or Bradley Schreiber at (202) 225–1721 no later than the close of business, Tuesday, March 4, 1997. The telephone request should be followed by a formal written request to A.L. Singleton, Chief of Staff, Committee on Ways and Means, U.S. House of Representatives, 1102 Longworth House Office Building, Washington, D.C. 20515. The staff of the Committee will notify by telephone those scheduled to appear as soon as possible after the filing deadline. Any questions concerning a scheduled appearance should be directed to the Committee staff at (202) 225–1721.
In view of the limited time available to hear witnesses, the Committee may not be able to accommodate all requests to be heard. Those persons and organizations not scheduled for an oral appearance are encouraged to submit written statements for the record of the hearing. All persons requesting to be heard, whether they are scheduled for oral testimony or not, will be notified as soon as possible after the filing deadline.
Witnesses scheduled to present oral testimony are required to summarize briefly their written statements in no more than five minutes. THE FIVE-MINUTE RULE WILL BE STRICTLY ENFORCED. The full written statement of each witness will be included in the printed record, in accordance with House Rules.
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In order to assure the most productive use of the limited amount of time available to question witnesses, all witnesses scheduled to appear before the Committee are required to submit 300 copies of their prepared statement and a 3.5-inch diskette in WordPerfect or ASCII format, for review by Members prior to the hearing. Testimony should arrive at the Committee office, room 1102 Longworth House Office Building, no later than Monday, March 10, 1997. Failure to do so may result in the witness being denied the opportunity to testify in person.
WRITTEN STATEMENTS IN LIEU OF PERSONAL APPEARANCE:
Any person or organization wishing to submit a written statement for the printed record of the hearing should submit at least six (6) copies of their statement and a 3.5-inch diskette in WordPerfect or ASCII format, with their address and date of hearing noted, by the close of business, Wednesday, March 26, 1997, to A.L. Singleton, Chief of Staff, Committee on Ways and Means, U.S. House of Representatives, 1102 Longworth House Office Building, Washington, D.C. 20515. If those filing written statements wish to have their statements distributed to the press and interested public at the hearing, they may deliver 200 additional copies for this purpose to the Committee office, room 1102 Longworth House Office Building, at least one hour before the hearing begins.
FORMATTING REQUIREMENTS:
Each statement presented for printing to the Committee by a witness, any written statement or exhibit submitted for the printed record or any written comments in response to a request for written comments must conform to the guidelines listed below. Any statement or exhibit not in compliance with these guidelines will not be printed, but will be maintained in the Committee files for review and use by the Committee.
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1. All statements and any accompanying exhibits for printing must be typed in single space on legal-size paper and may not exceed a total of 10 pages including attachments. At the same time written statements are submitted to the Committee, witnesses are now requested to submit their statements on a 3.5-inch diskette in WordPerfect or ASCII format.
2. Copies of whole documents submitted as exhibit material will not be accepted for printing. Instead, exhibit material should be referenced and quoted or paraphrased. All exhibit material not meeting these specifications will be maintained in the Committee files for review and use by the Committee.
3. A witness appearing at a public hearing, or submitting a statement for the record of a public hearing, or submitting written comments in response to a published request for comments by the Committee, must include on his statement or submission a list of all clients, persons, or organizations on whose behalf the witness appears.
4. A supplemental sheet must accompany each statement listing the name, full address, a telephone number where the witness or the designated representative may be reached and a topical outline or summary of the comments and recommendations in the full statement. This supplemental sheet will not be included in the printed record.
The above restrictions and limitations apply only to material being submitted for printing. Statements and exhibits or supplementary material submitted solely for distribution to the Members, the press and the public during the course of a public hearing may be submitted in other forms.
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Note: All Committee advisories and news releases are available on the World Wide Web at 'HTTP://WWW.HOUSE.GOV/WAYS_MEANS/'.
The Committee seeks to make its facilities accessible to persons with disabilities. If you are in need of special accommodations, please call 202–225–1721 or 202–225–1904 TTD/TTY in advance of the event (four business days notice is requested). Questions with regard to special accommodation needs in general (including availability of Committee materials in alternative formats) may be directed to the Committee as noted above.
—————
Chairman ARCHER. The Committee will come to order. The Chair would observe this is the quietest milling around he can remember in many, many years.
Today's hearing has been called to discuss the revenue raising provisions contained in the President's budget. When the President proposed his budget, I said that if it was, indeed, in balance and if it provided tax relief for the American people, then I would consider it live on arrival. One of the purposes of our hearings has been to determine whether the President's budget is alive and kicking or just barely breathing.
Before I indicate which condition has been met, we must never yield from our dedication to reach a bipartisan agreement on balancing the budget while providing permanent tax relief to the American people. Whatever shortcomings I or any other Member find in the President's proposals, we must not let them stop us from working together in good faith and with a firm dedication to completing our work.
The American people elected a Democrat President and a Republican Congress and they expect us to work together. While this budget may be flawed, I believe we can and we must constructively move forward to get our jobs done. That is why my regrettable conclusion is that this budget is just barely breathing.
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It has a $69 billion deficit in the year 2002. It raises taxes. It increases welfare spending by $21 billion. The deficit goes up from now through the year 2000, while 98 percent of the spending reductions come in the final 2 years, after the President has left office.
Its tax cuts are temporary while its tax hikes are permanent. The budget contains 42 separate revenue raisers adding up to $73.3 billion in higher taxes over 5 years and $150.6 billion over 10 years.
Three of these provisions are particularly noteworthy. They threaten worker's salaries by hiking the payroll tax. They raise taxes on 10 million middle-income investors, and possibly 15 million middle-income investors, and they penalize companies that create export jobs.
I am talking about the extension of the FUTA tax, the average cost basis proposal for taxing investors and the export source rule. I believe there is bipartisan opposition to these proposals that is widely shared on this Committee.
Just as I did last year, I am prepared to take action to modernize the Tax Code by reforming or eliminating anachronistic provisions, but I intend to protect the taxpayers from provisions that increase the taxes on hard-working Americans, threaten their salaries or cost them jobs, especially high-paying, good, export-related jobs.
I hope the President will agree to modify his budget so it is balanced and that he will do so without raising taxes or increasing welfare spending. If he does, he will aid our efforts to reach agreement on a budget resolution that can be supported by Republicans, Democrats, and the White House.
In all cases, we must move forward and I hope we can do so together. That is why we must fulfill our responsibility to have a budget resolution on the floor in May.
I, again, extend an open hand to the President: Give us a budget that is in balance, while providing permanent tax relief, and we will reach an overwhelmingly bipartisan agreement on a budget resolution.
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That is the best way for us to work together to complete the job the American people sent us here to do. And I yield to Mr. Rangel, the Ranking Minority Member of the Committee, for any statement he would like to make.
Mr. RANGEL. Thank you my friend, Mr. Chairman.
I assume everybody that will be testifying today would want to balance the budget and cut taxes, and that is good. That is the political thing for us to do. But somehow the last time we thought this way, 90 percent of the revenue that was raised was raised from programs that affect the poor. I would like to turn that around.
If we are really going to reduce taxes and balance the budget, we all ought to share in that effort. But, no matter how many books have been written on it, no one has said it better than Senator Russell Long when he said, ''Don't tax me, don't tax thee, tax the person behind the tree.''
So, we are going to see today who is behind the tree. I know it is not going to be any of the witnesses before us today. I also appreciate the fact that my Chairman wants to protect those high-paying jobs. We need those people out there.
So, since all revenue increases are difficult, I personally do not see how, in good conscience, we can talk about a tax cut. We all know the entire country really enjoys a tax cut. But we need to reduce our deficit. These were the things economists have been talking about, Greenspan says that deficit reduction is important to return the economy to one that is evergrowing and prosperous. It is just the Republican type of thinking that we should not be paying more than we get in.
But if you are going to reduce what we bring in, then we are going to have a problem in deciding where we are going to raise the revenue.
Mr. Chairman, it just seems to me that if we do not like what the President has sent to us in terms of a budget, and I am not in love with it myself, what we ought to do is come up with another plan. But if all we are going to do is to tell the President of the United States to keep preparing budgets until we feel he has done it right, then we may have a longer haul than the Members of this Committee want.
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It would help me a great deal if the witnesses today would volunteer whether they want a tax cut and a balanced budget. If each of you will let me know how you feel about tax cuts now, I will not have to ask you separately. It will make it a lot easier for us to understand each other. If everyone says they want a big tax cut—that we give this money back to the American people—but they still want to hold on to their incentives—which others, of course, will call welfare and loopholes but for purposes of fairness we will call it incentives—then it will be hard to accomplish our deficit reduction goals. If you are not behind the tree to be taxed, who is?
Thank you, Mr. Chairman.
Chairman ARCHER. We are pleased to have a panel of extremely competent witnesses this morning and our real purpose this morning is to evaluate the President's tax proposals that are in his budget.
Each of you is qualified to do that in perhaps a little different way. We are delighted to have you with us and Mr. Hayes, would you commence.
Let me say that the ground rules—probably most of you know this—but the ground rules in the Committee are that we would like for you to keep your oral testimony within 5 minutes if at all possible. Your entire written statement without objection will be included in the record. And if you, at the beginning, will identify yourself and whom you represent or with what organization you have a role, before commencing your testimony, we would appreciate that.
[The opening statement of Mr. Ramstad follows:]
INSERT OFFSET FOLIO 13 HERE
[The official Committee record contains additional material here.]
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Chairman ARCHER. Mr. Hayes, would you commence.
STATEMENT OF RICHARD A. HAYES, SENIOR VICE PRESIDENT, CORPORATE TAX DEPARTMENT, WELLS FARGO & CO., LOS ANGELES, CALIFORNIA; AND CHAIRMAN, TAXATION COMMITTEE, AMERICAN BANKERS ASSOCIATION
Mr. HAYES. Thank you, Mr. Chairman.
Mr. Chairman and Members of the Committee, I am Dick Hayes, senior vice president of Wells Fargo & Co. I am pleased to appear before you to present ABA, the American Bankers Association's, views on the revenue raising provisions of the administration's fiscal year 1998 budget proposal.
At the outset, I would like to commend you, Mr. Chairman, for holding these hearings. We are also particularly appreciative of your efforts with respect to expanding IRAs, cutting capital gains, and reforming the death tax. We agree the benefits to be gained from these proposals would be severely hampered by the budget's revenue raising provisions that I will discuss today. I will summarize a few of the issues raised in my written testimony and ask that both be included in the official record.
The provisions we find offensive share certain common characteristics. They are actually across-the-board corporate tax increases or significant tax policy changes rather than loophole closers. They are targeted at current provisions which are not, in fact, abusive and they will cause harm to the corporate community and its stockholders. We believe that the better course would be to equalize the business playingfield by closing genuine loopholes.
For example, limiting the proliferation of multiple common bond credit unions that have expanded their membership and customer base far beyond the parameters of their original common bond is a sorely needed loophole closer which we would respectfully offer for your consideration.
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The examples of the proposed provisions to which ABA strongly objects include the following proposed changes: Information reporting penalties, NOL, net operating losses, and S corporation rules.
Dealing first with the information reporting penalties, the information reporting penalty change will not improve compliance. Penalties typically are intended to discourage bad behavior and encourage good behavior, not to serve as revenue raisers.
The banking industry prepares and files information returns annually in good faith for the benefit of the IRS. We take particular umbrage with the suggestion that this proposal reduces corporate welfare or closes a corporate loophole in that it presumes noncompliance, a conclusion for which there is no substantiating evidence.
Second, in connection with NOL, the net operating loss carrybacks, limiting the NOL carryback to 1 year would add further distortion to the reporting of income in cyclical businesses since business cycles do not necessarily conform to the beginning and end of a 12-month taxable year.
The provision also effectively tilts the scale to the benefit of IRS which will receive a time value of money benefit.
Additionally, reducing the NOL carryback period could have an adverse impact on a bank's regulatory capital. For regulatory capital purposes, the value of the carryback would be reduced to the amount of taxes paid in the 1 year prior to the NOL.
The decrease in NOL value would not be compensated by an increase carryforward period because bank regulatory agencies have a capital limitation on deferred tax assets such as carryforwards that are dependent upon future taxable income. This significant tax policy change is unwarranted and should not be a part of the budget legislation.
Next, the repeal of code section 1374. As you know, the 104th Congress recently allowed banks and thrifts to elect S corporation status, a change for which we are greatly appreciative. However, the repeal of code section 1374 or so-called large S corporations, would make the cost of conversion to S corporation status prohibitively expensive for the majority of eligible banks and thrifts.
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This proposal would accelerate net unrealized built-in gains and create a corporate shareholder level tax with respect thereto. It may effectively close the window of opportunity for banks and thrifts to elect S corporation status and it is particularly unfair since these institutions never had the opportunity to elect S corporation status when they commenced business.
Additionally, there is a need for a technical correction with respect to qualified subchapter S subsidiaries that would allow electing parents to treat banks and thrifts as a qualified subchapter S subsidiary without changing its status under the particular rules that affect banks.
In conclusion, I appreciate this opportunity to present the ABA's views and I would be pleased to answer any questions you may have.
Thank you very much.
[The prepared statement follows:]
Statement of Richard A. Hayes, Senior Vice President, Corporate Tax Department, Wells Fargo & Co., Los Angeles, California; and Chairman, Taxation Committee, American Bankers Association
Mr. Chairman and members of the Committee, I am Dick Hayes, Senior Vice President, Corporate Tax Department, Wells Fargo & Co. As chairman of the Taxation Committee of the American Bankers Association (ABA), I am pleased to appear before you today to present the views of the ABA on the revenue raising provisions of the Administration's fiscal year 1998 budget proposal.
The ABA brings together all elements of the banking community to best represent the interests of this rapidly changing industry. Its membership—which includes community, regional, and money center banks and holding companies, as well as savings associations, trust companies, and savings banks—makes ABA the largest banking trade association in the country.
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The Administration's 1998 budget proposal contains several significant proposals about which we are deeply concerned. Although we support legislative efforts to curtail tax abusive transactions, certain of the corporate reform proposals have been inaccurately and pejoratively categorized as ''corporate welfare'' and ''loophole closers.'' Some of the revenue-raising proposals are actually across-the-board corporate tax increases rather than ''loophole closers.'' Others involve reductions on tax expenditures that were enacted to achieve a specific social or economic policy objective. In this connection, many of the Administration's corporate revenue raising proposals would be more properly addressed under the rubric of overall tax reform and should not be included in this budget legislation.
We strongly object to the use of the term ''corporate welfare.'' The term ''welfare'' is generally used to describe governmental assistance given to needy individuals during a difficult period in their lives. It connotes receiving ''something in exchange for nothing.'' The corporate tax law does not contain any analogous provisions. Corporate tax incentives are generally intended to induce or support specific taxpayer actions that achieve specified social and economic policy goals. Accordingly, the term corporate welfare is, at best, misleading. A ''loophole'' is generally considered to mean a hidden flaw in the tax law the exploitation of which does not reflect the intent of Congress. While we generally support the closing of loophole transactions, many of the Administration's proposals would, in effect, penalize the legitimate business activities of corporations for no other reason than to raise needed revenue.
In this regard, the current corporate reform debate seems to disregard the fact that the corporate income tax is ultimately paid by individuals. It also disregards the vital role played by corporations in our domestic economy. According to New York Stock Exchange statistics, a great many taxpayers have linked their economic futures to that of corporate America. More than one American in three owns stock, much of it through mutual funds and retirement accounts. Corporate America employs directly over 20 million taxpayers (more than one fifth of all domestic wage and salary workers). Thus, indeed, a hit to corporations will ultimately be felt by individual taxpayers. Given the technological innovations of today's competitive market place, this is not the time for Congress to further disadvantage domestic business entities by curtailing much needed corporate tax incentives. Rather, Congress could better equalize the business playing field by closing genuine loopholes. For example, credit unions that have expanded their membership/customer base far beyond the parameters of their original common bond continue to be exempt from taxation and compete, unfairly, with commercial banks and thrifts. Limiting the proliferation of multiple common bond credit unions is a sorely needed loophole closer, which we would respectfully offer for your consideration.
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We support the proposals to expand the availability of Individual Retirement Accounts, and to reduce the taxation of capital gains and estates involving closely held business. However, the Administration's revenue raising proposals will inhibit job creation, inequitably penalize business and lessen the overall economic stimulative impact of the budget proposal. In my statement today, I will discuss the proposals that we find most troubling.
Revenue Raising Proposals
Increased Information Reporting Penalties
The Administration proposes to raise the penalties, under section 6721, for failure to file correct information returns from the current $50 per return, not to exceed $250,000 during any calendar year, to the greater of $50 per return or 5 percent of the total amount required to be reported. The ABA strongly opposes the Administration's proposal.
The banking industry prepares and files information returns to report items such as employee wages, dividends, and interest (on Forms W–2, 1099–INT, –DIV, –B, –S, and –MISC) annually in, good faith, for the sole benefit of the IRS. The Administration reasons that the current penalty provisions may not be sufficient to encourage timely and accurate reporting. We disagree. Information reporting penalties were raised to the current levels as part of the Omnibus Budget Reconciliation Act of 1989, P.L. 101–239. The suggestion that this proposal reduces ''corporate welfare'' or closes a ''corporate loophole'' presumes that, irrespective of the legislative actions of the one hundred first Congress, corporations continue to be noncompliant, a conclusion for which there is no substantiating evidence.
Further, penalties typically are intended to discourage ''bad'' behavior and encourage ''good'' behavior, not to serve as revenue raisers. Let's presume that the new penalty levels achieve the Administration's goal of decreasing the number of taxpayers that incur penalties. In the next budget, will we have another proposed increase in the penalties in order to maintain the revenue flow? Certainly, the proposed increase in penalty is unnecessary and would not make sound tax policy.
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Modify Net Operating Loss (NOL) Carry-Back and Carry-Forward Rules
The ABA opposes the Administration's proposal to limit carry-backs of net operating losses (NOLs) to one year and extend carry-forwards to twenty years. Current law permits NOLs to be carried back three years and carried forward fifteen years to correct income distortions resulting from losses reported at the end of the taxable year. In many instances, NOLs result from general business cycles. This is particularly true for the banking industry, whose performance, over time, tends to mirror the financial ups and downs of its customers. Business cycles often last longer than twelve months and do not necessarily conform to the beginning and end of a taxable year. Accordingly, a one-year carry-back limitation would further distort and prevent accurate reporting of income for the combined period and of the current and previous taxable years.
In its explanation of the reason for change, the Administration cites the increased complexity and administrative burden associated with carry-backs vis-a-vis carry-forwards. This rationale is inconsistent with sound tax policy and is not an adequate justification for so significantly limiting the NOL carry-back period. The notion of a carry-back has always had a quasi-equitable component to it—i.e., it allows a taxpayer, struggling with a financial downturn, to receive a cash infusion from the refund of previously paid taxes. The proposed one-year carry-back effectively tilts the scale to the benefit of the IRS, which will receive a time value of money benefit. Refunds would be paid at some point in the future rather than currently.
Additionally, reducing the NOL carry-back period could have an adverse impact on a bank's regulatory capital. The value of the carry-back for regulatory capital purposes would be limited to the amount of taxes paid in the year prior to the operating loss rather than the total amount of taxes paid in the three previous years.
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Increasing the life of a net operating loss carry-forward from fifteen to twenty years is not likely to compensate for this immediate reduction in the value of net operating loss carry-backs. Current regulations cap the amount of net operating loss carryforwards that can be included in regulatory capital to the lesser of the amount that can be realized within one year or 10% of Tier 1 capital.
Bank regulatory agencies have a capital limitation on deferred tax assets (such as net operating loss carry-forwards) that are dependent on future taxable income. The capital limitation does not apply to net operating loss carry-backs because they are not dependent on future taxable income. The amount of deferred tax assets that are dependent on future taxable income (such as net operating loss carry-forwards) that can be included as regulatory capital is the lesser of:
• The amount of deferred tax assets that the institution expects to realize within one year based on its projection of taxable income, or
• 10% of Tier 1 capital, net of goodwill and intangible assets other than mortgage servicing rights and purchased credit card relationships.
Accordingly, we suggest that this proposal not be included in the budget package.
Modify Foreign Tax Credit (FTC) Carryover Rules
The ABA opposes the Administration's proposal to limit carry-backs of foreign tax credits (FTCs) to one year and extend carry-forwards to seven years. The proposed FTC carryover limitation would further distort and prevent the accurate reporting of income for previous years. The Administration's explanation for the proposed limitation on FTC carry-backs cites increased complexity and administrative burden associated with carry-backs as opposed to carryforwards. The Administration's rationale is inconsistent with sound tax policy and is not an adequate justification for so significantly limiting the FTC carry-back period. For the reasons set out above, there is little, if any, justification for making such a significant tax policy change. We suggest that this proposal not be included in the budget package.
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Repeal Section 1374 for Large Corporations
The ABA opposes the proposal to repeal Internal Revenue Code section 1374 for large S corporations. The proposal would accelerate net unrealized built-in gains (BIG) and create a corporate level tax on BIG assets while also creating a shareholder level tax with respect to their stock. The BIG tax would apply to gains attributable to assets held at the time of conversion, negative adjustments due to accounting method change, intangibles such as core deposits and excess servicing rights and recapture of the bad debt reserve.
Financial institutions were permitted to elect S corporation status for the first time pursuant to the provisions of the Small Business Jobs Act. Effectively, this proposal would shut the window of opportunity for those financial institutions to elect S corporation status by making the cost of conversion prohibitively expensive for the majority of eligible banks. We believe such a change would be contrary to Congressional intent.
Additionally, we note that technical correction legislation is necessary with respect to the treatment of nonfinancial institution S corporations that hold S bank or thrift corporation subsidiaries. Under current law, an S corporation is allowed to own a and elect S corporation status for a ''qualified subchapter S subsidiary'' (QSSS). If a nonfinancial institution parent corporation elects to treat a bank or thrift subsidiary as a QSSS, the QSSS is not treated as a separate corporation and all the assets, liabilities, and items of income, deduction, loss and credit of the subsidiary are treated as the attributes of the nonfinancial institution parent corporation. A technical correction is necessary to allow Treasury regulations to provide that an election to treat a bank subsidiary as a QSSS would not change the status of either the nonfinancial institution parent or the subsidiary for purposes of selected provisions of the Internal Revenue Code applicable to banks and thrifts (such as sections 265(b) interest expense disallowance; 582(c) bad debts and 6050P returns relating to cancellation of indebtedness).
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With respect to thrifts, Section 593(e), as amended by the Small Business Job Protection Act of 1996, provides that distributions by a thrift to its shareholders are taken first out of earnings and profits (E&P) then out of the frozen base year reserves. Moreover, when a C corporation becomes an S corporation, it retains its accumulated C corporation E&P; however, it does not accumulate any additional E&P while it remains an S corporation. According to recent IRS pronouncements, failure to have C corporation E&P may trigger unintended reserve recapture under section 593(e). In order to make subchapter S benefits available to all eligible thrifts, S corporation earnings should be counted as E&P for section 593(e) purposes. We would urge that such technical corrections legislation be included in the instant tax legislation.
Limit Dividends Received Deduction
The ABA strongly opposes the Administration's proposals to reduce the dividends-received deduction (from 70 percent to 50 percent for corporations owning less than 20 percent of the stock of a U.S. corporation), modify the holding period requirement, and to deny the deduction on limited term preferred stock. In explaining the proposed changes, the Administration states, inter alia, that the 70 percent deduction is too generous; that the holding period requirement does not assure that the owner of stock bears sufficient risk of loss; and that the current rules for the deduction are too complex. We disagree. The ABA, along with other members of the financial services community, has steadfastly opposed limitation of the dividends received deduction.
The dividends-received deduction mitigates multiple level taxation of earnings from one corporation paid to another. Originally ''corporations were not taxed on dividends received from other corporations in order to prevent multiple taxation of corporate earnings as the earnings passed from one corporation to another possibly within the same chain of ownership.''(see footnote 1) The deduction was first cut back (to 85%) in an attempt to simplify corporate structures and to discourage the use of multiple entities for tax avoidance. However, the deduction remained at 85 percent until 1986, when it was reduced to 80 percent. It was further scaled back in 1987 to 70 percent. In several years since, the deduction has been on the ''usual list of suspects'' almost anytime revenue is needed. Currently, the dividends received deduction is a necessary tool in maintaining corporate viability rather than an implement of tax avoidance. The dividends received deduction does not constitute ''corporate welfare'', nor should it be considered a ''corporate loophole.'' Cutting back the deduction from 70 percent to 50 percent would not only be a tax increase but, in effect, a move closer to imposing a full triple tax on profitable banks and thrifts.
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The Administration has a separate proposal that would deny the interest deduction for certain debt instruments and reclassify certain other debt instruments, because such instruments have ''substantial equity features.'' If the Administration is successful in curtailing the dividends-received deduction to 50 percent (and perhaps even further in the future), we wonder whether such reductions put even greater pressure on issuers to avoid equity instruments and structure debt instruments to achieve their corporate goals?
Reducing the dividends received deduction, as proposed, would also disrupt the preferred stock market with resulting harm to investors, such as IRAs, pensions funds and corporations. The holding period changes would create uncertainty for preferred stock investors as to the availability of the deduction, discourage market-driven hedging practices, and impose significant compliance costs on companies with large portfolios. It would also further erode U.S. competitiveness. We do not believe that tax policy should sacrifice equity in order to achieve simplicity. We strongly urge that this proposal not be included in the 1998 budget package.
Basis of Substantially Identical Securities Determined on an Average Basis
The ABA opposes the Administration's proposal to require taxpayers to determine their basis in substantially identical securities using the average of all of their holdings in securities. We also oppose the proposal to require that taxpayers use a first-in, first-out method for purposes of determining whether gain or loss on the sale of a security is long or short term. These proposals would unnecessarily create additional and complex recordkeeping burdens. Taxpayers would be required to maintain two sets of records for each investment: one for average cost (which must be adjusted at the time of each purchase) and another for acquisition dates (which must be adjusted at the time of each purchase or sale). The burden would be further complicated for taxpayers who maintain computerized records. Programming, in and of itself, in order to establish, maintain and adjust two sets of records at the time of each transaction, would be substantial. We oppose the significant imposition of costs and compliance burdens associated with the proposal to change the timing aspects of reporting gain or loss from the sale of stock or securities. This proposal is not targeted toward abuse, but is a significant tax policy change with respect to the timing of reporting gain or loss from the sale of stock and is inappropriate for inclusion in the budget.
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Require Reasonable Payment Assumptions for Interest Accruals on Certain Debt Instruments
ABA opposes the proposal to require prepayment assumptions for interest accruals that would cause credit card issuers to pay tax on grace period interest before having a fixed right to the income. The proposal would require issuers to include in currently taxable income an estimate of the amount of grace period interest that will accrue in the future. This estimate would be based on the credit card issuer's assumptions of the likelihood that its credit card customers will not pay their entire balance before the end of the applicable grace period. This proposal effectively repeals the longstanding and long accepted ''all events'' standard in this area. It is not a ''loophole closer'' nor does it constitute ''corporate welfare.'' Moreover, this proposal can only be viewed as a tax increase and an arbitrary departure from well established tax policy.
Other Issues
The Administration's proposal contains a number of other provisions to which we object as being harmful to banks and thrifts, as listed below.
• Extend section 265 pro rata disallowance of tax-exempt interest expense to all corporations;
• Registration of confidential tax shelters;
• Deny the interest deduction on certain debt instruments; and
• Defer the deduction on certain convertible debt.
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Conclusion
I appreciate having this opportunity present ABA's views on the revenue raising provisions contained in the President's fiscal year 1998 budget proposal. We look forward to working with you in the future on these most important matters. I would be pleased to answer any questions you may have.
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Chairman ARCHER. Thank you, Mr. Hayes.
Our next witness is Arthur Hyde. If you would identify yourself, you may proceed.
STATEMENT OF ARTHUR D. HYDE, MANAGING DIRECTOR AND HEAD, CORPORATE DEBT, SALOMON BROTHERS, INC., NEW YORK, NEW YORK; AND CHAIRMAN, CORPORATE BOND DIVISION, PSA THE BOND MARKET TRADE ASSOCIATION
Mr. HYDE. Thank you, Chairman Archer, Mr. Rangel, and good morning. My name is Arthur Hyde, and I am managing director of Salomon Brothers, Inc., in charge of corporate debt. I am also chairman of the corporate bond committee of PSA. I am pleased to be here to present PSA's views on some of the revenue raising tax proposals in the Clinton administration's fiscal year 1998 budget.
My specific focus is those proposals which affect corporate and municipal bonds. I begin by stating that PSA strongly disagrees that the debt instruments I will discuss today are being issued by corporations in order to exploit tax loopholes. These securities provide issuers with efficient and flexible capital raising alternatives to finance investment. They have been embraced by investors small and large and fill important gaps in their portfolios.
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Moreover, the PSA questions whether these proposals will generate the revenues projected by the administration. And it is clear to us that on the margin they will inhibit capital formation.
Chairman ARCHER. Mr. Hyde, there are some of us up here who have gotten along in life and whose ears are not quite as good as others, and a comment or two that you have made cannot be totally understood. So, if you could move the mike just a little bit closer to you, that would be great. We will put that time back on your record that I have taken away from you.
Mr. HYDE. Thank you.
Chairman ARCHER. Thank you.
Mr. HYDE. One administration proposal would prohibit corporations from issuing debt with maturities longer than 40 years. The administration has drawn an arbitrary line as to the maximum maturity of a debt instrument with no apparent justification.
Under the proposal, a 40-year bond would qualify for an interest expense deduction but a 41-year bond would not. With all due respect to the U.S. Treasury, debt does not magically turn into equity after 40 years. Maturity should not be a decisive factor. Debt holders are creditors, and stockholders are owners. Interest is a business expense, and dividends are paid out of profits. Nonpayment of interest is an event of default, nonpayment of dividends is not. Creditors can force issuers into bankruptcy, preferred stockholders cannot. Creditors' claims in bankruptcy are senior to equity holders.
Debt instruments with very long maturities have provided certain borrowers, including domestic and foreign corporations, with secure, low-cost, long-term capital. Why frustrate that process?
Prohibiting U.S. corporations from deducting payments on long-term debt would cutoff domestic companies from this important source of funding, while allowing foreign corporations a competitive advantage as they tap U.S. investor's funds.
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Another administration proposal would effectively prohibit corporations from issuing fixed-rate capital securities with maturities longer than 15 years. Fixed-rate capital securities have all the characteristics of debt. Perhaps most important, they are regarded as debt in the way they are priced and traded.
The administration argues that fixed-rate capital securities, longer than 15 years, are more like equity than debt due to their accounting treatment. PSA disagrees. The market disagrees.
By any reasonable definition of debt, they qualify. Moreover, they provide low-cost, long-term capital for corporations and added flexibility under times of stress which strengthens U.S. corporations' capital base.
It is for this very reason that the Federal Reserve made the conscious decision last fall to let banks issue these securities. Since then, over $25 billion has been issued and our financial system is all the stronger for it.
The administration has also proposed reducing DRD, the dividends received deduction, to 50 percent from 70 percent and eliminating it altogether for certain preferred stock. Reducing the DRD would exacerbate one of the most egregious problems in our tax system, the multiple taxation of corporate earnings.
It would represent a direct tax increase, not just on corporations that hold preferred stock and qualify for the DRD, but also on corporations that issue DRD-eligible preferred stock.
Another administration proposal would force corporations that issue convertible debt with OID, original issue discount, to defer their OID deduction until the interest was actually paid in cash. However, investors would still be required to recognize and pay taxes on their accrual of OID.
This proposal violates the basic tenet of tax symmetry, that a deduction by one taxpayer be offset by a recognition of income by another.
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Finally, the administration has proposed denying a portion of interest expense deduction for corporations that earn tax-exempt interest on municipal securities. Although nominally a tax increase on corporations, those who would lose the most under the proposal would be State and local governments and their citizens who issued tax-exempt securities to finance investments and manage cash flow. They would face significant increases in capital costs.
PSA fully supports a balanced budget. We believe strongly, however, that tax increases which would raise capital financing costs and discourage new investment are inconsistent with the goals of a balanced budget. We also question whether the proposals would raise the amount of revenue which has been estimated. It is certain the proposals would result in decreased issuer flexibility, higher issuer financing costs, reduced investment alternatives for investors, and place U.S. corporations at a competitive disadvantage relative to foreign corporations.
Again, thank you for the opportunity to be here.
[The prepared statement follows:]
Statement of Arthur D. Hyde, Chairman, Corporate Bond Division, PSA The Bond Market Trade Association
Thank you, Chairman Archer, and good morning. My name is Arthur Hyde and I am a Managing Director and Head of Corporate Debt at Salomon Brothers Inc. I am also the Chairman of the Corporate Bond Division of PSA The Bond Market Trade Association and it is in that capacity that I appear today. I am pleased to be here to present PSA's views on some of the revenue-raising tax proposals in the Clinton administration's fiscal year 1998 budget. PSA represents securities firms and banks that underwrite, trade and sell debt securities, both domestically and internationally. Our membership includes most major dealers in corporate and municipal bonds.
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PSA's members help provide capital financing for corporations and state and local governments throughout the nation. We take a very active interest in issues that affect the cost of capital for issuers of debt instruments. We firmly believe that investment in capital assets, both public and private, in addition to creating jobs, is one of the most important factors that determines productivity. Improved productivity, in turn, is the means by which the standard of living for all Americans improves. We are, therefore, extremely supportive of fiscal policies that raise the levels of savings and investment. For this reason, PSA has long been a vocal advocate of a balanced federal budget. Eliminating the deficit is the most direct way to raise savings rates. Taking the federal government out of the competition for a limited pool of funds available for investment will lower the cost of capital for other borrowers and will result in higher levels of private-sector and state and local capital spending. Indeed, one of the most important reasons for balancing the federal budget is the positive effect on savings and investment.
We are dismayed, therefore, that the administration's plan to balance the budget is based in part on proposed tax increases which would raise the cost of capital for corporations and state and local governments and discourage capital investment. We strongly disagree with the administration's characterization of instruments affected by its proposals although they have been couched as cuts in ''unwarranted corporate tax subsidies'' and as ways to close ''tax loopholes.''(see footnote 2) The proposals which we oppose are really nothing more than tax increases. Moreover, the revenue-raising proposals they are targeted at capital investment, an activity which we feel the tax code should encourage. We feel as you do, Chairman Archer that the tax code ought to foster economic growth. We agree with recent statements you have made that ''raising taxes on job makers, risk takers and investors''(see footnote 3) is the wrong way to balance the budget. We therefore appreciate the opportunity to express our firm opposition to proposed tax increases in the president's budget which would increase the cost of capital for corporations and state and local governments, discourage capital investment and job creation, and otherwise weaken the overall economy.
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There is a number of proposals in the Administrations FY 1998 budget released on February 6, 1997, which would have negative effects on the capital markets and savings and investment.
My statement this morning will focus on the following proposals in the administration's FY 1998 budget released on February 6, 1997:
• Deny interest deduction on certain debt instruments;
• Reduce dividends-received deduction to 50 percent and eliminate dividends-received deduction for certain preferred stock;
• Defer original issue discount deduction on convertible debt; and
• Extend pro rata disallowance of tax-exempt interest expense to all corporations.;
• Defer original issue discount deduction on convertible debt; and
• Require reasonable payment assumptions for interest accruals on certain debt instruments.
The staff of the Joint Committee on Taxation has estimated that together, these proposals represent a tax increase on capital investment of over $4 billion over the period 1997–2002, and over $9 billion over the period 1997–2007.(see footnote 4)
When they were originally released in December 1995, the above provisions were proposed with an immediate effective date.(see footnote 5) The result was considerable uncertainty and confusion among capital markets participants. Transactions that were on the verge of execution were suspended. The trading and issuance of certain financial instruments was virtually halted. It took the March 29, 1996 joint statement by Chairman Archer and Senate Finance Committee Chairman Bill Roth on the future effective dates of the pending proposals to put to rest the market's concerns over when the administration's tax proposals would be applied if they were enacted.(see footnote 6) PSA is grateful to you, Chairman Archer, and to Chairman Roth for this clarification. We are also pleased that in its current budget proposal, the administration generally proposed effective dates of ''first committee action'' or final enactment with regard to the above proposals. However, we remain steadfastly opposed to the substance of the proposals on their substance. In addition, even the more sensible effective dates proposed by the administration this year raise significant questions regarding the effect that the proposals would have on the value of certain outstanding financial instruments, especially preferred stock, if the tax treatment of their future payments was changed adversely.
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In our written statement to the Ways and Means Committee last year,(see footnote 7) we outlined some of the political opposition to the administration's tax proposals that had arisen since their release in December 1995. Since our statement last year, that political opposition has intensified. Indeed, we are aware of no public expression of support for the proposals by any member of Congress in the 15 months since their original release apart from members of the administration. PSA has compiled a collection of statements by numerous members of Congress and market participants opposing the above proposals which outlines the scope and breadth of opposition. We will be happy to make this compilation available to Committee members and staff.
The Characterization of Debt and Equity
Three of the administration's proposals outlined above relate to the taxation of financing instruments issued by corporations. Corporations have available to them two ways to finance capital investment: equity and debt. In general, because they are business expenses, payments or accruals on debt are characterized as interest and are deductible for corporate taxpayers. Payments on equity instruments are characterized as dividends and generally are not deductible. The non-deductibility of dividends on equity capital, discussed further below, results in the multiple taxation of corporate earnings, which in turn makes the after-tax cost of equity capital much higher than it would otherwise be. Because of the multiple taxation of corporate earnings corporate interest expense deduction, debt is a favored form of capital under our system of corporate income taxation not from any justifiable policy consideration, but simply as a historical anomaly. For this reason, tax considerations play a role in a corporation's choice of financing mechanism. However, the decision to raise capital in the first place is not tax-motivated. Corporations issue securities and raise capital, debt or equity, because the expected returns on the assets financed from the proceeds of the securities is attractive. The deductibility of payments or accruals on debt capital securities, therefore, can not be reasonably characterized as a tax loophole or benefit.
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The administration's proposals related to corporate financing instruments reflect a fundamentally new approach to the characterization for tax purposes of corporate debt and equity, an approach which is a radical departure from accepted tax policy and which would entail negative consequences for corporate investment in capital assets. Indeed, the administration's proposals represent a significant departure from existing Internal Revenue Service (IRS) rules and practices regarding the classification of debt and equity. Currently, in distinguishing between the two, the IRS considers the following eight factors:(see footnote 8)
• whether there is an unconditional promise on the part of the issuer to pay a sum certain on demand or at a fixed maturity date that is in the reasonably foreseeable future;
• whether holders of the instruments possess the right to enforce the payment of principal and interest;
• whether the rights of the holders of the instruments are subordinate to rights of general creditors;
• whether the instruments give the holders the right to participate in the management of the issuer;
• whether the issuer is thinly capitalized;
• whether there is identity between holders of the instruments and stockholders of the issuer; the label placed upon the instruments by the parties; and
• whether the instruments are intended to be treated as debt or equity for non-tax purposes, including regulatory, rating agency, or financial accounting purposes.
According to the IRS, ''no particular factor is conclusive in making the determination of whether an instrument constitutes debt or equity. The weight given to any factor depends upon all the facts and circumstances and the overall effect of an instrument's debt and equity features must be taken into account.'' As discussed below, however, the administration's proposals would impose new, arbitrary criteria which would supersede a more reasonable ''facts-and-circumstances'' evaluation of particular financing instruments.
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Although we do not necessarily disagree with a ''facts-and-circumstances'' approach to distinguishing between debt and equity, the existing guidelines leave unanswered questions regarding the tax status of particular financial instruments and products. Even more important, the guidelines fail to recognize some fundamental differences in the nature of the income derived from debt and equity instruments and place undue emphasis on accounting factors in distinguishing between the two. PSA believes that there are several general, guiding principles that should apply in defining debt and equity for tax purposes. Before addressing the administration's proposals specifically, a discussion of these principles would be useful.
Single Taxation of Corporate Earnings
The problem of double and triple taxation of corporate profits under prevailing tax law is a fundamental concern for PSA under prevailing tax law. Because corporate equity is not afforded the same tax treatment as debt, corporations' earnings are often taxed multiple times. If a corporation holds stock in another corporation, it is taxed on the dividends paid on that stock to the extent that the dividends do not qualify for the dividends-received deduction (DRD). It is also, of course, taxed on its earnings from all other sources. If the corporation pays dividends to a tax-paying investor, that investor pays taxes on the dividends. To the extent that accumulated, unpaid earnings are represented in the appreciated price of a stock, those earnings are taxed as capital gains when shares are sold by a taxable investor. If the stock is part of an estate, the holdings are taxed when the estate is distributed. The effect of these multiple levels of taxation is to raise financing costs for corporations, reducing incentives for capital formation, and creating serious concerns about global competitiveness.
Ultimately, the solution to the problem of multiple taxation of corporate earnings short of moving to an entirely new system of taxation, such as a consumption tax is to integrate fully the corporate and individual tax systems. Many of the proposals for corporate tax integration which have been circulated in recent years suggest either abolishing the corporate income tax altogether and taxing all corporate earnings at the level of investors, or exempting investment earnings from taxation at the individual level and fully subjecting all corporate earnings, whether paid as interest or dividends, to the corporate income tax.(see footnote 9) PSA would fully support further study and consideration of the issue of corporate tax integration with the goal of amending the federal tax code to ensure that corporate earnings are not taxed more than once. Ultimately, we would favor a tax system without arbitrary distinctions between debt and equity and where financing decisions were made solely on the basis of the lowest cost source of capital. In the end, these issues would be more appropriately considered in the context of a fundamental review of the entire tax system. Short of fully integrating the individual and corporate tax systems, however, we firmly believe that in cases where a reasonable question exists as to the characterization of an instrument as debt or equity, tax law should err on the side of favor treatment as debt so as to minimize the problem of multiple taxation.
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The Nature of Equity Investment
Equity and debt investments are fundamentally different in an important sense. An investor typically buys an equity instrument as a way to participate directly in the long-term growth of the issuing corporation. Such is the case with common stock. Debt investments do not afford this benefit to holders. In buying a debt instrument, an investor is purchasing an income stream or interest accrual, not a participation in the success or failure of a company. It is true that a debt investor can benefit from a corporation's strong performance if a corporation's financial condition improved enough so that its credit rating were upgraded, for example or can be hurt by a corporation's poor performance if a corporation were downgraded or the company went bankrupt. However, the potential risks and rewards of a corporate debt investment related to the performance of a company usually represent only a very small aspect of an investor's total return on his or her investment.
Ultimately, the characterization of an instrument as equity or debt should rest on whether by buying the instrument in question, an investor is purchasing a direct participation in the long-term growth of the issuing corporation, or a stream of cash flows based on an agreed upon rate. A reasonable test to distinguish debt and equity might include the following questions:
• Does the instrument have a fixed maturity?
• Does the holder receive or accrue periodic income at an agreed-upon rate?
• Does the instrument offer the holder the opportunity to participate in the growth or decline of the company during the period in which payments are made or accrued?
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• Can the obligations of the issuer be enforced? Can a default force the issuer into bankruptcy or, ultimately, liquidation?
For most financial instruments, the distinction between debt and equity is obvious. Common stock clearly is equity. Senior and subordinated corporate bonds clearly are debt. Traditional preferred stock, since it represents an interest in a stream of fixed dividend payments, also would fall under the definition of debt. Fixed-rate capital securities(see footnote 10) also represent interests in fixed streams of payments, and therefore would be debt.
Accounting Treatment and Tax Policy
How a financing instrument is treated under accounting rules should play no role in determining its tax treatment. Distinguishing between debt and equity for accounting purposes serves a goal fundamentally different from that for tax purposes. The characterization of financial instruments under accounting rules is based on an issuer's payment obligations and an investor's rights in bankruptcy. The rules also provide common definitions and conventions so that the accounting statements of one company are easily comparable to those of another. The distinction under the tax code exists so that similar types of income are afforded similar tax treatment. There is no reason to expect that the treatment of a given financial instrument under the tax code should necessarily mirror its treatment under generally accepted accounting principles (GAAP) or under the information disclosure requirements of securities statutes and regulations.
Indeed, relying on accounting rules as the basis for how a particular instrument is taxed would effectively grant tax policy authority to the Financial Accounting Standards Board and the Securities and Exchange Commission (SEC). With all due respect to these two highly regarded organizations, PSA firmly believes that tax policy authority should rest with Congress and, to the extent such authority is granted in law, the Treasury Department. The designation of certain hybrid financial instruments as non-debt liabilities in SEC filings, for example, relates to accounting concerns with respect to their status in bankruptcy, not to the nature of the income or other benefits received by the holder or to the obligations of the issuer.
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Deny Interest Deduction on Certain Debt Securities
The administration's budget plan contains a proposal to deny corporate interest expense deductions for debt with a maturity longer than 40 years and instruments with maturities longer than 15 years not characterized as debt in an issuer's SEC filings. This proposal appears to be aimed at eliminating the interest deductibility of innovative new financial instruments, such as fixed-rate capital securities. These instruments are issued by a wide variety of companies, including banks, utilities, insurance companies, media and telecommunications companies, energy companies and manufacturers. They are bought by both institutional and retail investors. In 1996, U.S. corporations raised over $3224 billion of investment capital through the sale of these instruments. Since 19931, corporations have issued over $62388 billion of fixed-rate capital securities.
Fixed-rate capital securities are popular among corporations because by providing a long-term, fixed-rate source of capital that is junior to all other debt but senior to all equity, they fill an important void in a corporation's capital structure. Traditional preferred stock, for a variety of reasons, is an expensive and relatively unattractive source of capital for most corporations. Alternatively, by relying too much on senior and even subordinated debt, corporations run the risk of becoming ''over-leveraged.'' Fixed-rate capital securities can fill an important gap in many corporations' balance sheets. Most forms of fixed-rate capital securities offer corporate issuers the added feature of the deferability of interest payments. In most cases an issuer can, if necessary, defer payments on fixed-rate capital securities for up to five consecutive years. The deferral entails several requirements. A corporation must first stop paying dividends on all common and preferred stock. During the deferral period, interest continues to accrue and is treated under current tax rules for tax purposes as original-issue discount. At the end of five years, if the issuer is still unable to make payments to fixed-rate capital securities investors, its obligations are fully enforceable. Nevertheless, the ability to defer payments in a time of stress is attractive and gives corporations a great deal of financial flexibility. Conceivably, for example, it could prevent a corporation from taking more drastic cost-cutting actions during a downturn, such as lay-offs or plant closings.
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The administration has proposed essentially to prohibit companies from issuing fixed-rate capital securities longer than 15 years apparently on grounds that ''they have substantial equity features (including many non-tax benefits of equity).''(see footnote 11) The administration has characterized this proposal as a way to curb transactions which have ''exploited'' regulatory ambiguity. However, there is no evidence that corporations have in any way attempted to skirt existing distinctions between debt and equity or have otherwise engaged in abusive activity. Indeed, it is only because of a favorable IRS ruling several years ago that fixed-rate capital securities with deductible payments are now able to be issued. The IRS had the opportunity then to take a more aggressive position on the question of interest expense deductibility and chose not to. PSA disagrees with the administration that the current tax treatment of these instruments needs to be changed. Even if the current tax status of these instruments were under debate, fixed-rate capital securities can in no way be reasonably characterized as abusive. Issuers are able to deduct interest payments on fixed-rate capital securities FRCS because these instruments are virtually identical to other forms of corporate debt with regard to payment characteristics and the legal and financial obligations assumed by issuers.
A careful analysis of the affected instruments reveals that they possess the critical attributes of debt. Indeed, Treasury's proposal does not rely on any of these attributes to curtail the interest deductibility of these instruments. Rather, Treasury has focused on the fact that fixed-rate capital securities are not typically shown as debt on a company's balance sheet. The reality is, balance-sheet treatment of these instruments has never before been relevant to their tax treatment and whether they are identified as debt obligations for tax purposes.
Fixed-rate capital securities issued through a trust are a case in point. A company utilizing these instruments issues debt obligations to a trust which, in turn, issues trust securities to investors. The transaction is structured in this way because securities issued through a trust are viewed more favorably by a nationally recognized credit rating agency to improve the attractiveness of the securities to the public. Because these debt obligations are issued through a trust, they are not shown on an issuer's consolidated balance sheet as debt, although the footnotes to the issuer's balance sheet disclose that the sole asset of the trust is the junior, subordinated debt of the issuer status of the obligations as indebtedness is clearly disclosed in a footnote to the company's balance sheet. It should also be noted that fixed-rate capital securities are not characterized as equity on an issuer's balance sheet.
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The balance-sheet characterization of fixed-rate capital securities as non-debt liabilities does not alter the conclusion that the underlying debt securities possess all the critical attributes of debt. This is clearly illustrated by the facts that:
• Investors in these instruments are the legal owners of an undivided interest in the underlying debt obligations, and they enjoy all the creditor legal rights and economic benefits as if they had purchased the debt obligations directly from the issuer, rather than certificates from the trust. In addition, holders of these instruments do not enjoy any participation in an issuing corporation's growth, as do holders of common stock.
• Issuers of these securities despite their ability to extend an interest payment period for up to five years have an absolute obligation to pay interest and principal at maturity. In the case of a default, investors can enforce the obligations of an issuer. Ultimately, the issuer could be forced into bankruptcy or liquidation.
• Holders of fixed-rate capital securities are higher in seniority the ''pecking order'' of payments in the case of bankruptcy than any equity investors.
Contrary to Treasury's revenue projections, this proposal would likely fail to raise revenue. Issuers that are affected by the proposed legislation would either choose to issue hybrid preferred securities with a maturity of 15 years or less, or they would maintain the 15-plus-year maturity of the instruments and issue them directly to investors, rather than through a partnership or trust, albeit at a potentially higher overall cost of capital. In only very few cases limited to commercial banks due to unique regulatory capital rules would an issuer substitute its hybrid financing with equity. In cases where a higher financing cost makes an investment project unfeasible, an issuer would simply not undertake the transaction at all. In any case, Treasury's proposal will ultimately fail to reduce substantially the amount of interest issuers deduct, and it will therefore be unlikely to raise significant tax revenue.
The administration's proposal would also affect corporate debt instruments with maturities longer than 40 years. Here, the administration's distinction between debt and equity is completely arbitrary and capricious. Under the proposal, two otherwise identical debt securities, one with a maturity of 40 years and the other with a maturity of 41 years, would be treated in entirely different ways.
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In the past two years, corporations have taken to issuing debt with very long maturities, sometimes as long as 100 years. The reasons involve the unique market conditions which have prevailed in recent months that have made the transactions attractive to both issuers and investors. Because they can borrow for 100 years at interest rates only slightly higher than, say, 30-year financing, corporations are able to take advantage of stable and long-term financing sources. Domestic corporations are not the only borrowers who have discovered this means of financing. Foreign corporations and governments have also issued 100-years bonds in the U.S. market over the past two years. Since 1990, corporations have raised approximately $8 billion in capital through the sale of 50- to 100-year debt securities. Relative to the corporate bond market overall corporations issued nearly $449 billion in debt securities in 1996 alone instruments with very long maturities represent only a very small portion of total corporate debt financing. However, the instruments provide an attractive, alternative financing source for certain companies.
The administration has offered no explanation as to its choice of 40 years as the criterion for debt. It has also not explained why maturity alone should characterize an instrument as debt or equity when it otherwise has all the characteristics of debt. Any distinction based solely on one factor the maturity of an instrument ignores long-standing definitions and conventions regarding what constitutes debt financing. The administration's proposal would prevent corporations from accessing an efficient source of financing. Foreign corporations, which generally are not burdened by such arbitrary tax policy distinctions as those represented in the president's budget, would still have access to this source of long-term capital and hence would enjoy an advantage over domestic companies. In addition, the administration's proposals would deny debt treatment for certain instruments without fully re-characterizing them as equity so that they would qualify for the dividends-received deduction. These instruments would, in effect, be subject to the worst tax aspects of both debt and equity.
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The administration has proposed capricious, arbitrary distinctions as to what qualifies as debt financing eligible for interest-expense deduction. In addition, the administration's proposals would deny debt treatment for certain instruments without fully re-characterizing them as equity so that they would qualify for the dividends-received deduction. These instruments would, in effect, be subject to the worst tax aspects of both debt and equity.
The definition of equity should rest on more than the criteria proposed by the administration. It should defensible grounds by encompassing only securities whose returns are directly related to the long-term growth of the issuing corporation, such as common stock. Neither long-dated corporate bonds nor fixed-rate capital securities afford this benefit to holders. In both cases, the holder is buying an income stream, not an equity participation.
Reduce Dividends-Received Deduction to 50 Percent and Eliminate Dividends-Received Deduction for Certain Preferred Stock
Under current law, corporate taxpayers that earn dividends on investments in other corporations are permitted a tax deduction equal to at least 70 percent of those earnings. The deduction is designed to mitigate the negative economic effects associated with multiple taxation of corporate earnings. The administration has proposed reducing the minimum dividends-received deduction (DRD) to 50 percent, which would increase the taxation of corporate earnings and discourage capital investment. A companion proposal to eliminate the DRD altogether for preferred stock with certain characteristics would also entail harmful effects.
A generous DRD is important because it reduces the effects of multiple taxation of corporate earnings. As discussed earlier, when dividends are paid to a taxable person or entity, those funds are taxed twice, once at the corporate level and once at the level of the taxpayer to whom the dividends are paid. These multiple levels of taxation raise financing costs for corporations, create global competitiveness problems, and generally reduce incentives for capital formation. The DRD was specifically designed to reduce the burden of one layer of taxation by making dividends largely non-taxable to the corporate owner.
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The administration has argued only that the current 70-percent DRD is ''too generous.''(see footnote 12) It has provided little additional justification for a proposal which would magnify the problem of multiple taxation of corporate earnings and raise the cost of capital investment for U.S. corporations. It has also argued that certain preferred stock, such as variable-rate and auction-set preferred, ''is economically more like debt than stock.''(see footnote 13) However, the administration has not proposed that such instruments be formally characterized as debt eligible for interest payment and accrual deductions. As with the previous proposal to deny an interest deduction for certain debt instruments, the administration has sought to characterize certain preferred stock in such a way as to maximize tax revenue; it would be ineligible for both the DRD and the interest expense deduction.
Scaling back the DRD would exacerbate the effects of multiple taxation. The change would be tantamount to a tax increase on corporate earnings since the minimum deduction available to certain investors would fall. This tax increase would flow directly to issuers of stock, especially preferred stock, who would face higher borrowing costs as investors demanded higher pre-tax yields. Preferred stock is an especially important source of capital for certain corporations and industries, such as commercial banks and utility companies. In response, corporations would tend to cut capital expenditures, reduce working capital, move capital raising and employment overseas, and otherwise slow growth-oriented investment. Amplifying the competitive disadvantages of multiple taxation of American corporate earnings would be the fact that many of our largest economic competitors have already adopted tax systems under which inter-corporate dividends are largely or completely untaxed. Eliminating the DRD altogether for preferred stock with certain characteristics would cut U.S. corporations off from an efficient source of financing. The administration's DRD proposal would thus have a wide range of unintended consequences that would harm the national economy.
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The administration's proposal to reduce the DRD to 50 percent would be effective for ''dividends paid or accrued more than 30 days after the date of enactment.''(see footnote 14) While the proposed effective date can not strictly be characterized as retroactive, it would apply to a large volume of outstanding instruments and would have some very negative consequences for investors and issuers. The proposal would be applied to instruments which were issued and purchased under an assumption of a 70-percent DRD. Reducing the DRD to 50 percent would substantially erode the after-tax value to investors of future payments on these instruments. If a holder sold its investment in the secondary market, its price would reflect the lower, less attractive DRD. In these cases, investors would effectively bear the additional tax liability. A large volume of recently issued outstanding preferred stock was originally sold with ''gross-up'' provisions which essentially require issuers to compensate investors for the additional tax liability associated with adverse changes to the DRD. In these cases, issuers would directly bear the burden of the tax increase. In both cases, taxpayers who made decisions based on prevailing tax policy would be harmed by an adverse change. When the DRD was lowered in previous years, the legislation contained ''grandfather'' provisions to protect issuers and investors who would have been harmed by the change. While we remain steadfastly opposed to the proposal to reduce the DRD to 50 percent, we feel strongly that at the very least it should apply only to stock issued after the date of enactment.
Defer Original Issue Discount on Convertible Debt
The administration has proposed to change the tax treatment of original issue discount (OID) on convertible debt securities. OID occurs when the stated coupon of a debt instrument is below the yield demanded by investors. The most common case is a zero-coupon bond, where all the interest income earned by investors is in the form of accrued OID. Under current law, corporations that issue debt with OID may deduct the interest accrual while bonds are outstanding. In addition, taxable OID investors must recognize the accrual of OID as interest income. Under the administration's proposal, for OID instruments which are convertible to stock, issuers would be required to defer their deduction for accrued OID until payment was made to investors in cash. For convertible OID debt where the conversion option is exercised and the debt is paid in stock, issuers would lose the accrued OID deduction altogether. Investors would still be required to recognize the accrual of OID on convertible debt as interest income, regardless of whether issuers took deductions.
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The administration's proposal is objectionable on several grounds. First, convertible zero-coupon debt has efficiently provided corporations with billions of dollars in capital financing. The change the administration proposes would significantly raise the cost of issuing convertible zero-coupon bonds, and in doing so would discourage corporate capital investment. Second, the administration's presumptions for the proposal are flawed. The administration has argued that ''the issuance of convertible debt with OID is viewed by market participants as a de facto purchase of equity.''(see footnote 15) However, performance does not bear out this claim. In fact, of the convertible zero-coupon debt retired since 1985, approximately 70 percent has been retired in cash, and only 30 percent has been converted to stock. Indeed, the market treats convertible zero-coupon bonds more as debt than as equity.
Third, and perhaps most important, the administration's proposal violates the basic tenet of tax symmetry, the notion that the recognition of income by one party should be associated with a deduction by a counterparty. This fundamental principle exists to help ensure that income is taxed only once. Under the proposal, investors would be taxed fully on the accrual of OID on convertible zero-coupon debt, but issuers' deductions would be deferred or denied. The proposal would compound problems associated with the multiple taxation of investment income, thereby raising the cost of corporate capital.
Because the proposal would exacerbate problems of multiple taxation of corporate income and because it would raise the cost of corporate capital investment, PSA urges the rejection of the administration's proposal.
Extend Pro Rata Disallowance of Tax-Exempt Interest Expense to All Corporations
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Another proposed tax increase in the administration's budget, while it would nominally apply to corporations, would in reality be borne by state and local governments in the form of higher financing costs. Rather than closing a ''tax loophole'' for corporations, the proposal would make it more expensive for state and local governments to finance vital public services.
Under current law, investors, including corporations, are not permitted to deduct the interest expense associated with borrowing to finance purchases of tax-exempt securities. Financial institutions that earn non-qualified tax-exempt interest are automatically disallowed a portion of their interest expense deduction in proportion to the ratio of municipal bond holdings to total assets. Non-bank corporations that earn tax-exempt interest, in order to avoid a loss of interest-expense deduction, must demonstrate that they did not borrow to finance their purchases. Under an IRS procedure in place since 1972, as long as a corporation's tax-exempt bond portfolio does not exceed two percent of its total assets, the IRS does not attempt to determine whether the corporation borrowed to finance its municipal bond holdings.(see footnote 16) This is the so-called ''two-percent de minimis rule.'' The administration's proposal would effectively repeal this ''safe harbor'' and automatically deny corporations that earn tax-exempt interest a pro rata portion of their interest expense deduction. The proposal effectively exempts insurance companies from its proposed new treatment.
The administration's proposal would raise the costs of borrowing for state and local governments, and would make it more expensive to finance new investment. The Treasury Department argues that the proposal would not significantly affect municipal borrowing rates. In a letter sent last year, Treasury Secretary Rubin argues that ''eliminating the 2 percent de minimis rule will not materially affect the costs of borrowing for State and local governments'' because non-financial corporations hold only about 5 percent of outstanding tax-exempt bonds.''(see footnote 17) In other words, the administration argues, the departure of non-financial corporations will at worst have only a minimal influence on total municipal market conditions. While it is true that non-financial corporations account for a small percentage of total municipal securities outstanding, the administration's argument fails to recognize the absolutely vital role they play in important market segments: short-term municipal notes and certain variable-rate securities, state and local government housing and student loan bonds, and municipal leasing transactions. The effects of the administration's proposal would be most felt by state and local governments in these three areas.
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Short-Term Municipal Note Market
State and local governments issue short-term securities to finance a variety of programs and services. The most common use of short-term financing is to fund mismatches between revenues and expenditures. States and localities may incur expenditures before they receive tax and other revenues. Through short-term borrowing, state and local governments can finance temporary cash-flow shortfalls. States and localities also issue longer term bonds that are designed to behave like short-term instruments in order to appeal to certain investors and to take advantage of prevailing market conditions. These longer term ''variable rate demand notes'' (VRDNs) are issued to finance a variety of public investment projects.
Non-financial corporations are major purchasers of short-term municipal notes and VRDNs. Corporations buy short-term municipals as a cash management vehicle. In doing so, corporations finance their municipal investments from surplus cash and working capital accounts, not from the proceeds of borrowing. Corporate investment in the municipal market is almost never tied to corporate borrowing in any way. By participating actively in the short-term market, corporations help to keep municipal borrowing rates incredibly stable. Currently, short-term municipal borrowing rates are approximately 65.5 percent of comparable taxable rates. This ratio has remained virtually constant in recent years, due largely to participation in this market by corporations. The ratio of longer term municipal borrowing rates to taxable rates is much more volatile, ranging in recent years from 75 to 90 percent, since corporations do not actively participate in the market for longer dated municipal bonds. The administration's proposal would effectively discourage virtually all corporate investment in the municipal market. In doing so, the proposal would significantly raise the cost of short-term borrowing for state and local governments and would make short-term municipal rates more volatile relative to taxable rates. We agree with you, Chairman Archer, that the administration's proposal ''would plainly have a negative impact on State and local governments that rely upon tax-exempt debt.''(see footnote 18) We also appreciate your commitment to ''resist attempts to include this provision in any balanced budget agreement.''(see footnote 19) Numerous others in Congress have expressed similar sentiments, including over one-third of the Senate in the 104th Congress,(see footnote 20) and we are encouraged by these expressions of opposition to this short-sighted proposal.
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The administration has argued that the law as presently written permits non-financial corporate taxpayers ''to reduce their tax liabilities inappropriately through double Federal tax benefits of interest expense deductions and tax-exempt interest income.''(see footnote 21) Implicit in the administration's argument is the assumption that corporations have deliberately engaged in arbitrage practices by borrowing in the short-term market and investing in tax-exempt obligations. However, there is no evidence to suggest that corporations are engaging in abusive, arbitrage-motivated transactions. Holdings of municipal bonds have averaged only 0.47 percent of the financial assets and 0.15 percent of the total assets of non-financial corporations since 1987,(see footnote 22) a level that has remained fairly consistent. Moreover, given that the top corporate income tax rate is 35 percent and the short-term tax-exempt/taxable yield ratio hovers around 65.5 percent, the level of after-tax return available to corporations in the municipal market simply does not justify arbitrage transactions.
The Treasury has also argued that ''the treatment of financial institutions and dealers should be applicable to all corporations, without regard to the type of business activity the corporation conducts.''(see footnote 23) In reality, the proposal would result in grossly unfair treatment for a large number of corporations which, under current law, may legitimately invest in the tax-exempt bond market by clearly showing they did not borrow to do so. It would do this through a provision that would extend the pro rata disallowance of interest expense on a combined basis to ''affiliated companies'' that file consolidated returns and by eliminating the present-law analysis of the intent of the corporation.
Non-financial corporations currently purchase a substantial portion of newly issued short-term state and local securities. They are, in effect, buyers of last resort that prevent excessive interest rate volatility. In their absence, short-term, tax-exempt rates would likely rise in times when other short-term investors are net sellers. Non-financial corporations would not be major buyers of short-term municipals in the future under the proposal, with the result being higher, more volatile state and local borrowing rates.
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Housing and Student Loan Bonds
The housing and student loan sectors of the municipal market would also be negatively affected by the administration's proposal. State and local governments issue bonds to finance home mortgage loans for low- and moderate-income families as well as loans for low-income, multi-family rental projects. Both these programs provide limited, targeted, below-market financing for housing. Over the past several decades, state and local housing bonds have provided tens of billions of dollars in rental housing for low-income families and have made home ownership available to families who may not have been able to finance a home through any other source. Student loan bonds are issued to finance below-market loans to college students who may not otherwise be able to obtain tuition financing.
Together, Fannie Mae, Freddie Mac, Sallie Mae and other government-sponsored corporations and agencies hold about $8.6 billion of outstanding municipals. These entities invest primarily in state and local housing bonds (Fannie Mae and Freddie Mac) and student loan bonds (Sallie Mae). Indeed, it is a condition in Fannie Mae's and Freddie Mac's statutory charters that they help support the market for low- and middle-income housing, and investing in state and local housing bonds is one of the ways in which these agencies carry out that obligation. Under the administration's proposal, these organizations would simply stop buying municipals. State and local housing and student loan agencies would become almost completely dependent on individual investors, acting directly or through mutual funds. Individuals tend to be more volatile and less consistent sources of demand. Higher financing costs in these sectors ultimately mean less financing of low- and moderate-income single family and multi-family housing and less student loan financing. a result, the cost of mortgage financing provided through state and local governments would increase substantially.
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Municipal Leasing Transactions
The proposal would also have profound effects on municipal leasing. States and localities routinely lease assets and equipment, such as school buses, police cars, and computers. If the administration's proposal were adopted, equipment lessors estimate that their cost of financing for state and local governments would increase dramatically. After originating municipal lease transactions, most lessors generally sell their financing contracts to private funding sources to generate the capital they need to continue to operate their business. Those who invest in tax-exempt leasing include corporations, commercial banks and investment banks. Individuals and mutual funds, through certificates of participation, also purchase tax-exempt leases. Although the administration's proposal would not apply ''to certain non-salable tax-exempt bonds acquired by a corporation in the ordinary course of business in payment for goods and services sold to a state or local government,'' this intended relief is illusory. The vast majority of equipment manufacturers who sell to state and local governments prefer not to hold municipal leases because they do not want to tie up their capital. These companies generally sell their financing contracts to third party investors. The administration's proposal would discourage vendor financing of capital equipment leased to states and localities. As a direct result, the cost of new capital investment by state and local governments would rise substantially. Require reasonable payment assumptions for interest accruals on certain debt instruments
This proposal would require investors in certain asset-backed securities (ABS) to use ''reasonable payment assumptions'' in determining their annual accrual of original-issue discount. ABS are important because they permit banks and other issuers to manage their balance sheets by selling otherwise illiquid assets efficiently. This proposal represents a tax increase on (ABS) investors because in most cases it would accelerate their recognition of OID income. Investors would likely pass this additional tax onto issuers in the form of higher rates of return. The proposal would apply to already outstanding ABS, thereby subjecting these investors to more onerous tax treatment after their investment decision, similarly to the proposal to reduce the DRD.
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Summary
Again, we appreciate the opportunity to comment on the tax proposals contained in the administration's FY 1998 budget proposal. Although we strongly oppose many of the administration's proposals on the grounds that they would discourage capital formation and public and private investment, we welcome the Ways and Means Committee's attention to these important issues, and we look forward to working with members and staff of the committee as your work on the budget progresses.
PSA is truly encouraged that a balanced federal budget may finally be at hand. We support eliminating the deficit because it we believe that capital investment creates jobs and is vital for a stronger economy. A balanced budget will foster greater levels of savings and investment, which in turn will result in higher productivity and better living standards. We are deeply troubled, however, that the administration has proposed increased taxes on capital investment as part of its balanced budget plan. PSA believes that policy-makers at all levels should be looking for ways to encourage greater savings and investment, not discourage it by making it more expensive for corporations and state and local governments to raise capital. We strongly urge the Committee in its deliberations on the administration's budget to oppose all proposals that would increase the cost of capital investment.
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Chairman ARCHER. Thank you, Mr. Hyde.
Our next witness is very familiar to Members of the Committee, but I will let you identify your background and what you are currently doing, Fred Goldberg.
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STATEMENT OF HON. FRED T. GOLDBERG, JR., PARTNER, SKADDEN, ARPS, SLATE, MEAGHER & FLOM LLP; AND FORMER COMMISSIONER, INTERNAL REVENUE SERVICE, AND FORMER ASSISTANT SECRETARY FOR TAX POLICY, U.S. DEPARTMENT OF THE TREASURY
Mr. GOLDBERG. Thank you, Mr. Chairman.
My name is Fred Goldberg, and I am here in my individual capacity. I served at one point as the IRS Commissioner; at another point as the Assistant Secretary for Tax Policy, and I am now in private practice.
I do want to note that a number of clients that I represent have an interest in these proposals; that many of the clients of the firm I am with are affected by these proposals, but I am here today in my individual capacity.
It is a pleasure to appear before you today, and it has been several years since I last testified before this Committee and, Mr. Chairman, I must say I am pleased to note you have changed seats since I was last here.
I will limit my remarks today to summarizing why I believe most of the administration's proposals should be rejected.
However, I request that my entire statement be entered into the record, and I do note that my statement does identify several areas where legislation would be warranted.
The administration's proposals are not loophole closers. They are not a tax on corporate welfare. I implore you and your colleagues to get past these labels. These proposals are tax increases on real people and real businesses. They are tax increases that will discourage savings and investment, they are tax increases that will undermine our economy's ability to respond to competitive pressures and to restructure key industries to create jobs and meet the needs of customers. They also represent major changes in long-established tax policy.
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The proposals suffer from four fundamental defects. First, as I note in my written statement, the administration proposals represent ad hoc, unwarranted, and sometimes astonishing changes in basic tax policy. I believe they are unprincipled in the truest sense of the word.
To prove this point, ask yourself the following questions: Is there a unifying theme to these proposals? Can you take the rationale for one proposal and apply it consistently to other proposals? Should tax consequences be determined solely by financial accounting and nontax regulatory rules, but only when it raises revenue? Should instruments be classified as debt or equity based on how they are ''viewed,'' but only when it raises revenue? Are we really comfortable with a wholesale departure from symmetry, from the notion that what is fair and right on one side is fair and right on the other? In my opinion, the answer to these questions is, no. And if the answer to these questions is no, then you should reject the administration's proposals out of hand.
But whatever you do, please, do not kid yourselves. The administration's proposals embody fundamental changes in tax policy.
Second, as I note in my statement, the administration's proposals are contrary to fundamental economic policy goals. They undermine savings, investment, and economic growth. As a practical matter, they do little more than penalize middle-class Americans who work and save, either save directly or through mutual funds or through retirement plans. The target may be Wall Street but the victims live on Main Street.
Third, as I note in my written statement, several of the administration's proposals are very much like the Energizer Bunny, they keep taxing and taxing and taxing the same income over and over again.
Finally, the administration's proposals are inconsistent with the goals of balancing the budget and tax reform. In making this observation I want to emphasize that it applies with equal force to those who want to reform the existing system as well as those who want to start over. Not only do the Treasury proposals move in the wrong direction, but they consume time and energy that would be far better spent on fundamental tax policy issues.
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In sum, the administration's proposals are not supported by sound tax policy. At most, they reflect an arbitrary bias in favor of our current income tax system. When in doubt, tax it.
Thank you, Mr. Chairman.
[The prepared statement follows:]
Statement of Hon. Fred T. Goldberg, Jr., Partner, Skadden, Arps, Slate, Meagher & Flom LLP; and Former Commissioner, Internal Revenue Service, and Former Assistant Secretary for Tax Policy, U.S. Department of the Treasury
Mr. Chairman and Members of the Committee, it is a pleasure to appear before you today to testify on the Administration's so-called revenue raisers that affect savings, investment and economic growth.
While I am appearing here today in my individual capacity, I want to note that I am currently engaged to represent clients regarding certain of the proposals I will address today. I am not being paid for the time I have spent preparing my testimony, and my written statement has not been reviewed or approved by any clients of the firm.
Taken as a whole, the Administration's revenue raising proposals would, if enacted, have a material adverse impact on most of the individuals and businesses we represent. I should hasten to point out, however that this should come as no surprise. The Administration's proposals, if enacted, would have a direct and material adverse impact on millions of individual and business taxpayers throughout the country. Indeed, this is the most important point I have to make. To think of the proposals as ''loop-hole closers'' to provisions which were ''corporate welfare'' would be a mistake. I implore you and your colleagues to get past these labels. These proposals are tax increases on real people and real businesses. They are tax increases that will discourage and penalize the very activities that are essential to savings, investment, job creation and economic growth. They also represent major changes in long-established tax policy.
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I have had the honor and privilege of spending almost seven years in various tax administration and tax policy positions with the IRS and Treasury, and about 15 years as a tax professional in private practice. Like many others in the private sector, I support your ongoing efforts to address areas of the tax law that confer unwarranted tax benefits. Having ''been there and done that,'' I can also empathize with the enormous pressure that Treasury and Congress are under to raise revenue without raising taxes. I have the highest respect for the staff of the tax-writing committees, the Joint Tax Committee, and Treasury's Office of Tax Policy. They are trying to do an extremely difficult job under extremely difficult circumstances.
Based on my experience in government and the private sector, it is my judgement that most of the Administration's proposals should be rejected out of hand, that others must be modified to achieve their stated objectives, and that others can be modified to advance basic tax policy and tax administration objectives that you and your colleagues have long supported.
I would like to begin by addressing the following proposals:
• Proposals to recharacterize debt for tax purposes solely to deny interest deductions(see footnote 24)
• Proposal to defer the interest deduction on OID convertible debt until cash payment(see footnote 25)
• Proposals to further restrict the dividends received deduction (DRD)(see footnote 26)
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• Proposal to require use of average cost basis in computing gain on sale of securities(see footnote 27)
• Proposal to accelerate interest accruals on certain pools of debt (see footnote 28)
• Proposal to impose corporate level capital gains tax on certain tax free reorganizations (the so-called ''Morris Trust'' proposal)(see footnote 29)
For convenience, I will refer to these proposals collectively as the ''Administration Proposals.''
I have focused on these proposals because I am convinced that the most important tax policy issues we face involve the ability of everyday Americans to save and invest, and the ability of businesses to respond to competitive pressures, create jobs and meet the needs of their customers. The imposition of multi-levels of taxation—through the asymmetrical treatment of debt and equity, the asymmetrical treatment of expenses and income, and through the double taxation of corporate earnings—only make savings and investment less advantageous for these everyday Americans.
My testimony should not be construed as support for the Administration's proposals I do not mention. To the contrary, I think many of them are also ill-advised on tax and economic policy grounds.
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The Administration Proposals suffer from four fundamental defects.
First: The Proposals Represent Ad Hoc, Random, Unwarranted, and Sometimes Astonishing Changes in Basic Tax Policy
• The proposals to recharacterize certain debt instruments as equity depart from settled law regarding the definitions of debt and equity for Federal income tax purposes. In addition, the proposal to defer interest deductions on OID convertible debt departs from settled notions of economic accrual. Instruments that are clearly debt under current law are subject to radically different treatment under the Administration's proposals. What is particularly troublesome is that there is no coherent reason for the suggested changes. The rationale for any particular proposal is ad hoc, not applied consistently to other instruments, and often justified by anecdote rather than evidence.
• These same proposals violate basic notions of symmetry. For the most part, they would treat the same instrument in entirely different ways—as debt from the holder's perspective and equity from the issuer's perspective. The OID convertible debt proposal would require investors to accrue interest income currently while denying interest deductions to issuers of the same instrument. While this may not trouble some inside the beltway, it violates long-standing tax policy and basic notions of fair play.(see footnote 30)
• Certain of these proposals require treatment of instruments as equity based solely on their treatment for regulatory and/or financial accounting purposes. As a result, two instruments that are identical from the standpoint of their economics and the legal rights and obligations of the parties—two instruments that have always been treated the same for Federal income tax purposes—will be treated differently based on their treatment for regulatory and/or accounting purposes.(see footnote 31)
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• The OID convertible debt proposal alters the tax treatment of a particular instrument solely because it is said to be ''viewed as equity.''(see footnote 32) A similar rationale is offered for a number of the other proposals recharacterizing debt as equity.
• The Administration's ''Morris Trust'' proposal would reverse long-standing policy regarding the treatment of tax-free reorganizations. It would impose a corporate-level capital gains tax on certain transactions that historically have not been subject to tax. The stated policy concern is that certain of these transactions are really disguised sales—the problem is that the Administration's proposal taxes transactions in which there is no inappropriate movement of cash or debt and does not impact many other transactions in which there is a significant movement of cash or debt.(see footnote 33)
With all due respect, I believe there is simply no tax policy justification for these changes. The proposals are unprincipled in the truest sense of the word. Ask yourselves: Is there a unifying theme to these proposals? Can I take the rationale for one proposal and apply it consistently to other suggested changes? The answer to each of these questions is no.
As a tax policy matter:
• Should tax consequences be determined by financial accounting and non-tax regulatory rules—but only when it raises revenue?
• Should instruments be classified as debt or equity based on how they are ''viewed''—but only when it raises revenue?
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• Are we really comfortable with a wholesale departure from symmetry—but only when it raises revenue?
• Does it make sense to abandon well-established notions of what constitutes a tax-free reorganization and impose a corporate-level capital gains tax—under circumstances where the proposal bears no relationship to the stated tax policy concern?
Maybe some would answer these questions in the affirmative. But don't kid yourselves: these are fundamental changes in policy—changes that I urge you to reject out of hand.
Second: These Proposals Are Contrary to Fundamental Policy Goals—They Undermine Savings, Investment, and Economic Growth
• Most of the Administration Proposals are little more than tax increases on savings and investment. Raising taxes is like raising prices. If you increase taxes on savings and investment, you will get less savings and investment. If you get less savings and investment, you will get less economic growth and job creation.
• As a practical matter, these proposals do little more than penalize middle class Americans who work and save, either directly or through mutual funds and retirement plans. The target may be Wall Street, but the victims live on Main Street. For example:
—The Joint Tax Committee has estimated that the average basis rule would affect more than 10 million individual taxpayers.
—87.5% of all OID convertible debt is held directly or indirectly by individuals. Approximately 43% of these individuals hold this debt through mutual funds, with the remaining 57% holding the debt through retail accounts. With no colorable tax policy justification, the Administration's proposal would deny millions of individual savers this investment opportunity in the future.(see footnote 34)
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—Millions of individual shareholders have benefitted from Morris Trust transactions. The Administration's effort to curtail these transactions would harm many millions of investors in the future.
• The Administration's average cost basis proposal penalizes long-term investors and reenforces the ''lock in'' effect of capital gains taxes. The proposal is especially harsh on middle class taxpayers who make modest investments each year in stocks that they follow for many years.
• Many of our basic industries are restructuring to implement changing business strategies, confront competitive pressures, create jobs, and meet their customers' needs. Fundamental changes are taking place in industries ranging from defense, health care, and telecommunications, to transportation, entertainment, and consumer products. This flexibility is a primary reason why our economy is generally recognized as the strongest in the world. In its current form, the Administration's ''Morris Trust'' proposal would impose substantial and unwarranted restrictions on certain critical restructuring activities—restrictions that would harm employees, customers and shareholders.
Third: Several Proposals Are Very Much Like the Energizer Bunny—They Keep Taxing, and Taxing, and Taxing the Same Income . . . Over and Over Again
• For example, under our current system (which even the New York Times thinks ought to be changed), we tax income once at the corporate level and again at the shareholder level. The proposal to further restrict the DRD means that we are taxing income at the corporate level more than once, and taxing that same income again at the shareholder level.
• Likewise, the Morris Trust proposal to tax corporate-level capital gain in certain tax-free corporate reorganizations has the practical effect of taxing the same capital gains more than once.(see footnote 35)
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• Finally, the Treasury proposals that eliminate the symmetric treatment of certain instruments (i.e. treating the same instrument as equity to the issuer and debt to the holder; deferring the issuer's deduction, but taxing the holder's income currently) are very much like taxing the same income several times.
Fourth: The Administration Proposals Are Inconsistent With the Goals of Balancing the Budget and Tax Reform
• There is widespread agreement that a balanced budget would be good for the economy because it would increase net national savings and encourage economic growth. As I have already noted, the Administration Proposals move in the opposite direction.
• Common themes in most tax reform proposals (including proposals for reform within the framework of the current income tax) include: don't tax income more than once; encourage savings and investment; promote economic efficiency; simplify the rules. The Administration Proposals run directly contrary to these goals.
• There is also another problem with the Administration Proposals in the context of tax reform. In making this observation, I again want to emphasize that it applies with equal force to those who want to reform the existing income tax system (not just those who want to start over). My point has to do with opportunity costs—you, your colleagues and professional staff will spend an enormous amount of time and energy on the Administration's proposals. This time and energy could be far better spent on fundamental tax policy issues that hold far more potential for improving the system.
In sum, these proposals cannot be justified as a matter of tax policy. More important, however, is that they run directly contrary to fundamental public policy goals. Savings, investment, the ability to respond to competitive pressures, the restructuring of key industries to create jobs and meet the needs of individual customers—these goals matter a lot. They will have a big impact on our well-being in the 21st century.
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As I have indicated, these proposals are somewhat surprising because they aren't supported by a coherent notion of sound tax policy. These proposals don't even pose a ''choice'' between good tax policy and good economic policy. At best, they reflect an arbitrary bias in favor of our current income tax system: when in doubt, tax it. If the question is under taxing or over taxing corporate income, over tax it. If the question is under taxing or over taxing investment income, over tax it. If the question is under taxing or over taxing capital gains, over tax it. Those who are wedded to our current income tax system might well accept and support this bias as achieving some kind of rough justice. My own view is that it would be a terrible mistake for you and your colleagues to accept that perspective.
In case it's not obvious, I think that most of the Administration's proposals should be rejected by the Congress. They are bad tax policy and bad economic policy. On the other hand, I do believe that there are a number of revenue raising proposals that the Congress may wish to pursue. I would like to mention three. First, the Administration has proposed, and in 1995 the Republican Congress accepted, a proposal to require registration of certain corporate transactions that confer substantial tax benefits. While it is important that the proposal not impose needless reporting burdens, and that it be tailored to meet its stated objectives, it is an area that holds promise. Tim Hanford of your staff should be commended for his ongoing efforts in this area.
Second, the Administration has proposed taxing so-called short-against-the-box transactions. While there are certainly principled arguments on both sides of this issue, I think it merits your careful consideration. In this regard, however, I do believe that the current Administration proposal is flawed in two respects. In its current form, it is far too broad, and will have a material adverse impact on legitimate economic activity that is consistent with sound tax policy. In addition, the Administration's proposal applies on a retroactive basis to existing transactions. I think this is a mistake.
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Taxpayers are expected to comply with all existing laws and regulations—including some that over tax their income, impose excessive compliance costs, or simply make no sense. For the most part, taxpayers accept their duty to play by the rules and follow the tax laws as they are written. These taxpayers should also be permitted to rely on the tax rules that are beneficial to taxpayers. Certainly if (or when) Congress and the Administration decide to make changes that benefit the taxpayer, they do so prospectively. The same should apply when changes are made that are to the taxpayers' detriment. If the government hopes to keep in tact the integrity of our voluntary income tax system, it must care about these equities.
Third, as the head of the Joint Tax Committee has aptly noted, Morris Trust transactions may be structured in ways that look like the cash sale of a business. This is an area of legitimate concern from a tax policy standpoint that Congress may wish to explore. Unfortunately, the Administration's proposal is fatally flawed.(see footnote 36) Given the choice between doing nothing and enacting the Administration's proposal, it is absolutely clear that you should do nothing. In its current form, the proposal would do serious harm and should be rejected.
I would also like to suggest that this area may present an unusual opportunity. If you do decide to address Morris Trust transactions, the focus should be on cash and debt. At the same time, I think you can make complementary changes that would greatly simplify the law governing these types of transactions and advance your goals of efficiency and economic growth.
Once again, I appreciate the opportunity to appear before you today. I would be happy to answer any questions you may have.
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Chairman ARCHER. Thank you, Mr. Goldberg.
Our next witness is Donald Crumrine. If you will identify yourself, you may proceed.
STATEMENT OF DONALD F. CRUMRINE, CHAIRMAN OF THE BOARD, FLAHERTY & CRUMRINE, INC., PASADENA, CALIFORNIA
Mr. CRUMRINE. Mr. Chairman and Members of the Committee, I am Donald Crumrine of Flaherty & Crumrine, Inc., an investment advisory firm located in Pasadena, California, that specializes in the management of preferred stock portfolios.
My remarks today will focus primarily upon the administration's proposals concerning the intercorporate DRD, dividends received deduction, as we all refer to it.
I am appearing on behalf of the Preferred Income Group of closed-end funds, three New York Stock Exchange listed investment companies for which our firm is the investment adviser. Those funds have over 30,000 shareholders, most of whom are individual investors seeking income and preservation of capital.
As I am sure you are aware, the DRD reduces to something over double taxation what would otherwise be triple taxation of income. This is in contrast to our major trading partners who, by and large, tax income once through integration or partial integration of their Tax Codes.
Traditional preferred stocks which qualify for the DRD have long played a very supportive role in equity financing in this country. They are a relatively expensive form of financing compared with debt, however, simply because the dividends paid to preferred shareholders are not deductible as are interest payments on debt.
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Any attempt to tap traditional preferred stocks for increased tax revenues by reducing the DRD will significantly undercut their role as a source of equity financing, will accelerate the recent shrinkage of this market, and will end up being counterproductive from a revenue standpoint.
I should distinguish between traditional preferreds that are eligible for the DRD and the new class of securities generally known as ''tax-deductible preferreds,'' including MIPS, TOPrS, trust preferreds, and capital securities and the like. Tax deductible preferreds are basically debt structured to allow the issuer a tax deduction for payments made to investors. However, they also have some equity-like features such as the potential deferral of interest payments for up to 5 consecutive years, subordination to all other debt, and very long lives.
The three features just mentioned were specifically required by the Federal Reserve last fall when it first allowed banks to treat tax-deductible deferreds as tier I equity capital.
The emergence of tax deductible preferreds provides a dramatic illustration of how sensitive financing decisions are to the cost differential between debt and equity, which is fostered by the present tax law. In the 14 months since the end of 1995, the amount of deductible preferreds has increased over fourfold to approximately $61 billion, with the volumes of new issues exploding since the Federal Government's action last fall.
In the same period, the size of the traditional or DRD-eligible preferred market has shrunk by about 9 percent, and we estimate the completion of refinancings already in motion will shrink the traditional preferred stock market by over 24 percent in total to about $50 billion.
In the last 2 weeks, a spokesman for one of the corporations involved in this was quoted on the Bloomberg News Service as saying, ''This is strictly a refinancing, substituting a tax deductible preferred for a non-tax-deductible preferred. There is an economic advantage.''
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Let me emphasize that the principle problem here is not tax deductible preferreds; it is the bias in the Tax Code that favors financing with debt instead of equity. To the extent that tax deductible preferreds overreach to get the advantages of both debt and equity, in effect, having it both ways, these can be addressed, although the solution may not be exactly what the administration has suggested.
With regard to preferred stocks, reducing the DRD would increase even further the cost differential between debt and equity financing and accelerate the substitution of debt for equity. Corporate America would end up being more highly leveraged and paying less in taxes.
The foregoing also applies to the administration's proposal to eliminate the DRD for new issues of several long established forms of preferred stock financing. These include adjustable rate preferred stocks and auction rate preferred stocks, both of which are shrinking markets anyway, and sinking fund preferred stocks with maximum lives of less than 20 years.
In each case, the distinctive feature of these preferred stocks is designed to deal with one aspect or another of interest rate risk, not equity risk. Nothing in their structures protects the preferred shareholder against a deterioration of the issuer's ability to meet its financial responsibilities.
The stockholder cannot declare default or seize collateral. In the case of bankruptcy, the preferred stockholder has to stand at the end of the line behind all debt holders.
That is the essence of equity risk and history is full of examples of how real that risk can be.
Thank you.
[The prepared statement follows:]
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| Flaherty & Crumrine Inc. |
| Investment Counsel |
| March 7, 1997 |
A.L. Singleton, Chief of Staff
Committee on Ways and Means
U.S. House of Representatives
1102 Longworth House Office Building
Washington, D.C. 20515
In re: Request dated 2/25/97 for comments on revenue raising provisions in the Administration's fiscal year 1998 budget proposal
Dear Mr. Singleton:
We wish to comment on the Administration's proposals concerning the intercorporate dividends received deduction (''DRD'').
Flaherty & Crumrine Incorporated (''F&C'') is an investment adviser registered with the SEC that specializes in the management of preferred stock portfolios. Assets under F&C's management total approximately $1.2 billion, the great bulk of which is traditional preferred stocks that qualify for the DRD.
We are commenting on behalf of three publicly held investment companies for which F&C is the investment adviser, Preferred Income Fund, Preferred Income Opportunity Fund and Preferred Income Management Fund, that have over 30,000 shareholders potentially impacted by the proposals. Our firm also manages preferred stock portfolios for a small number of large corporate investors, but we do not purport to speak for them specifically.
Overview of Our Positions on the DRD Proposals as They Affect the Traditional Preferred Stock Market
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We shall address these proposals solely from the viewpoint of the preferred stock market simply because that is our area of expertise. We believe that many of the same considerations would apply to the common stock market as well, but we are not the right people to make those arguments.
In summary, these are our views:
• We believe the proposals fail to recognize the market effects of increasing the cost of financing with traditional preferred stock, which is already very high versus debt.
• The proposed reduction of the DRD from 70% to 50% would accelerate the replacement of traditional preferreds eligible for the DRD with debt financing, thereby harming an important segment of the capital markets and precluding increased tax revenues from preferred stocks. We will expand upon this later.
• The current proposals to constrain so-called ''tax deductible preferreds'' such as MIPS , TOPrS , Capital Securities, Trust Preferreds, etc. would not alter the future course of events much even if they were enacted. Tax deductible preferreds are basically debt. Only a few equity-like features such as the ability to defer interest for up to five years without triggering default and their treatment as equity for credit and financial statement purposes allow issuers to have both the tax benefits of debt and the other benefits of equity at the same time. Wall Street has learned how to sell corporate debt to Main Street, and that will not change even if Congress cleans up the more overreaching aspects of these tax deductible preferred securities.
• The proposals to eliminate the DRD on ''preferred stock with certain non-stock characteristics'' are misguided with regard to the economics of the preferred stock market. The test of a ''stock'' is equity risk, that is, the security's ranking in the financial order of priorities in which the issuer must meet its obligations. The proposals generally attack features intended to deal with interest rate risk, which is fundamentally different than equity risk. As Chairman Greenspan of the Federal Reserve recently pointed out in a Congressional hearing, interest rates are also a key driving force affecting common stocks. The only real issue we see here would be an extreme case involving an enforcement question of substance versus form.
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• The proposal to modify the holding period for the DRD is more debatable. One could argue that certain positions, if they are sufficient to suspend the holding period initially, should not be ignored just because the holding period has been satisfied once. We are more inclined to question these proposals because of the lack of evidence that a lot of undesirable activity would be caught in this net. A long series of tax reform acts and regulations issued by the IRS has eliminated many of the ''games'' that were being played in the 1980's. The proposals would further increase the complexity of the tax code without much to show for it.
Significance of the U.S. Preferred Stock Market
The United States has the only well developed preferred stock market in the world. Traditionally, the DRD has allowed domestic issuers, particularly utilities and banks, to obtain lower cost equity capital in the preferred stock market by partially shielding corporate investors from an additional layer of corporate taxation. Foreign issuers commonly access the U.S. market, often taking advantage of favorable tax treatment at home or under treaty with the United States.
The preferred stock market also provides a ''safety valve'' for companies in need of equity capital. This was best demonstrated by the crisis in the U.S. banking industry in the early 1990's. When the banks were unable to raise additional equity capital in the common stock market, their needs were accommodated through the issuance of traditional preferred stocks eligible for DRD.
Preferred stock dividends account for a disproportionately large share of total dividend income received by corporate investors. The yields of preferreds are much higher than those of common stocks, and the largest share of outstanding DRD eligible preferreds is owned by corporations. Thus, structural changes in the preferred stock market that would take place in response to a change in the DRD would have a substantial impact on the amount of tax revenues gained or lost.
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Replacement of Traditional DRD Eligible Preferred Stocks by New ''Tax Deductible'' Preferred Securities
Since late 1993, there has been dramatic growth in the issuance of a new type of security variously called MIPS, TOPrS, Capital Securities, Trust Preferreds, etc., all of which are commonly referred to as ''tax deductible preferreds.'' These hybrid securities, which combine features of both debt and equity, are being used for new financing and to replace large amounts of traditional preferred stocks eligible for the DRD. The logic is best described by a spokesman for a large public utility currently making a repurchase offer for its outstanding traditional preferred stocks to be financed by a recently issued tax deductible preferred. He was quoted by Bloomberg last week as saying ''This is strictly a refinancing, substituting a tax-deductible preferred for a non-tax deductible preferred. There is an economic advantage.''
We estimate that the par value of tax deductible preferreds outstanding was almost $61 billion as of 2/28/97, up from roughly $14 billion at the end of 1995. New issues of such securities have been particularly heavy since last fall when the Federal Reserve allowed domestic banks to treat them as Tier 1 equity capital. In approving such equity credit, the Federal Reserve required that such securities have ''. . . a minimum five-year consecutive deferral period on distributions to preferred shareholders,'' ''. . . be subordinated to all subordinated debt and have the longest feasible maturity.''
In contrast, the amount of traditional preferred stocks eligible for the DRD is shrinking. We estimate that the par value of such issues outstanding on 2/28/97 was $59 billion, down from $66 billion at the end of 1995. Looking a year or so ahead, further shrinkage to around $50 billion is already well assured, which would represent a contraction of almost 25% from the end of 1995. We calculate that companies participating in the recent rush of tax deductible preferreds to market have approximately $6 billion of high dividend rate traditional preferred stocks outstanding that will become redeemable for the first time between now and the end of 1997. We have also identified another $3 billion of recent issues of tax deductible preferreds that appear to be earmarked for refunding traditional preferred stocks that are first callable in 1998. There have been no recent new issues of traditional preferreds eligible for the DRD.
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Impact of a DRD Cut on Preferred Stock Investors
Reducing the DRD to 50% would obviously make DRD eligible preferreds less attractive to corporate investors who are the marginal buyers of these securities. All other things being equal, the after-tax yields to such investors would fall, causing declines in the market prices of DRD eligible preferreds. It is difficult to justify this treatment of investors, both corporate and individual, who have relied on the tax laws as they have existed for many years.
The interaction of DRD eligible preferreds with other market sectors would also be an important factor if the DRD were cut. If only corporate investors were involved, reestablishing market equilibrium could require prices to decline and pre-tax yields to rise enough to bring preferred yields after corporate taxes back to the levels existing prior to the DRD cut. However, that sort of market adjustment would also cause the pre-tax yields on DRD eligible preferreds to rise relative to interest rates on bonds. Ultimately, that would make DRD eligible preferreds competitive with fully taxable bonds on a pre-tax yield basis, and ''total return investors'' such as pension funds would then become potential buyers of DRD eligible preferred stocks.
In a broad range for the DRD around 50%, we believe DRD eligible preferreds would be ''neither fish nor fowl.'' Lower after-tax yields of DRD eligible preferreds would cause some corporate investors to lose interest. At the same time, the pre-tax yields of such preferreds would not be high enough to stimulate many total return investors to reorient their investment practices to include such preferreds. DRD eligible preferreds would be cushioned to a degree against further price decline, but the market's ''audience'' would shrink. This would be matched by shrinking supply, as discussed in the following section, which would greatly reduce the depth of this important market sector.
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Impact of a DRD Cut on the Issuance of Preferred Stocks
Domestic corporations have a strong bias toward financing with debt instead of equity, particularly in good economic times. It is simply a matter of interest being deductible for income tax purposes while dividends are not. A lower DRD would accentuate this bias in favor of debt financing.
The proposed reduction of the DRD would further increase the incremental cost of capital of issuing DRD eligible preferreds versus financing with debt. The dividend rates on such preferreds would certainly rise relative to interest rates on bonds and other forms of debt, as discussed in the section immediately above. Since dividend payments are not deductible, higher dividend rates on newly issued preferreds would increase the issuer's after-tax cost of capital dollar for dollar with no corresponding increase in the cost of debt financing.
The experience of the last several years is abundant proof that corporate financing decisions are extremely sensitive to the after-tax cost of issuing DRD eligible preferreds versus debt. ''Tax deductible preferreds,'' which stem from underlying debt, have replaced DRD eligible preferreds at a rapid pace, even with the DRD at 70%. Reducing the DRD to 50% in the face of the substantial potential redemptions of DRD eligible preferreds over the next several years would open the floodgates for replacement of equity financing by debt.
Implications for Revenues to the Treasury
The proposal to cut the DRD to 50% is not just an incremental change that would increase Treasury revenues without changing much else. A 50% DRD would set in motion major structural changes in the market for DRD eligible preferreds. Those changes must be taken into account in estimating the revenue impact.
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We should point out that the system is producing tax revenues that might not exist if there were no DRD. When one corporation pays a dividend to another, an effective tax of 10.5% is imposed. If the same transaction took place in the form of interest on debt, the interest deduction to the payer would offset the interest income taxable to the payee, and no tax liability would be created on balance. In actuality, the process would be considerably more complex than this example, of course, but the point remains the same. It is quite possible to reduce tax revenues by raising the tax rate on a financial sector if, as a result, the financial sector shrinks in size.
Although revenue projections depend on many variables, none has a more profound impact than the extent of the replacement of traditional DRD eligible preferred stocks by debt financing. We have developed a computer model at F&C to test the sensitivity of Treasury revenues to changes in the critical underlying assumptions and would be more than willing to share our model with the Committee. Based on the amount of such refinancing that has already occurred and is now in view, we think it is questionable whether, with respect to DRD eligible preferreds, reducing the DRD would be more likely to increase or decrease overall tax revenues.
Proposed Elimination of the DRD for ''Preferred Stock With Certain Non-Stock Characteristics''
These proposals would essentially eliminate new issues of adjustable rate preferred stocks, auction rate preferred stocks and sinking fund preferred stocks with maximum lives of less than twenty years by making them prohibitively expensive forms of equity financing. Each of these types of preferred stock has a distinctive feature designed to deal with one aspect or another of interest rate risk. The implication that these features in some way reduce equity risk is not true. Nothing in their structures provides any assurance about the issuer's financial standing should it fall on hard times. Furthermore, if that happened, these preferreds would have none of the typical remedies of debt instruments such as declaring default and instituting bankruptcy proceedings.
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The contention that these instruments are ''. . . economically more like debt than stock'' simply ignores actual market history. For example, when Bank of New England went bankrupt, its adjustable rate preferred became worthless. Similarly, when the big Texas bank holding company, M Corp., got into financial trouble, its auction rate preferred also became worthless. A further example is the market pressure currently impacting Niagara Mohawk Power's various traditional preferred stocks, including some adjustable and sinking fund issues, due merely to the company's delay in declaring the regular quarterly dividends on its preferred stocks. For decades, it has been common for sinking fund preferreds to have maximum lives of less than twenty years, which has still been plenty of time for many issuers' financial situations to deteriorate.
Adjustable rate preferred stock, auction rate preferred stock and sinking fund preferred stock are all equity instruments that have been well established over time. Eliminating their use would not produce new revenue. It would simply be one more step toward replacing equity financing with debt. This would also appear to be a dangerous step in the direction of ''micromanaging'' the capital markets through the tax laws.
The ''Fairness Argument''
We have heard it argued that the DRD is ''too generous'' and is not fair because it allows a corporate investor holding a diversified portfolio of stocks to pay a tax that is significantly lower than an individual investor would pay on the same dividend income. This argument ignores the reality that all taxes are ultimately borne by individual consumers and investors. Corporate investors are merely one step higher up the investment ''food chain.'' It is impossible to make the system fairer to individuals by taking more money out of the chain before it gets to them. The system already falls between double and triple taxation of the same dollars before individuals get the benefit of them.
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Conclusion
It is essential to distinguish between corporate welfare and the structures that make the capital markets in United States so efficient and the envy of the rest of the world. Reducing the DRD is a proposal that has come up many times before as a potential revenue raiser and has been turned down as counterproductive. We believe that any revenue produced by cutting the DRD would be meager in relation the administration's budget estimates and would come at a cost of damaging the DRD eligible preferred stock market. The recent shrinkage of that market would escalate, and its traditional base of corporate investors would be fragmented. This raises issue of whether the market would have the capacity to rise to the occasion again if there were another crisis on the scale of the domestic banking industry's problems in the early 1990's.
Very truly yours,
| Donald F. Crumrine |
| Chairman of the Board |
—————
Chairman ARCHER. Thank you, Mr. Crumrine.
Our last witness in this panel is Robert Gordon. Mr. Gordon, welcome, and identify yourself and proceed.
STATEMENT OF ROBERT N. GORDON, PRESIDENT, TWENTY-FIRST SECURITIES CORP., NEW YORK, NEW YORK; AND MEMBER, BOARD OF DIRECTORS, AND CHAIRMAN, TAX POLICY COMMITTEE, SECURITIES INDUSTRY ASSOCIATION
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Mr. GORDON. Thank you, Chairman Archer, Mr. Rangel, and Members of the Committee, for the opportunity to share SIA's, Securities Industry Association's, views on certain revenue provisions in the President's 1998 budget. I am Robert Gordon, president of Twenty-First Securities. I appear before you today in my capacity as a member of the Securities Industry Association's Board of Directors as well as chairman of its Tax Policy Committee.
SIA commends you for holding this hearing. We share your belief that economic growth requires both a balanced budget and an increased savings rate in America. We are encouraged that several provisions in the President's budget recognize the importance of savings and investment, in particular, proposals to improve IRAs and make targeted capital gains tax cuts. We believe, however, that both these provisions should be expanded to allow all Americans to make tax-deductible contributions to their IRAs and to provide for broad-based capital gains tax cuts that treat all assets equally.
Several revenue raising provisions in the budget, however, contradict the policy of savings and investment and would have a negative impact on our capital markets. In particular, 14 proposals target investors and issuers with almost $6 billion in new taxes. These are not new proposals. Treasury first published many of them last year as part of the 1997 budget. They were not enacted, and we believe you should reject the capital markets tax increases again this year.
They are offered in reaction to a few well-publicized transactions and are not well-thought-out or coherent tax policy. Taken together, these proposals will make it more difficult for companies to raise capital and create jobs, deter investors from protecting their investments against risk, increase taxes on individual and corporate investors, and add to the regulatory burdens of securities firms. In short, the capital markets' tax increases will stifle savings and investment when we should be encouraging economic growth.
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I elaborate on each of these proposals in my written testimony and will summarize our key points in my statement. I have grouped the proposals into three categories: Those that affect individual investors, those that affect issuers, and those that increase our industry's regulatory burden.
I will begin with the proposals that harm individual investors. Individuals are investing in the capital markets as never before. More than one-third of all adult Americans owns corporate stock. Instead of encouraging these investors, Treasury would raise their taxes through its average cost basis and constructive sales proposals.
The United States already has one of the highest capital gains tax rates in the world. The average cost basis proposal would increase this rate by requiring investors to use an average basis to calculate gain or loss when they sell shares of the same company that were purchased at different times. Keeping track of average basis would also put tremendous burdens on people who participate in dividend reinvestment or employee stock ownership programs. The constructive sale or ''short-against-the-box'' proposal would impose punitive and unjustified taxes on individuals who use certain hedging techniques to protect their portfolios from risk. It contradicts well-established policy requiring investors to pay taxes on unrealized gains on shares that have not been sold. This proposal was aimed at several well-publicized transactions by wealthy individuals, but is drafted so broadly that it would unfairly capture a wide range of transactions.
SIA is most concerned about the proposal's January 12, 1996, effective date. As a matter of fundamental fairness, Congress should avoid retroactive effective dates. At the very least, if you adopt this proposal, we urge you to apply constructive sale treatments only to transactions entered into after Treasury issues detailed guidelines. Anything else would penalize investors who have already entered into transactions in reliance of current rules and congressional pronouncements.
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Treasury does not stop with investors but also takes aim at the ability of issuers to raise capital. The United States has the most liquid, efficient capital markets in the world. The securities industry raises more than $1 trillion annually for U.S. companies, capital that is used to finance research and development, expansion, and new jobs. Our clients depend on us to raise these funds in ways that best suit their particular needs. Congress should not enact laws that discourage innovation in the capital markets but, rather, should encourage growth through sound economic policies.
Responding to market demand, the securities industry has developed innovative debt securities such as 100-year debt, trust-preferred securities, and zero-coupon convertible debt. Treasury rewarded our creativity by proposing to deny the interest deductions for these debt securities because they have some equity-like characteristics. Instead of looking at the broader issue of where to draw the line between debt and equity generally, Treasury chose to eliminate beneficial products on an ad hoc basis. This is not sound tax policy and would narrow financing alternatives for companies looking to raise funds for expansion, increase the cost of capital, and impose new taxes on business.
Treasury also proposes to raise taxes on corporations by lowering the dividends received deduction, or DRD, to 50 percent. The United States has a double tax on corporate earnings, and the DRD was designed to prevent triple taxation of this income. Treasury's proposal heads in the wrong direction. The United States should follow the example of our trading partners, which all offer the equivalent of 100-percent deduction. Lowering the DRD to 50 percent in general and eliminating it completely from any types of preferred stock would exacerbate the multiple taxation of corporate income, discourage corporations from making equity investments, and disrupt the preferred stock market.
Treasury also takes issue with corporate reorganizations by imposing new conditions on Morris Trust transactions. Morris Trust transactions, in which companies effect a tax-free spinoff of a division or line of business in anticipation of a merger, allow companies to organize in the most productive and efficient manner while satisfying antitrust and other regulatory concerns.
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Finally, two proposals would increase the regulatory burdens and compliance costs on securities firms. Increased penalties for inadvertent failures to file information returns are unwarranted, given the securities industry's excellent record of compliance. In addition, we believe current corporate tax shelter registration requirements are adequate to address abusive transactions.
In conclusion, Mr. Chairman, SIA believes none of the capital markets tax proposals should be included in the budget, and we urge you to strike them from the outset. If these proposals are included in the budget, however, we urge you to consider at the very least a date-of-enactment effective date that grandfathers all existing positions and transactions to give market participants a reasonable time to consider the implications of the proposals without interrupting the normal course of their business.
Thank you, Mr. Chairman, for allowing me to voice SIA's opposition to the capital markets tax increases. We share your commitment for a balanced budget, but believe it must not come at the expense of savings, investment, and capital formation. SIA looks forward to working with you to find solutions to these issues. I will be happy to answer any questions you may have.
[The prepared statement follows:]
Statement of Robert N. Gordon, President, Twenty-First Securities Corp., New York, New York; and Member, Board of Directors, and Chairman, Tax Policy Committee, Securities Industry Association
Chairman Archer, Mr. Rangel, members of the Committee, thank you for the opportunity to share the securities industry's views on some of the revenue provisions in the President's fiscal 1998 budget. I am Robert Gordon, President of Twenty-First Securities Corporation, a securities firm located in New York City. I appear today in my capacity as a member of the Board of Directors of the Securities Industry Association(see footnote 37) and as Chairman of SIA's Tax Policy Committee.
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SIA commends you for holding this hearing. We share your belief that future economic growth requires both a balanced budget and an increased U.S. savings rate. SIA appreciates your efforts over the years, Mr. Chairman, to encourage all Americans to save and invest. The President and Congress are making considerable efforts to balance the budget. We are encouraged by provisions in the Administration's budget that recognize the importance of savings and investment in particular, proposals to improve Individual Retirement Accounts and make targeted cuts in capital gains tax rates. We believe, however, that these provisions should be expanded to allow all Americans to make tax-deductible contributions to their IRAs, and to provide for broad-based capital gains tax cuts that treat all assets equally.
Several revenue-raising provisions in the budget, however, contradict a policy of savings and investment and would have a negative impact on our capital markets. In particular, 14 revenue proposals would impose approximately $5.9 billion(see footnote 38) in new taxes on certain securities products and transactions that companies use to raise capital to finance growth, expansion, and new jobs and to reduce uncertainty and risk in the marketplace. These are not new proposals. Indeed, Treasury first published many of them last year as part of the Administration's 1997 budget. Congress recognizing that more taxes on the capital markets would slow economic growth struck these proposals from the final budget.
You should reject Treasury's capital markets tax proposals again this year. They are an ill-considered reaction to a few well-publicized transactions, and are not sound tax policy. These proposals will make it more difficult for companies to raise capital, deter individuals from protecting their investments against risk, increase taxes on businesses and investors, and add to the regulatory and reporting burdens of securities firms. The capital markets tax increases will stifle savings and investment when Congress should be encouraging economic growth. I will elaborate on the proposals in more detail below.
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Proposals That Harm Investors
Individuals are investing in the capital markets as never before. Stable interest rates, steady price appreciation for stocks and bonds, and low returns on traditional long-term savings products are a few of the reasons more than one adult in three owns corporate stock. Less than a decade ago, it was one in five adults. Despite this record level of investment, however, the savings rate in the U.S. is still far too low when compared with the rest of the industrialized world. Two of Treasury's proposals average cost basis and short-against-the-box are aimed directly at individual investors. Rather than encourage individuals to save and invest, Treasury's proposals send the wrong message by raising taxes on investors.
Average Cost Basis for Securities
Treasury proposes to modify the rules under which investors compute capital gains on sales of securities. Under current law, when investors sell securities, they are allowed to identify the shares that they sell to calculate their basis the price they originally paid for the securities. The Treasury proposal, on the other hand, would require sellers of stocks, bonds, or other securities to compute capital gains or losses using an ''average cost basis'' the average amount paid for shares of Corporation X stock, whenever purchased rather than the amount actually paid for the shares sold.
SIA opposes Treasury's average cost basis proposal. The current law rules for determining cost basis where sellers of securities have an option to compute gain and loss using either the specific identification or first-in-first-out (FIFO) are simple and fair. The specific identification method allows investors who purchase securities at different times and different prices to identify, if they wish, which shares they are selling.
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Raises Taxes on Individual Investors. The proposal would result in larger capital gains tax liabilities compared to those arising from the specific identification method regardless of whether an investor sells less than all of his or her shares of a particular company. The U.S. already has among the highest capital gains tax rates in the world. The proposal increases this already-too-high rate and penalizes, rather than encourages, investment. Consequently, the proposal would encourage investors to hold rather than sell securities, thereby exacerbating the lock-in effect caused by capital gains taxation and reducing the flow of capital to higher-return investments.
Overly Complex. In addition, the proposal would greatly complicate the calculation of gains and losses by requiring that a taxpayer determining the cost basis of any share of Corporation X stock take into account every share of Corporation X stock in his or her portfolio. These calculations would be particularly burdensome for investors who repeatedly purchase additional shares of a particular company, such as through a dividend reinvestment program. For example, a shareholder reinvesting dividends in a company with quarterly dividends would have 41 separate blocks of shares at the end of 10 years. Any company that were to attempt to calculate average cost basis for its investors would incur significant systems modifications that would increase costs and reduce investor returns.
Investment Disincentive. The proposal would discourage additional purchases of shares in successful companies. In a rising market, average cost basis in a particular security will be less than the basis of recently acquired shares, increasing the capital gains that will be due on sales. As a result, investors would have a disincentive to purchase additional shares in the same corporation as opposed to equally priced shares of another corporation because basis in the additional stock would be lower than the purchase amount. This would penalize individuals who invest in the same company over time.
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Short Against the Box
SIA strongly opposes Treasury's proposal to treat certain appreciated financial positions as constructive sales. Current law allows taxpayers to enter into hedging transactions to reduce or eliminate risk of loss on financial assets without incurring taxable gains. As a general rule, gain or loss is realized on financial assets only when they are sold or otherwise disposed of (the ''realization'' requirement). Treasury, however, would require taxpayers to recognize gain (but not loss) upon entering into a ''constructive sale'' of any appreciated position in stock, debt instrument, or partnership interest. For purposes of the provision, a constructive sale occurs when an investor ''substantially eliminates'' risk of loss and opportunity for gain on an investment by entering into one or more positions i.e., short sale, equity swap with respect to the same or substantially identical property. Any effort to integrate this proposal with the realization requirement would raise insurmountable line-drawing problems, create substantial uncertainty, and chill legitimate hedging transactions. We note that the proposal with regard to income in respect of a decedent would prevent taxpayers from using hedging transactions to avoid gain recognition. The remainder of the proposal is intended to prevent taxpayers from deferring gain recognition to a later date. This proposal, as drafted, far exceeds what is necessary to address the abuses it is intended to prevent.
Technical Deficiencies. There are also a number of serious technical problems with the proposal, and SIA is not persuaded that these problems can be fixed. For example, taxpayers would be treated as having sold appreciated financial positions even though they did not borrow, or otherwise monetize, their positions. Given that taxpayers generally sell appreciated property to obtain the proceeds of the sale, this treatment is irrational the ''selling'' taxpayers would not even have the money to pay the resulting tax. Likewise, under the proposal, temporary hedging of an appreciated position would result in a constructive sale, even though the hedge was closed before the end of the taxable year and could not result in a deferral of gain for tax purposes. The proposal would affect a broad range of hedging transactions which serve important economic purposes, which do not resemble sales, and which have nothing to do with avoiding tax.
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Overly Broad Response. This proposal was issued shortly after the press called attention to several transactions by high-net-worth individuals. As drafted, however, constructive sales treatment turns on whether the taxpayer had ''substantially eliminated risk of loss and opportunity for gain.'' The transactions which might, or might not, result in constructive sales (depending on how Treasury interprets the language) is far broader than the proposal's original intent. It would include collar transactions, issuances of exchangeable debt securities, issuances of letter stock, issuances of employee stock options and other incentive compensation, forward sales agreements, and hedging transactions of all sorts. Moreover, the consequences of a constructive sale under any particular set of circumstances and its interaction with numerous other tax rules and regimes, would be fraught with uncertainty and complexity. Congress should not take the bold step of deeming certain hedges to be sales for tax purposes without first considering all the collateral effects such a proposal would have on other provisions of the Internal Revenue Code.
Retroactive Tax Increase. The proposal would apply to all constructive sales entered into after the date of enactment, as well as transactions entered into before that date but after January 12, 1996, if they are not closed within 30 days of the date of enactment. SIA objects to the January 12 effective date. The basic rule that a short sale against the box is not a taxable event dates back to specific guidance issued by the IRS over 65 years ago. Taxpayers who have relied on this long-standing guidance should not be penalized retroactively by making their earlier transactions taxable. Nor should they be forced to incur the economic and tax costs of closing their short positions. If Congress enacts legislation similar to Treasury's proposal, we urge that constructive sales treatment be generally applied only to transactions that are entered into after Treasury issues detailed and fully considered guidelines. If Congress believes that a date-of-enactment effective date should apply to certain specific transactions that are viewed as abusive, then those transactions should be described in the legislation, and Treasury should be granted regulatory authority to deal with new transactions on a prospective basis. We note that Congress took a similar approach in dealing with hedging transactions which minimize a taxpayer's risk of loss under section 246(c)(4).
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Proposals That Harm Issuers
The U.S. capital markets are the most liquid, efficient markets in the world. Every year since 1991, the securities industry raised over $1 trillion in capital for U.S. companies capital that is used to finance research and development, expansion, and new jobs. Our clients rely on us to raise low-cost capital to meet their particular financing needs. Several Treasury proposals, however, are aimed directly at the ability of U.S. companies to raise capital. Congress should not enact policies that discourage innovation in the capital markets, but rather, should encourage growth through sound economic policies.
Deny Interest Deductions for Certain Debt Securities
Treasury would restrict the ability of corporations to raise capital by severely limiting the availability of certain widely used debt securities, including long-term bonds, trust-preferred securities, and convertible debt securities. These proposals would disallow interest deductions for debt instruments that Treasury believes have substantial equity characteristics. The structured debt instruments affected by the proposal, however, are clearly debt under principles of federal income taxation. They include:
• Long-term bonds, which permit issuers to lock in low interest rates for up to 100 years. The proposal would not allow companies to deduct interest on bonds that do not mature for at least 40 years;
• Greater-than-15-year notes held through a trust. By issuing debt through a trust, rather than selling it directly to the public, companies are able to maintain good credit ratings and satisfy regulatory requirements that limit the amount of a company's debt. The proposal would classify trust-preferred securities as equity if they have a maximum term of at least 15 years and are not reported as debt on the issuing corporation's balance sheet; and
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• Convertible debt payable in equity of the issuer or a related party, which permit corporations to issue stock in the future. The proposal would classify such investments as equity, and would deny the interest deduction that a company would normally receive for such a debt security.
Incoherent Tax Policy. SIA opposes enactment of tax proposals that restrict the ability of U.S. corporations to raise capital and urges Congress to reject them. Treasury's proposals are reactive they strike at innovative products developed by the securities industry to serve our clients' needs. Treasury's ''reverse engineering'' to address perceived abuses on a case-by-case basis further muddies the line between debt and equity. Treasury has ample authority to formulate general debt/equity rules, but has not done so since 1986. Instead, they draw an arbitrary line between debt and equity with these proposals without considering the broader tax policy implications of such a move. Such a complex matter should not be undertaken on an ad hoc basis, but should be given careful, comprehensive consideration.
Structured Debt Is Not Equity. Furthermore, Treasury's assertion that these innovative financial instruments are really equity masquerading as debt is unfounded. Long-term debt obligations have all the same attributes as other debt instruments. These bonds are typically issued by well-established, stable companies that are likely to remain in business throughout the obligation's term. Issuing companies price their long-term obligations to give investors a stable return over time, and investors do not assume the risks, or reap the rewards, of equity investments. In addition, the balance sheet characterization of innovative debt securities does not change the fact that the securities possess all the characteristics of debt. Investors who purchase notes issued through a trust have a direct ownership interest in the underlying debt and have the same legal rights as if they had purchased the debt directly from the company. As with any debt security, issuers of trust-preferred securities have an absolute obligation to pay the interest and principal at maturity.
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Defer Deductions for Original Issue Discount Until Payment
Many companies issue debt securities that allow either the issuing company or the investor, at some time in the future, to convert the debt into shares of stock of the issuer or a related party. If these instruments are issued at a discount less than face value companies are able to deduct the original issue discount (OID) as it accrues over the term of the debt, regardless of whether it is paid at maturity in stock or cash. The Treasury proposes to defer deductions for interest accruing on convertible debt instruments with OID until this interest is paid. At the same time, however, they do not propose to alter the tax treatment of OID for holders of these instruments. So while companies will not be able to deduct OID until they pay it out, investors will still be required to pay taxes on OID, even though they have not received this income
Contrary to Congressional Intent, Regulatory Policy. SIA opposes this proposal and urges Congress to reject it. Congress enacted the OID rules to eliminate the distortions caused by the mismatching of income and deductions by lenders and borrowers. The IRS reviewed the deductibility of OID in 1991 and determined in a private letter ruling that zero-coupon convertible securities are indeed debt, and that OID is deductible as it accrues. In fact, statistics bear out the IRS's determination. Only 30 percent of all zero-coupon convertible debt retired since 1985 were paid in common stock, while the remaining 70 percent were retired with cash. In contrast, of all non-OID convertible debt retired since 1985, 79 percent were converted into common stock, while only 21 percent were retired with cash. Furthermore, the Treasury Department, after nine years of study, did not single out convertible debt OID for special treatment when they issued the final OID regulations in 1994. Treasury's proposal would abruptly reverse this policy without public hearings or full consideration of the consequences.
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Reduce the Dividends Received Deduction to 50 Percent or to Zero for Limited-Term Preferred Stock
Treasury proposed to exacerbate the multiple taxation of corporate dividends by lowering the dividends received deduction (DRD) to 50 percent and in some cases to zero. Corporate income is already taxed at least twice first to the corporation when it is earned; and second, to the shareholder when dividends are paid out. Corporations that own less than 20 percent of the common and preferred stock of other corporations are allowed to deduct 70 percent of the dividends they receive from this stock from their taxable income. The DRD rises to 80 percent if the corporation owns more than 20 percent, and to 100 percent if the corporation owns more than 80 percent of the other corporation. By allowing corporate shareholders to deduct at least 70 percent of dividends received, the law mitigates but does not alleviate a third layer of tax on this income. Indeed, the partial DRD imposes an additional tax burden on corporations in excess of $1 billion annually.
International Competitiveness. Treasury, however, would reduce the DRD to 50 percent, except for shares of limited-term preferred stock, for which the DRD would be eliminated entirely. This proposal applies to all dividends received after the effective date not just to dividends received on stock purchased after that time and does not grandfather existing holdings. SIA opposes this proposal because it unfairly targets income that is already subject to multiple layers of taxation. Allowing companies to deduct only 50 percent of their inter-corporate dividends would move closer to imposing a full triple tax on profitable companies. As it stands, the U.S. is the only major industrialized country that subjects corporate profits to multiple layers of tax. Our trading partners either allow a 100 percent deduction for dividends received or have integrated their corporate and income tax systems to alleviate this problem altogether. SIA believes Congress should increase the DRD, if anything, as a matter of international competitiveness.
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Increases the Cost of Capital. Corporations invest heavily in the common and preferred stock of other companies, providing a significant source of capital to finance growth, research, and new jobs. As the DRD is reduced and the return corporations can earn on their investments in other companies falls, corporate investors will require a higher rate of return from issuing companies raising the cost of capital. A higher cost of capital will make corporations more likely to rely on debt, rather than equity, to finance expansion. Interest on debt may be deducted by the issuing company, and is not subject to multiple levels of tax.
Significant Impact on Preferred Stock Market. These proposals will change the rules for the entire preferred stock market. Reducing the DRD would immediately decrease the value of preferred stock and yield-oriented common stocks that have a regular schedule of dividend payments. SIA is particularly troubled by Treasury's willingness to impose a retroactive effective date on this proposal. By not grandfathering existing positions, the proposals penalize corporations for investments made in reliance on existing rules. At the very least, Congress should specify that this provision applies to positions established after the date of enactment.
Furthermore, by eliminating the DRD for limited-term preferred stock such as money market preferred and adjustable rate preferred stocks Treasury removes a powerful incentive for companies to issue this class of shares. Companies issue limited-term preferred stock to raise low-cost, short-term capital as an alternative to commercial paper. Indeed, this is a substantial market at present there are $11 billion in money market preferred stocks outstanding, and another $4 billion in adjustable rate preferred shares outstanding. Cutting the DRD altogether makes it more likely that companies will issue debt, rather than other types of equity, to raise short-term cash.
Modify the DRD Holding Period
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Treasury would modify the DRD holding period requirement for corporations that hold stock in other corporations. SIA opposes this proposal and urges Congress to reject it. It would interfere with prudent hedging practices, reduce the efficiency of the financial markets, and expose investors to increased risks.
As explained above, corporations generally are entitled to a dividends received deduction (DRD) for dividends received on stock they hold. They are entitled to the DRD only if they own the dividend-paying stock for at least 46 days (91 days for certain types of preferred stock). The holding period is not satisfied if, at any time during that period, the shareholder corporation is protected from risk of loss (i.e., has hedged the position). Once the holding period is satisfied, it need not be met again with respect to subsequent dividends paid by the same stock.
The Treasury proposal, on the other hand, provides that a corporate shareholder is not entitled to the DRD if the holding period is not met during the time immediately before and after each dividend is received. The proposal would be effective for all dividends received more than 30 days after the date of enactment, regardless of when the shares were purchased. Treasury once again is imposing a retroactive tax hike on shareholders because the proposal does not grandfather existing positions.
Discourages Risk Reduction. Modifying the DRD holding period would discourage companies from hedging against market and interest rate risk. Market conditions prompt investors to use various hedging techniques to reduce risk in their portfolios, and interest rate hedging is an important component of corporate risk management. Prudent hedging strategies to reduce these risks could put corporations afoul of the modified holding period requirements and disqualify certain dividends from the DRD. In addition, the proposal changes the rules in the middle of the game for corporations that hedged positions in stock in reliance on existing rules. Retroactively penalizing risk reduction strategies is not sound public policy. At the very least, Congress should clarify that the proposal applies to positions established after the date of enactment.
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Increases Compliance Costs. SIA believes, however, that Congress should refrain from modifying the DRD holding period at all. Changes in the holding period will force companies with large portfolios to monitor how hedging activities may impact the aggregate DRD. Every corporation will have to maintain detailed records to substantiate their DRD. The projected revenue increase from modifying the holding period is so slight that it does not warrant the significant increase in compliance costs for companies.
Morris Trust
Treasury proposes to restrict the ability of corporations to reorganize in the most efficient manner by taxing Morris Trust transactions in which a company effects a tax-free spin-off of a division or line of business as part of a merger. SIA opposes the Morris Trust proposal. It contradicts fundamental income tax principles and would discourage tax-efficient corporate reorganizations that are motivated by legitimate non-tax business purposes.
Section 355 of the Internal Revenue Code generally allows a parent corporation to ''spin-off'' a subsidiary through a distribution of stock to shareholders on a tax-free basis, provided that the spin-off meets certain requirements. If these requirements are not met, a corporation generally must recognize gain on the distribution of the subsidiary, and shareholders must treat the distribution as a dividend. A Morris Trust transaction generally involves a corporation that spins off a subsidiary and then merges with another corporation. These transactions occur most often to address antitrust concerns arising from a merger. In these transactions, the corporation's shareholders hold stock after the spin-off in both the spun-off subsidiary and in the newly-merged corporation. Courts and the IRS determined that a Morris Trust transaction constitutes a tax-free spin-off and merger under sections 355 and 368.
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Treasury, however, would impose additional restrictions under section 355 on acquisitions and dispositions of the stock of both the distributing corporation and the spun-off subsidiary. Specifically, the distributing corporation would be required to recognize gain on the distribution unless its shareholders ''control'' the stock of both the parent and the subsidiary during the four-year period beginning two years before the distribution. Shareholders would ''control'' this stock if they own at least 50 percent of the voting shares and 50 percent of all other classes of the parent corporation's stock. As a result, a corporation generally would not be able to spin off a subsidiary without recognizing gain if it intends to merge with a larger corporation. In those cases, shareholders would own less than 50 percent of the vote and value of the stock in the merged company.
Contradicts Sound Tax Policy. This proposal is contrary to fundamental income tax principles. The rationale behind tax-free spin-offs and reorganizations is that gains or losses should be recognized only when an investment leaves corporate solution that is, when shareholders cash out their investments. All corporate earnings and assets in the parent corporation and the spun-off subsidiary continue to be held by a corporation at their original tax basis and, as such, remain subject to corporate-level taxes. Shareholders end up with the same assets as when they started, but in different form.
Ignores Legitimate Business Purposes. In addition, this proposal does not consider that corporate reorganizations are driven by business needs and market opportunities. The tax law has long provided for tax-free transactions to encourage efficient management and deployment of business assets. Business reasons for spin-offs include:
• Maximizing management efficiencies, particularly where the acquiring corporation lacks the industry expertise to manage the unwanted business.
• Addressing antitrust concerns or regulatory restrictions regarding the acquiring corporation's ownership of the subsidiary. In this case, Treasury's proposal directly conflicts other areas of federal law and will force corporations to incur great expense to comply with laws and regulations.
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• Protecting the corporation's customer base, when the customers of the acquiring corporation's may compete with the subsidiary.
Current section 355 rules allow tax-free treatment only if the transaction has a valid business purpose. Other rules specify that the transactions cannot be a ''device'' for the distribution of earnings and profits. Moreover, the corporation and the subsidiary must stay in business after the reorganization. Taken together, these rules ensure that spin-off transactions are not undertaken primarily for tax reasons and make the Treasury's proposal an unnecessary restriction on corporate reorganizations.
Finally, the Treasury proposal will apply to a number of transactions which are subject to written agreements or for which ruling requests have been filed with the IRS or public announcements or SEC filings have been made, but which may not be completed by the time the Committee acts. Imposing such a fundamental change in the corporate tax rules retroactively to these transactions would be unfair.
Proposals To Increase Regulatory and Reporting Burdens of Securities Firms
Treasury also includes two proposals that increase the regulatory and reporting burdens of securities firms by requiring registration of confidential corporate tax shelters and imposing increased penalties for failure to file information returns. SIA opposes all unjustified increases in the regulatory and compliance burdens of securities firms. Securities regulations serve very important customer protection and market integrity purposes and are crucial to maintaining the public's trust and confidence in the markets and the industry. Regulatory requirements such as tax shelter registration and information return penalties, however will not provide any additional safeguards or information to justify the added costs and burdens of compliance.
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Registration of Confidential Tax Shelters
Current law requires offerors of large-scale syndicated partnerships to register tax shelters with the IRS, and penalizes taxpayers for taking a position in a tax shelter without either informing the IRS or having substantial authority for the position. Treasury's proposal, however, would require individual companies to register with the IRS all confidential tax shelters in which the organizers receive more than $100,000 in fees.
SIA opposes the tax shelter registration proposal. The registration, disclosure, and penalty requirements of current law are adequate to address abusive transactions. The proposal, however, will increase the reporting burdens of corporations and tax advisors engaged in transactions for legitimate business purposes. By imposing a disclosure requirement when a tax-planning strategy is discussed (rather than when a position is taken on a return) the proposal is excessively broad. In addition, it would require registration of transactions that are clearly permissible under IRS rules and regulations. This will significantly increase the burdens of business advisors and tax planners, without any corresponding benefit to the IRS.
In addition, the proposal would interfere with confidential business relationships. Business transactions are negotiated in confidentiality because premature disclosure might disrupt the market. Because tax consequences are always an important consideration in business transactions, this proposal would significantly alter the relationships of parties by requiring disclosure of information about a transaction while it is still under development.
Information Return Penalties
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Securities firms, banks, mutual fund companies, and corporations are required to file certain ''information'' returns with the IRS to report items such as employee wages, dividends, and interest. Current law includes substantial penalties for non-compliance, which include a $50 penalty per failure to file information returns, with an annual cap of $250,000 per payor; and higher penalties and no cap for intentional failures to file. Treasury's proposal would increase the penalty for failure to file an information return by August 1 to the greater of $50 or 5 percent of the amount required to be reported, capped at $250,000 annually. Firms in substantial compliance (97 percent) would continue to be fined at $50 per return.
Because compliance rates are high within the securities industry, the proposal will raise revenue from higher penalties, in direct contradiction to Congressional intent that ''civil tax penalties exist for the purpose of encouraging voluntary compliance.'' Following Congress' direction, it is IRS policy that civil penalties are not considered a source of revenue. Absent a high rate of non-compliance, the increased penalties are unjustified and unfair. There is no evidence that firms do not comply with the reporting requirements. The IRS has vigorously enforced these provisions, using its authority to fine companies that do not comply, whether inadvertently or intentionally. The extremely high level of voluntary compliance is proof that current penalties are adequate.
In addition, the proposal singles out entities who file returns under multiple names for harsher treatment. Rather than apply the penalty cap to the entire institution, the proposal would create a separate penalty cap for every name under which an institution files information returns. This would produce particularly onerous results for banks, broker dealers, mutual fund companies, and transfer agents, all of which file returns under many different names. This proposal significantly increases the potential liability of these institutions, without any showing of noncompliance with filing requirements.
Finally, the industry devotes substantial resources to timely and accurate compliance with information reporting requirements. Given their excellent record of compliance, this provision would unjustly increase the burdens of securities firms without providing any corresponding benefit to the IRS.
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Effective Dates
SIA believes that none of the 14 capital markets tax proposals should be included in the budget, and we urge you to strike them from the outset. If these proposals are included in the budget, however, we request in fairness that the effective dates be postponed until at least the ''date of enactment.'' Any earlier date would hit taxpayers conducting routine business financing transactions with unforeseen taxes.
Retroactive or immediate effective dates would send shock waves through the capital markets; the mere announcement of these proposals in December 1995 caused enough uncertainty that many companies suspended legitimate financing transactions structured in reliance on the existing tax laws. Mr. Chairman, you were concerned enough about this last year to disavow retroactive effective dates in a joint statement to the press with Senate Finance Committee Chairman Roth. We urge you to consider, at the very least, a ''date of enactment'' effective date that grandfathers all existing positions and transactions to give market participants a reasonable time to consider the implications of the proposals without interrupting the normal course of their businesses.
Conclusion
Thank you again, Mr. Chairman for allowing me to share the securities industry's opposition to the Administration's capital markets tax increases. We share your commitment for a balanced budget, but believe it must not come at the expense of savings, investment, and capital formation. SIA looks forward to working with you to find solutions to the issues identified in my testimony.
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Chairman ARCHER. Thank you, Mr. Gordon.
If I could ask one basic question of all of you, whenever the Congress receives proposals to change the way corporations are taxed, who pays for that? If it raises extra revenue out of the corporate structure, who pays for that? Who receives the impact of that?
Clearly, corporations are an insulator that the American people look at as being remote from themselves. But who actually absorbs those increased taxes?
Mr. Crumrine.
Mr. CRUMRINE. Mr. Chairman, corporations are just a conduit. The impact is passed through to investors, either that invest directly in the corporation or invest through their retirement plans.
Chairman ARCHER. Well, this is very basic——
Mr. GOLDBERG. Mr. Chairman, I think it is even broader than that. I think that in today's economy, yes, the investors are going to pay, but I also think the workers are going to pay. It is one of three groups. It is going to be higher prices, lower wages, or a lower return to investors, which means in the public markets a lower return to pension plans and private savings. So it is going to come out of people's pockets, and the people who are paying are largely going to be workers and middle-class savers.
Chairman ARCHER. Because with the President's proposals there are so many increases of taxes on corporations and businesses, I want to pursue this line of questioning a little more. Why are corporations created? What is the role of a corporation?
Mr. HAYES. Ultimately to make money for its shareholders.
Chairman ARCHER. But is it not created to form a vehicle where many people can pool their savings in order to be able to reach some economic goal?
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Mr. GORDON. Chairman Archer, I think you are on the right track, that corporations are just the collective ownership of individuals of that company. And if the taxes go up on that company, as Mr. Goldberg said, either the investors or owners of that corporation are going to receive less out of it or the company must raise its price on goods sold in order to make more profits to have the same amount of aftertax dollars to pay out to their shareholders. And corporations are not entities on their own, so to speak. They are really just the collective unit of ownership of how the U.S. individuals own corporate——
Chairman ARCHER. So it is a mechanism whereby thousands, if not millions, of individual investors can pool their assets in order to achieve a certain economic goal that they could not do individually?
Mr. GORDON. That is right.
Chairman ARCHER. So who are the owners of the corporations? Who are the major owners of the corporations?
Mr. HAYES. Well, Mr. Chairman, there are various statistics that are out there, but one statistic provided by the New York Stock Exchange is that one in three Americans own shares of stock, either directly or through mutual funds or through their retirement plan accounts. And part of my work involves dealing with employee benefits, some with our customers but also with my organization's own plans. And our primary plan is a 401(k) plan where our typical employee is very interested in the investment choices and the companies and how well they are doing as part of investment choices under our plan.
Chairman ARCHER. So would it be true to say that the various retirement plans, pension plans, are the single biggest stockholders of the corporations of this country?
Mr. HAYES. Certainly they are up there with any other group, yes. They are as big as any other group, if not bigger.
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Chairman ARCHER. And millions of working Americans depend upon those pension plans for their retirement, do they not?
Mr. HAYES. Yes.
Chairman ARCHER. So are they not the ones who are really being taxed any time that we try to squeeze more money out of corporations?
Mr. HAYES. Most definitely.
Chairman ARCHER. OK. Thank you very much.
Mr. Rangel.
Mr. RANGEL. Thank you, Mr. Chairman. With your permission, I would like to continue this course in Capitalism 101.
Mr. Hayes, you said that the primary responsibility of the corporate structure is to present a profit and dividend for the shareholders, right?
Mr. HAYES. Yes.
Mr. RANGEL. And as you see it, that would include minimizing your taxes and increasing your profits.
Mr. HAYES. Well, obviously we pay attention to our tax liability.
Mr. RANGEL. Right. And you really find the whole idea that these incentives we provide for businesses in order to be more productive and to create more jobs, the whole idea that they are called corporate welfare is misleading and really disparaging to the corporate structure, wouldn't you say?
Mr. HAYES. Well, in this context, the administration has used it very loosely, and as we pointed out, there are various provisions that do not come close to any typical concept of a loophole closer, and because that term has become overused over the term, now it is corporate welfare.
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Mr. RANGEL. But you said that, in your opinion, corporate welfare is putting out something and receiving nothing in return, didn't you?
Mr. HAYES. Yes. If you interpret that what corporate welfare is supposed to mean if you were to use that term, right. I will defer to Mr. Webster.
Mr. RANGEL. Mr. Webster talks about providing more productivity and doing well, respect for good fortune, happiness, well-being, and prosperity.
Now, that sounds like pretty good stuff there for corporations and individuals, doesn't it? So maybe people have been knocking welfare and you are feeling the resentment of it. You have to appreciate the fact—all of you want a balanced budget, right? Anyone against that in 6 years, please put up your hands? And all of you do want tax cuts; it is just a question of degree. Right? Anyone against tax cuts?
Mr. Goldberg, I know that you have changed sides, but do you think the best thing for the economy at this time is a tax cut?
Mr. GOLDBERG. Mr. Rangel, I think that in my judgment the best thing for the economy would be for all of us to start dealing with some very hard issues about savings. The biggest challenge we face as a country is savings——
Mr. RANGEL. Are you an attorney?
Mr. GOLDBERG [continuing]. For middle-class Americans.
Mr. RANGEL. Are you a lawyer?
Mr. GOLDBERG. Yes, sir.
Mr. RANGEL. Do me a favor. Treat me—I am treating you like a lawyer. Do you really think this is the time to have a tax cut?
Mr. GOLDBERG. I think a properly structured tax cut, properly sized, is appropriate at this time.
Mr. RANGEL. OK. Now, would all of you support a capital gains tax cut? And the followup question would be, Do you have any economists that can show that providing a substantial tax cut in capital gains would not have a tremendous revenue shortfall after 2002? And we might even get to the IRAs.
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Mr. GOLDBERG. Mr. Rangel, I do disagree with that. I think a properly structured tax cut would result in a net revenue increase over time. That is my personal opinion.
Mr. RANGEL. OK. All I am asking for is an economist to support that view. Anyone supporting the tax cut, of course, says we will make a lot of money. It is just that it is hard to get anyone from OMB or CBO to join with you. Those are the agencies we have to work with, including your former agency, Treasury. Right?
Mr. GOLDBERG. I believe my former agency, the Treasury Department, believed that a properly structured capital gains cut would raise revenue.
Mr. RANGEL. They are talking about targeted for housing. You guys are talking about big cuts.
Well, let me ask this: Can you help us to identify the money that is going to be necessary? Anything that is called a credit, a deduction, or an exemption, these rascals are calling welfare. That is terrible. But what they are saying is if we did not have these things, you would be paying the regular rate of this unfair tax, right? So anything that alleviates pain and tries to make it fairer is a cushion for you. So it may not be welfare. It may be an incentive. But it is hard not to call it a break in terms of trying to bring about fairness.
So if we are fair about it, it is going to cost money. Besides taxing your competitors, which I understand that is OK, but setting that aside, Where do you get the money, Mr. Goldberg? I keep picking on you because I remember when you used to sound different. That is all.
Mr. GOLDBERG. I hope I have always sounded pretty much the same, Mr. Rangel, but it has always gotten me in trouble.
I think there are a number of proposals in the administration's package that are worthy of a look. I have identified three of them in my testimony where I think that there are opportunities to make changes consistent with sound tax policy, in a manner that will, in fact, raise revenue, but will do so in a way that does not undercut where we are trying to go, which has to do with savings, investment, and economic growth. I think the labels get us in trouble. As you suggested last year, labels can get you in trouble in lots of policy debates.
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If you believe the objective is to make it work better for working Americans and Americans who want to work, and if you believe the best way to do that or one of the important components is to help them save, help them invest, help create jobs, balance the budget—and those are all part of a notion that the economy has got to work right for working people—why would you pursue tax policies that move in the opposite direction? I do not understand it. I believe that the administration's proposals move in the opposite direction.
To the extent they do not, I think they are fine. And as I say, I have identified three in my testimony where I think, if properly structured——
Mr. RANGEL. Well, the administration's proposal in the past, even though it was not bipartisan, did provide a more improved, more vigorous economy, and we all are doing better as a result of it. And it certainly did not include this tax cut. It would seem to me if you want the tax cut and call it good, sound policy, you have to be in the position to find out where you are going to get the revenue in order to provide the cut and at the same time balance the budget. And we do not find that flexibility.
Thank you.
Chairman ARCHER. I hate to break into this colloquy, but the gentleman's time has expired. There is another area of the budget, obviously, and that is the spending side, not just the tax side.
Mr. Crane.
Mr. CRANE. Thank you, Mr. Chairman.
I want to thank all the witnesses for their presentations. I was impressed, Mr. Goldberg, with one of the quotes in your written testimony. Common themes in most tax reform proposals include: Tax income only once, encourage savings and investment, promote economic efficiency, and simplify the rules.
I have paid tribute to our distinguished Chairman here, although I have some modest reservations about his proposal for throwing the whole structure out and going to a consumption tax. I have been trying to promote a flat tax on your gross income at the time you earn it, but eliminate all other taxes. And one of the themes I have tried to hit on for years is that businesses do not pay taxes.
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Now, would you disagree with that statement? You mentioned earlier it comes out of the pockets of employees. It comes out of the pockets of consumers because like plant, equipment, and labor, you have got to pass those costs on and get a fair return, or you are out of business. But another area of concern to me is in trade. If we would eliminate this stupid burden, I, as a businessman, might not have to hire you as my tax consultant to get my books in order. I know there may be lawyers that would disagree with that, but the fact of the matter is, all of these burdens hurt our competitive position and, hence, our economic growth and the chance for greater expanded opportunity, for higher wages on the one hand and higher employment on the other.
Would you take issue with that?
Mr. GOLDBERG. I agree with you, Mr. Crane.
Mr. CRANE. Any of you see a problem with that?
[No response.]
Mr. CRANE. Something else in analyzing here what you would recommend in the way of tax reform. I have cited this example before, but my son, when he got his first job where he got a paycheck, I counseled him, as we were all counseled, and we try and counsel our kids still, to not blow it on instant gratification at the end of the week, but put something away for the proverbial rainy day. And that means investing it. He said, ''That is nuts, Daddy.'' And I said, ''Nuts? What are you talking about?'' He said, ''If I blow it on instant gratification, they only get at it once.''
The code we have had on the books all these years violates all of our moral values. If I invest in Caterpillar, for example, and they make a profit, my income takes a second hit, dividend distribution, a third hit, sell my stock and enjoy a capital gain, it gets a forth hit. Why these repeated penalties for doing the things that we all know to be right?
Now, I share with the distinguished Ranking Member the concern about how we can cut taxes and simultaneously get our books in balance. Reining in spending and reining it in with a vengeance is important in terms of the legacy we are leaving my grandchildren. But there is evidence you can cut taxes and increase revenues. That has happened before. And you can because you generate more economic activity.
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So I commend all of you for your testimony, but it is a major educational battle to get the message out, I think, to the American voters. We must recognize the importance the business community plays in the lives of all of us and how it is beneficial to eliminate these arbitrary and unnecessary burdens because there are superior ways in which we might approach it.
I thank you all for your testimony.
Chairman ARCHER. Mr. Matsui.
Mr. MATSUI. Thank you, Mr. Chairman. I will be very brief.
Let me make one observation, if I may, and I do not want to spend a lot of time on this, but it is just an observation. I do not need a comment from anyone. But it is my understanding that Mr. Rubin, the Secretary of the Treasury, has advised the administration and all of its principal deputies and all those in the White House not to use the phrase ''corporate welfare.'' And the words ''corporate welfare'' are coming out of a few Democratic Members and also the Chairman of the House Budget Committee. He has used the phrase ''corporate welfare'' extensively.
What is somewhat troubling to me is that in your testimonies you seemed to all refer to corporate welfare and to explain it is not a good term to use. And it seems to me you are raising this issue, and that may be a mistake on your part to do so, because I had thought this issue was put aside. I have been using the words ''tax preferences,'' and it seems to me that is what we are talking about here. I think you need to be somewhat careful because if you try to inflame people, you are probably going to be the losers because it is a very catchy phrase. You could find yourself all of a sudden trapped, and I guarantee you Mr. Rubin has instructed his people not to use that phrase. If it comes out, it is a few Democratic Members and the Chairman of the House Budget Committee. So I would caution you to be careful. Maybe you are directing your attention in the wrong direction.
I want to make one further observation as well. I have been spending a lot of time meeting with some of the folks that are interested in some of these revenue raisers, short-against-the-box and the Morris Trust, Mr. Goldberg, I even got a little briefing on that yesterday, and I do not understand it, I have to say. I am going to admit I do not understand the whole concept behind all this.
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But one of the problems you all face now is because we are going to have a tax cut, and so some of these revenue raisers have to be part of the equation, because you are not going to get $100, $120 billion out of spending cuts. It is my belief—and I spent a little time on this over the last few months, particularly over the last few weeks—and one of the reasons we cannot sit down and come up with a consensus on balancing the budget is because you cannot do it unless you do something on the CPI if you are going to have a $100, $150 billion tax cut.
So you are either going to be stuck with the dilemma and no budget, which I think is quite conceivable today, or you are going to have to do something on the CPI, and I guarantee you the BLS will not be able to do anything in the next 2 months in order to provide the numbers to reduce the CPI. Or you are going to have to talk about whether or not you really want this tax cut.
I would only urge you—and I am not going to ask you today because you all are representing associations or companies, and you cannot really speak for yourselves. But I would urge you to begin to think about what you would rather have, a balanced budget by the year 2002, using CBO numbers, or would you rather have a tax cut, in which case you are going to have to be fighting these revenue raisers all the way through the conference and maybe even as a bill conceivably reaches the President's desk.
I urge you to think that issue through because as we really get into this budget debate, I am more and more convinced of the folly of any kind of tax cut, because it puts you in jeopardy for your tax increases we are talking about, and it probably jeopardizes the one opportunity we are going to have in maybe a decade to get a balanced budget.
Thank you, Mr. Chairman.
Chairman ARCHER. Mr. Collins.
Mr. COLLINS. Thank you, Mr. Chairman. I find with interest the statements made not only by the panel but some of my colleagues. I am glad to see, though, that they are talking about balancing the budget. I think one mentioned doing it in 6 years. I hope we can do it in 5 years.
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I want to go in a little bit different direction from you. I think you are more or less speaking on behalf of big business. Let's go back to the small business. Often small business does not have equal opportunity to do some of the things that you all do.
But the question was asked about corporations, why corporations are created or why is a business created. I am a businessperson. I still have my small family-run S corporation at home. But the reason that I invested in it was to provide a service, to sell a product, to get a return on my investment. Often people say that people invest to create jobs. To me the job was a byproduct of my investment. It is more that I was able to provide and more I was able to sell than the more people I needed to assist me.
There are two ways and two areas that I think we could look at that would help small business as well as investors, whether it be in stocks or whatever. And, yes, I do think we can reduce the tax rates in certain areas and the tax liability in certain areas that would help the economy and still lead us toward a strong economy and a balanced budget.
One of those areas is in the area of capital gains. I know I was campaigning back in 1992 for this job, and I stopped in a little small town, a little television rental shop, and this lady, when I walked in, I told her who I was and what I was doing and I would like to have her support. She said I want to talk to you about taxes. She said, I got this little piece of property that I could have sold three times, but I have not sold it. And you know why? I said, No, ma'am, I have no idea. She said, Because I do not want to give the government all the money that I make off of it. The taxes are too high. I said, You are talking about capital gains, lady. And she said, I do not know what you call it, but I know I am not going to sell my property because I do not want to give all my money to the government.
What happened then when she did not sell? Nothing. There was no liability on her part to pay any tax anywhere. Local, State, and the Federal governments all lost out because there was no tax liability. If we had a capital gains tax reduction, people like that lady would sell her property or sell their asset, and a lot of seniors today have accumulated a lot of assets over their lifetimes that they would love to be able to sell. It would make a stronger economy. History has shown every time we do that we have a strong return and a stronger growth in revenue. We just need to look at, as the Chairman said, the other side of the equation in budgeting and that is the spending side.
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The second area I want to refer to is—many people call it the death tax—the estate tax and how it affects small business and investors, those who are—today you do not have to be greatly successful to reach the threshold of the estate tax. But just some figures I received recently from a study from a gentleman in Columbus, Georgia, named Morton Harris.
It is estimated that over the next two decades, over $6 trillion will be transferred to the next generation. During the next 10 years, $1 trillion will be transferred to the next generation. Research shows that less than one-third of family businesses succeed in the next generation, and less than 15 percent will make it to the third generation.
There is also a survey of 749 failed family businesses that shows that 75 percent of them failed after the death of the owner, with the other 25 percent after the owner retired. Seventy percent of those that failed were due to lack of capital for one reason: To pay the tax liability on the estate.
Those are two areas we need to address and that I think will help continue the economy and grow the economy and help small business and investors and also help the purchasers, the consumers of those goods and services that those businesses provide.
Thank you very much. And, Mr. Rangel, I learned that in Truck Driving 101.
Chairman ARCHER. Mrs. Kennelly.
Mrs. KENNELLY. Thank you, Mr. Chairman.
I have introduced legislation. H.R. 846 has to do with short-against-the-box and swaps and things like that, transactions that are the equivalent of sales. And I notice—Mr. Goldberg, you address short-against-the-box in your testimony. I would like to ask you two questions.
I have modified the President's proposal to address concerns that it would adversely impact legitimate hedging transactions. I have changed from the President in that area.
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I notice you mention the fact that the President's proposal was retroactive. I have always been against retroactivity, particularly in tax law. My effective date was the same as the President's because I do not think a Member of Congress should do anything that moves the markets.
But having said that, I would like to ask you, Mr. Goldberg, if, in fact, this Committee did address this situation, would date of passage be acceptable?
Mr. GOLDBERG. Mrs. Kennelly, I think the issue in terms of the effective date in this particular context is transactions after. In form, the administration says it is prospective because transactions that happen happened, we are going to let them unwind, and at least my view has been that Congress should be very careful when it adversely affects citizens who have relied on, played by the rules the way the rules were written. So I would worry about transactions after. Now, as to whether it should be transactions entered into after the date of the President's proposal or transactions entered into after date of congressional enactment, I think the more important point is transactions that have been entered into should not be affected.
Second, as you mention, I do think this is an area that may be appropriate to look at, but as I said, I think the administration's proposal in its current form is too broad because it does adversely affect a substantial amount of legitimate economic activity. And so if you are going to go forward, I would try to limit it to the kinds of transactions that people find troublesome.
Mrs. KENNELLY. I have gone a little further—oh, I am sorry.
Mr. Gordon.
Mr. GORDON. Mrs. Kennelly, I was just going to comment on the short-against-the-box and other hedging transactions, and I think the first is that there is some misperception in that there may very well be some very narrow transactions that are almost the equivalent of a sale, but many transactions and hedging transactions and some of the transactions that are suggested to be caught within that net I think we do not believe are the equivalent of sales. As I said both in the oral and the written testimony, the rules on these hedging strategies have gone back almost 60 years.
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Mrs. KENNELLY. I address hedging because I realize that normal non-tax-motivated hedges are something that we do not have to argue about. I would like to follow up quickly—do any of you have swap funds?
Mr. GORDON. Excuse me?
Mrs. KENNELLY. Do any of you have swap funds in your business?
Mr. GORDON. Yes.
Mrs. KENNELLY. Well, you know, this is another area that we could talk about, Mr. Gordon. Here we have so many Americans going into the stock market, doing very well the last couple of years, and we worry on this Committee and other Committees about capital gains. And yet what we are seeing is the ability to do transactions that, in fact, are not taxed because they have the sophistication of very brilliant advisors.
Is there any way we can do something to shut down the egregious funds Congress has been trying to shut down for 30 years, and at the same time be fair? It is important to be fair to the smaller person who goes into mutual funds and does not have the brilliant advice.
What I am afraid of is we are going to hurt a lot of people if, in fact, we do not address some of the egregious things, and then we will hurt some of the things that make the business go. And I am wrestling with this, and I am open to suggestion.
Mr. GORDON. Well, I think the mutual funds themselves that are being advised by the same people you are talking about, work with the larger investors. Some mutual funds themselves may avail themselves of those opportunities. Swaps, because of the CFTC rules, can only be done by a qualifying swap participant, which is someone who has a net worth of $10 million or more. So it is really somewhat ironic because the one thing that is available to a small investor, even with 100 shares, would be a short-against-the-box as a hedging transaction, and some of the more structured transactions that may not be caught, as the proposal stands, are only available to the larger investors.
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Mrs. KENNELLY. Well, I guess what I am concerned about is whether you call it corporate welfare or tax subsidy, we are getting into a whole area now where those who trade in huge numbers do and have found ways to avoid taxation, and then all the people that have gone into the mutual funds have not—when they sell, they have to pay the capital gains.
What I am trying to wrestle with is that we can help everybody do better. The number one thing in this Congress is increase savings and planning for our future. So maybe some of you will work with me and try to get this legislation to be what I want, not to look like it is punitive but, on the other hand, let's be fair.
Mr. GORDON. And we welcome the changes you have made from the President's proposal because you have started to try to work with some of the problems that were with the proposal to begin with. We welcome the opportunity.
Mrs. KENNELLY. Thank you, sir.
Thank you, Mr. Chairman.
Mr. HOUGHTON [presiding]. Thank you, Mrs. Kennelly.
Mr. Hulshof.
Mr. HULSHOF. Thank you, Mr. Houghton.
Mr. Gordon, you and Mr. Goldberg both talked about section 355, the spinoff provision, the Morris Trust provision, and the proposal of the administration. As I understand section 355, it generally allows a parent corporation to spin off a subsidiary through distributions of stock to shareholders that would then be tax free with certain restrictions. And, Mr. Goldberg, you mentioned the administration cuts against the grain with some of these tax proposals. What is the rationale for section 355 and having these tax-free spinoffs?
Mr. GORDON. I can answer it probably generally, and Mr. Goldberg could probably answer it more technically.
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Mr. HULSHOF. OK.
Mr. GORDON. But let's say that—right now the Justice Department is opposing the Office Depot-Staples merger, and if they came to an agreement with the Justice Department that separating out some part of their business that created too much anti-competitiveness, by separating that out the merger could go forward. Then one of those companies would spin off the offending assets to the shareholders, and the shareholders, instead of owning one piece of paper representing their ownership in these assets, they are now going to have two pieces of paper representing their ownership in the same assets.
We do not see why that should be taxed differently just because they have two pieces of paper, especially when it was another part of the government that forced that to happen.
Mr. HULSHOF. Mr. Goldberg, anything in followup to that?
Mr. GOLDBERG. I agree with that. Mr. Hulshof, I think from an economic policy standpoint, it is important to let people move pieces of business around. Do you want to be conglomerates? Do you want to move to fit and focus? What about the defense industry? And, historically, the tax rules have said if you want to get bigger or smaller, if you want to change where the pieces are, without anybody getting any cash, you ought to be able to do it tax free because nobody is taking any cash out of the deal. And that is good tax policy because it is good economic policy, and that has been the rules forever.
Now, I will say the head of the Joint Committee on Tax has pointed out there are some situations where people may be walking around that basic rule because they are moving a lot of cash, and I think he has properly said that that is an issue worth looking at. But in its current form, the administration proposal completely misses the mark and I believe would do far more harm than good.
Mr. HULSHOF. Let me share with you a further concern because as I understand, the Treasury proposal would apply to stock distributions after the date of Committee action. Is that your understanding, anybody on the panel?
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Mr. GOLDBERG. That is correct.
Mr. HULSHOF. Without regard for any transition period. Is that a concern that any of you have, Mr. Goldberg, Mr. Gordon?
Mr. GORDON. Yes.
Mr. HULSHOF. Let me shift a little bit regarding the de minimis rule, and the de minimis rule for tax-exempt bonds. Is it not true the de minimis rule was explicitly created by the Treasury Department rather than by Congress? Is that not true?
Mr. HAYES. Yes, and I think it did grow out, originally, of a court case, too. But, yes, it——
Mr. HULSHOF. If Treasury thinks the de minimis rule is abusive, then why hasn't Treasury revoked the revenue procedure that established it initially? Any ideas?
Mr. HAYES. I do not know. You are right that conceivably they could pick the right case and go after it or something, that is true. I was going to say, within that area, too, there are actually two prongs of it. There is the 2-percent de minimis rule. There is also another aspect of it that happens to hit the bank industry, particularly; it would change the calculation from an entity-by-entity calculation to a consolidated group calculation. And most of the members in our association do their tax-exempt activity through the bank, which largely funds itself and has the lowest cost of funds. So by switching this calculation to a consolidated group, effectively you are increasing the interest expense disallowance, even though in point of fact none of the funds raised by other members of your group are being used for this activity.
Mr. HULSHOF. My time is about to expire. Mr. Hyde, I know that in the big picture this probably is a small point except for my constituents. You mentioned in your written statement regarding housing and student loans sectors of the municipal market are going to be somehow negatively impacted. Could you briefly, because we have to vote here in a few minutes, share with me how the administration's proposal is negatively going to impact these two markets?
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Mr. HYDE. Well, basically it will take some corporate investors out of that marketplace and will increase the cost because corporations will not be able to buy these securities or will not buy these securities, and it will increase the cost to municipalities in issuing certain types of bonds. So there will be a market for these securities, but the cost of financing will rise by, in our estimation, somewhere between 25 and 75 basis points.
Chairman ARCHER [presiding]. Gentlemen, the President has 42 tax increases, separate tax provisions that increase revenues in his budget. I believe Mr. Goldberg said there were three that he felt were consistent with good tax policy that he could support. Is that correct, Mr. Goldberg?
Mr. GOLDBERG. There were three among the proposal that I was talking about, yes, sir.
Chairman ARCHER. All right. I would like to ask each of you gentlemen what, if any, of these 42 do you believe are consistent with good policy, and which you could support?
Mr. Hayes.
Mr. HAYES. Well, actually, I had mentioned one that is not on the list which is a high priority for our organization, namely, credit unions.
Chairman ARCHER. I thank you for that entry.
Mr. HAYES. Actually, you know, not to be nonresponsive, but one aspect of it which touches our members, too, which gets back to some of the other points, is there are certain of these provisions that, even if they are in, are very broad and ambiguous at this point. And there is a real concern there of even if there is a kernel of something that the administration or Treasury wants to go after, that what they are doing is too broad, and that is——
Chairman ARCHER. So are there any provisions with modifications that you could support that would raise additional revenue?
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Mr. HAYES. Well, I guess I would have to get back to you on that.
Chairman ARCHER. All right. If you would, I would appreciate that. If you have any suggestions of modifications on the revenue raisers that you could support, if you would send that to the Committee in writing, I would appreciate it.
For the purpose of this meeting, are there any other provisions the other three of you feel would be supportable that are in the President's proposals?
[No response.]
Chairman ARCHER. No? So then we are left with Mr. Goldberg's three, and——
Mr. GOLDBERG. I may have a few more in my pocket, Mr. Chairman.
Chairman ARCHER. You may have some more? [Laughter.]
Well, if you do, again, it is an open invitation to each of you to tell the Committee where you think there are problems that need to be fixed, or where there are changes that are consistent with good tax policy that are not going to harm investments and harm job creation, and that the Committee could consider.
What about the short-against-the-box provision? Have each of you looked at that?
Mr. GORDON. We have extensively, and I think I have probably already taken enough time on our views of it. But we think it is much to broad and that if it could be dealt with on a more surgical basis, we think it would make more sense.
Chairman ARCHER. All right. Would all of you agree with that?
Mr. GOLDBERG. Yes.
Chairman ARCHER. So basically you think it would be appropriate for us to do something in that area, but not what the administration proposes; is that a fair statement?
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Mr. GORDON. Yes. I think that from discussions with the Joint Committee and others that there may be able to be something that could be crafted that would be acceptable.
Chairman ARCHER. OK. Thank you very much.
Mr. Crane, do you have any further questions?
Mr. CRANE. No.
Chairman ARCHER. Well, gentlemen, unless the invisible member wants to ask questions, I guess that concludes this panel's discussion. Thank you so much for your input.
Our next panel is invited to take seats at the witness table: Mr. Amacher, Mr. Zahren, Mr. Sullivan, Ms. MacNeil, and Ms. Parks.
The Chair would ask our guests to be seated so we can commence with the next panel.
Mr. Amacher, you are first on my written list up here, so if you will identify yourself for the record, you may proceed.
STATEMENT OF RICHARD C. AMACHER, VICE PRESIDENT AND DIRECTOR OF TAXES, BELK STORES SERVICES, INC., CHARLOTTE, NORTH CAROLINA; ON BEHALF OF NATIONAL RETAIL FEDERATION
Mr. AMACHER. Thank you, Mr. Chairman. My name is Dick Amacher, and I am vice president and director of taxes at Belk Stores Services in Charlotte, North Carolina. And on behalf of NRF, the National Retail Federation, I would like to express our grave concerns about a provision in the President's fiscal year 1998 budget to repeal the LCM, lower of cost or market, inventory accounting method. This method of inventory accounting is extremely important to U.S. retailers and consumers and should not be changed.
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By way of background, the NRF is the world's largest retail trade association. Its members represent an industry that encompasses over 1.4 million establishments, employs more than 20 million people, 1 in 5 American workers, and registered 1996 sales of more than $2.4 trillion.
What is the lower of cost or market method? Both retailers and manufacturers use LCM. LCM is applied by retailers to allow store owners to write down the value of their inventories at the time the value of the goods drop rather than when the item is eventually sold, disposed of, or destroyed. Without LCM, the value on the books of retail inventory could be significantly overstated compared to the actual value of the goods on the shelves.
Retail prices are reduced either because a newer product has been introduced, for example, computers or software; the goods are damaged, or the product was seasonal and has been permanently put on sale, for example, winter jackets. Once a product's price is permanently marked down, retailers are never able to sell the product for more.
Now, why do retailers use LCM? LCM has been the best accounting practice for tax purposes in the retail trade since 1918. It grew out of a need for the retail store to control its inventory during the thirties, taking into account the changes in value occurring in one period and affecting the price of goods to be sold in a future period.
If something occurs that diminishes the usefulness of inventory, the loss should be accounted for in the period in which it occurs. To do otherwise and retain historic cost basis of inventory fails to achieve a proper matching of costs and revenue and fails to clearly reflect income.
What would be the consequences of the proposed repeal? Taxes on retailers would increase if LCM were repealed. Higher taxes could mean higher costs for families and consumers. In the competitive retail environment, however, consumers often will not tolerate cost increases. Therefore, some retailers, especially smaller retailers, may be forced to shut their doors and working-class jobs would be lost.
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If LCM were repealed, retailers whose inventory value has been drastically and permanently reduced would not be able to deduct the lost value until the goods are finally sold or they are determined to be worthless, which could be months or even years. Retailers who are suffering because their goods are worth less would also end up paying higher taxes.
Consumers would have fewer choices since retailers will be less likely to carry unproven items in inventory, fearing higher taxes if they do not sell. Many taxpayers would be forced to make two sets of computations for inventory, one for books and one for tax. This would be an unnecessary additional cost burden to be imposed upon these taxpayers.
Repeal would cause behavioral changes which could actually render the anticipated increase in tax revenues illusory. For example, repealing LCM would probably push premature bulk sales of inventories from retailers to liquidators or donations to charity in order to secure earlier tax deductions for the diminished value of the goods. More orderly clearance sales are better for consumers, better for the retailers, and, consequently, better for the Federal Treasury. Repealing LCM will also encourage affected retailers to undertake the very expensive process of switching accounting methods to LIFO—last in, first out. The cost of changing accounting methods is a deductible expense, reducing projected revenue pickup for the Treasury.
Additionally, LIFO has the effect of lowering the value of goods on hand by a deflator, which takes into account annual inflation. This adjustment would also tend to offset anticipated revenue gains from repeal.
What is the administration's position? Repeal of LCM has consistently appeared on the administration's so-called corporate welfare list as a loophole closer and tax increase. In rebuttal, contrary to administration contentions, adjustments to value are not always negative under LCM. Additional markups and markdown cancellations are recognized immediately. In addition, there is no certainty that the goods will be sold at the current reduced offer price.
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Also in rebuttal, LCM is not a corporate loophole but, rather, an established method of accounting specifically authorized by longstanding IRS regulations, and it is a determinant of clearly reflected income.
In conclusion, repeal of LCM would be bad tax policy, given its history, utility, and fairness. It would result in higher prices for American families and less flexibility for retailers. Repeal would be an unjustified tax increase on the retail industry following on the heels of the enactment in the uniform capitalization costing rules in 1986 that increased many retailers' tax inventory costs by 5 percent or more, and would specifically target those taxpayers who could least afford it.
We hope your Committee will seriously consider the problems enacting this proposal will cause and that you will reject, once again, the President's proposal to repeal the lower of cost or market accounting method.
Thank you.
[The prepared statement follows:]
Statement of Richard C. Amacher, Vice President and Director of Taxes, Belk Stores Services, Inc., Charlotte, North Carolina; on Behalf of National Retail Federation
On behalf of the National Retail Federation (NRF), I express our grave concerns about a provision in the President's FY98 Budget to repeal the ''Lower of Cost or Market'' method of accounting.
The retail industry is unanimously opposed to repealing the ''Lower of Cost or Market'' inventory accounting method. This method of inventory accounting is extremely important to U.S. retailers and consumers and should not be changed.
By way of background, the NRF is the world's largest retail trade association with membership that includes the leading department, specialty, discount, mass merchandise and independent stores, as well as 33 national and 50 state associations. NRF members represent an industry that encompasses over 1.4 million U.S. retail establishments, employs more than 20 million people—one in five American workers—and registered 1996 sales of more than $2.4 trillion.
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What Is the Lower of Cost or Market (LCM)
• Both retailers and manufacturers use LCM.
• LCM, as applied by retailers, allows store owners to write down the value of their inventories at the time the value of the goods drop—rather than when the item is eventually sold, disposed of, or destroyed. Without LCM, the value ''on the books'' of retail inventory could be significantly overstated compared to the actual value of the goods ''on the shelves.''
• Retailers may use the Retail Inventory Method (RIM) to determine the cost of their inventory. Under this method, the retailer accounts for inventory based on its retail sales price, adjusted to cost by applying the retailer's gross profit ratio. Retailers may also use invoice cost to account for inventories. Regardless of which method is used, the retailer may elect to use LCM.
• Retail prices are reduced either because a newer product has been introduced (i.e., computers or software), the goods are damaged, or the product was seasonal and has been permanently put on sale (i.e., winter jackets). Once a product's price is permanently marked down, retailers are never able to sell the product for more.
Why Do Retailers Use LCM
• LCM has been the ''best accounting practice'' for tax purposes in the retail trade since 1918 and has always been the best accounting ''retail trade'' practice for generally accepted accounting principles (GAAP) purposes. RIM has been the best accounting practice since 1941 when a predecessor to the NRF had the method approved by Treasury just before WWII for department stores. LCM grew out of a need for the retail store to control its inventory during the 1930's, taking into account the changes in value occurring in one period affecting the price of goods to be sold in a future period. If something occurs that diminishes the usefulness of inventory, the loss should be accounted for in the period in which it occurs. To do otherwise, and to retain the historic cost basis of the inventory, fails to achieve a proper matching of costs and revenue and fails to clearly reflect income. This effort was headed up by the industry and Professor N.P. McNair of the Harvard Graduate School of Business, who wrote the first major book on this subject: The Retail Method of Inventory.
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What Would Be the Consequences of Repeal
• Taxes on retailers would increase if LCM were repealed. Higher taxes could mean higher costs for families and consumers. In the competitive retail environment, however, consumers often will not tolerate cost increases. Therefore, some retailers (especially smaller retailers) may be forced to shut their doors and jobs would be lost. A.
• If LCM were repealed, retailers whose inventory value has been drastically and permanently reduced would not be able to deduct the lost value until the goods are finally sold or they are determined to be worthless—which could be months, even years. Retailers who are suffering because their goods are worth less would end up paying higher taxes.
• Consumers would have fewer choices, because retailers will be less likely to sell products that have a higher chance of failing.
• Manufacturers and vendors will have a tougher time selling new products to retailers. Store owners will not want to take as many risks with unproven items, because their taxes will be higher if the items don't sell well.
• Many taxpayers would be forced to make two sets of computations—one for accounting and the other for taxes. This would be an unnecessary additional cost burden imposed upon these taxpayers.
• Repeal would cause behavioral changes which could actually render the anticipated increase in federal tax revenues illusory.
For example, repealing LCM would probably push premature bulk sales of inventories from retailers to liquidators or donations to charity in order to secure earlier tax deductions for the diminished value of the goods. More orderly clearance sales would be better for consumers, retailers and, consequently, the Treasury.
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Repealing LCM will also encourage affected retailers to undertake the very expensive process of switching accounting methods to LIFO (Last-In, First-Out). The cost of changing accounting methods is a deductible expense, reducing projected revenue pick-up for the Treasury. Additionally, LIFO has the effect of lowering the value of goods on hand by a ''deflator'' which takes into account annual inflation. This adjustment would tend to offset anticipated revenue gains from repeal.
What is the Administration's Position
• ''The allowance of write-downs under the LCM and subnormal goods methods is an inappropriate exception from the realization principle and is essentially a one-way mark-to-market method that understates taxable income.''
• Repeal of LCM has consistently appeared on the administration's so-called ''corporate welfare'' list as a ''loophole closer.''
In Rebuttal
• To the contrary, adjustments to value are not always negative under LCM as used in conjunction with RIM. Additional mark-ups and markdown cancellations are recognized immediately. In addition, there is no certainty that goods will be sold at the current offer price.
• LCM is not a so-called ''corporate loophole,'' but rather an established method of accounting, specifically authorized by long standing IRS regulations, which is a determinant of clearly reflected income.
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In Conclusion
Repeal of LCM would be bad tax policy, given its history, utility and fairness. It would result in higher prices for American families and less flexibility for retailers.
Repeal would be an unjustified tax increase on the retail industry, following on the heels of the enactment of the uniform capitalization costing rules in 1986 that increased many retailers' tax inventory costs by 5% or more, and would specifically target those taxpayers who can least afford it.
Thank you for your careful consideration of this important issue for retailers and consumers. We hope your Committee will seriously consider the problems this proposal will cause and that you will reject, once again, the President's proposal to repeal the Lower of Cost or Market accounting method.
—————
Chairman ARCHER. Mr. Zahren.
STATEMENT OF BERNARD J. ZAHREN, PRESIDENT, ZAHREN ALTERNATIVE POWER CORP., AVON, CONNECTICUT; ON BEHALF OF SOLID WASTE ASSOCIATION OF NORTH AMERICA
Mr. ZAHREN. Thank you, Mr. Chairman. I appreciate the opportunity to speak to you this morning. My name is Bernie Zahren. I am a small businessman based in Avon, Connecticut. I have 45 employees and my annual sales are about $9 million, so I am not a large company.
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I am here today in my capacity representing the Solid Waste Association of North America, which has 6,400 members representing all aspects of the solid waste industry in the United States. We are here today to talk about the section 29 provisions relative to incentives for landfill gas. Landfill gas is a very important renewable energy resource in the United States. In fact, I believe it is the most important renewable energy resource because not only does it provide an alternative energy source which replaces our dependence on foreign oil or other nonrenewable sources of carbon-based fuel, but it is also, in its natural state, an environmental pollutant. Almost every member of this panel has a large landfill somewhere in their region, and that landfill will emit landfill gas. It is a biological certainty that it will. If that gas is not controlled, it is a very detrimental greenhouse gas that causes smog, greenhouse warming, and so forth.
The EPA is strongly in favor of controlling landfill gas. In fact, they have launched a special program called LMOP, the Landfill Methane Outreach Program, or LMOP, and they are spending a lot of money promoting the value of landfill gas as a renewable energy source. We are strongly behind that initiative, and we thank this Committee for supporting the provisions in the Small Business Job Protection Act of 1996, which you passed a mere 7 months ago, which included two very important extensions for the section 29 provisions. Those were specific contract dates, which are very important. One was that we had until December 31, 1996, to sign binding contracts to build new landfill gas collection facilities. My company did that. I signed a number of contracts in December of last year. The second important date, which is what is at issue here today, is that we have, by law today, until June 30, 1998, to finish and place those gas collection facilities into service.
Now, I am here to tell you this morning the contracts that I signed are legally binding. They have penalties and liquidated damages and other costs associated with them. I signed those in good faith, based on the law of the land at that time, which you folks passed last August and gave me the right to sign those contracts. Now I am being told by the provisions in the President's budget that he wants to cut short the inservice date from June 30, 1998, to June 30, 1997, less than 4 months from now. There is no way I can comply with the contracts I signed in December 1996 by June 30, 1997. In fact, it is unconscionable to our industry that you could give us this carrot and then immediately even consider taking it away.
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A landfill gas project takes at least 12 months to build, including the permitting, engineering, design, financing, and actual construction period. So unless I know very soon that this provision will not be changed and I will not have to live with June 30, 1997, as a cutoff date, by matter of practicality I will not be able to proceed with any of these contracts.
Furthermore, I could put my small business in jeopardy of bankruptcy because I have substantial costs and penalties from the contracts that I signed last December relying on the law that was passed in August 1996, which was deemed a Small Business Job Protection Act. I am a small businessman. I am an entrepreneur. To answer Mr. Rangel's question, I am in favor of both tax cuts and a balanced budget, but I am not in favor of either of them if they come at the expense of the environment or the energy dependency of this country. Landfill gas is the one renewable resource that accomplishes both of those environmental and energy concerns.
So not only do we ask you on behalf of the 6,400 members of the Solid Waste Association of North America to reject this provision in the President's proposed budget, we ask you to state as soon as possible that you intend to reject it. Right now I have to borrow the money to build these projects. My financing is in jeopardy because of the cloud that hangs over this provision. I do not dare start building these projects now because I know I cannot finish them 3 months from now, in June 1997. Therefore, I cannot start. If I do not start until you finish the budget process, which, Chairman Archer, I sincerely hope you can go home before Thanksgiving this year with this thing resolved, but if you do not, I will be dead either way. I cannot build them now and I cannot afford to cancel the contracts. I will no longer have the lead time I need to do the engineering, permitting, and construction, and place the facility in service by June 1998 if we have to wait until this fall for clarification of this provision.
We are not asking for a change. We are not asking for an extension. We are not asking for anything on the sunset date of 2007 for this incentive. We are simply asking this Committee and the Congress to reaffirm the law that they just passed 7 months ago, giving us until June 1998 to comply with the contracts that we signed less than 4 months ago.
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An analogy might be if I tried this in the private sector by giving an incentive to someone. Let's say our friends in Detroit came out with another one of their famous car rebate programs, and they said if you order a car in the next 2 weeks and you put a downpayment on it and then you will have 2 months to take delivery and pay the balance of the price for the car, plus get a $1,000 rebate. And halfway through that, after you have made a downpayment and contractually obligated yourself to buy this car, they said, Well, we changed our mind, you only have 1 month instead of 2 months to pay for the car, or the rebate is withdrawn. That is, in essence, what the Clinton administration budget does to me.
I have spent a lot of money and I have executed a lot of contracts that are very important to the future of my small business. I am obligated to either pay penalties to cancel those contracts or to build those facilities. I cannot do either of those right now because of the cloud that hangs over this provision.
I am very aware, Mr. Chairman, of the political problems of taking anything off the table today in the spirit of bipartisan budget negotiations. But I urge you to announce that you intend to take this provision, relative to the section 29 incentives for alternative fuels, off the table and notify our industry that we can proceed with our plans and our legally binding contracts as passed in the Small Business Job Protection Act of 1996. Allow us to proceed, start building these facilities, save the environmental quality of many of our cities, and help reduce our dependency on nonrenewable sources of energy.
Chairman Archer, you know—you are from a high-energy State—that we may not be concerned today about OPEC oil, but we are a long way from out of the woods long term on energy sufficiency. We still import a little bit more oil every year than we did the year before. We are still running out of coal, oil, and natural gas, and some time in the next century there will be another energy crisis. There are also provisions today in the Clean Air Act requiring hundreds of landfills to collect their gas, put in a collection system, and simply flare it off, simply waste it as a fuel, to get rid of it as an environmental pollutant. And yet without this incentive, I cannot turn it into a usable fuel.
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The other issue that is going to be hotly debated in Congress this year will be energy deregulation of the electric utilities. Well, that has created a competitive environment. I run 12 projects, and I make electricity with landfill gas. Without the section 29 subsidy, I cannot compete in a deregulated environment for energy as a commodity with the big utilities that operate sulphur-belching coal plants, people that burn imported oil, and people that use other types of nonrenewable resources. I must have this section 29 incentive to succeed and help the environment and our energy conservation policy, and I ask this Committee and this Congress to state very, very soon that you intend to reject this provision in the President's budget calling for cutting off my inservice date at June 30 this year and leave what you passed and what you argued and debated extensively last summer, namely, the existing provisions of the Small Business Job Protection Act, which gives me until June 1998 to finish my job.
If I do not finish a project by then, that is my fault. That is a risk I take. And I have signed contracts, and I am willing to back that with my business future as a small businessman to proceed under those contracts. Right now I am at a total stalemate. I cannot proceed. Please correct this uncertainty.
Thank you, Mr. Chairman.
[The prepared statement follows:]
Statement of Bernard J. Zahren, President, Zahren Alternative Power Corp., Avon, Connecticut; on Behalf of Solid Waste Association of North America
Mr. Chairman and Members of the Committee, I am Bernie Zahren, President of Zahren Alternative Power Corporation of Avon, Connecticut. I am here today to present the views of the Solid Waste Association of North America (SWANA), an association composed of local government and private sector professionals dedicated to advancing the practice of environmentally and economically sound municipal solid waste management. SWANA has been a strong proponent of the Section 29 tax credit for the production of nonconventional fuels, in particular, as it applies to the collection and beneficial use of gas produced by the decomposition of organic wastes in our nation's municipal landfills.
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President Clinton's 1998 Budget, as recently submitted to Congress, contains a provision which proposes to repeal an extension of the Section 29 tax credit which was passed by this Congress and signed by the President just last August, as part of the Small Business Job Protection Act of 1996. The extension allows taxpayers to qualify for the tax credit if they signed a legally binding contract by December 31, 1996, to construct a project producing a nonconventional fuel, and if they place the project in
service by June 30, 1998. The President's proposal would roll back the in-service date by one year, requiring that the projects be online by June 30, 1997, a little over three months from now. This proposed shortening of the construction period is extremely unfair, severely disruptive and wasteful, and simply poor public policy.
Congress has long been supportive of the development of alternative energy sources to bolster the nation's energy security. With its enactment of, and willingness to extend, the Section 29 tax credit, Congress recognized that economic support was critical in promoting the development of several nonconventional fuels which, if harnessed, could become important energy sources in the future. In the case of landfill gas, there are also significant environmental benefits to air quality and reduction in greenhouse gas emissions. With current technologies, however, the development and beneficial use of landfill gas is uneconomic in almost all cases in the absence of the Section 29 tax credit.
Indeed, the United States Environmental Protection Agency has been
aggressively encouraging the use of landfill gas for the last several years. EPA has implemented the Landfill Methane Outreach Program and committed substantial amounts of its taxpayer funded budget to the Program. My company is a Charter Member of this initiative. If President Clinton's proposal on Section 29 is implemented, all of the good work done to promote this environmentally positive and energy conserving alternative fuel will go for naught.
Under the extension granted by Congress last August, taxpayers intent on developing landfill gas projects were given until December 31, 1996, to negotiate and execute contracts legally binding them to construct those projects. Under IRS rules these contracts were required to have substantial penalty provisions for breaching the contracts. In addition to committing to pay contract damages, taxpayers that scrambled to get their contracts in place by the deadline have committed significant funds in designing their projects, procuring necessary equipment, obtaining the required permits, and securing commitments for utilization of the fuel.
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These taxpayers took these actions in good faith reliance on Congress' complementary extension of the construction period for the projects to June 30, 1998.By providing 18 months after the execution of a binding contract to place the landfill gas projects in service, Congress recognized that the construction season in many parts of the country is limited to just a few months a year preventing many of these projects from being constructed in a lesser period of time. Now, however, the President's proposal would effectively preclude use of the Section 29 tax credits by the same taxpayers the government encouraged to legally bind themselves, and expend significant resources, by its previous commitment to make the tax credit available as long as the deadlines were met.
SWANA strongly urges Congress to reject the one-year roll back of the ''placed-in-service'' date and, thereby, prevent the unconscionable hardship that the President's proposal would place on these taxpayers and prevent the waste of all the resources which have already been committed to develop these beneficial projects. The President's proposal has created a ''chill'' over the financing of landfill gas projects and has undermined the further dedication of resources by project developers to bring the projects on-line. For these reasons, SWANA also urges Congress, as it proceeds to develop the federal FY98 budget, to remove the uncertainty over the availability of the tax credit by stating, as soon as possible, its intent to reject the President's proposal.
Mr. Chairman, I have appreciated this opportunity to present the views of SWANA on the Section 29 tax credit. The tax credit is critical to ensuring that the benefits of landfill gas utilization are realized. We are hopeful that you and the other Members of the Committee will act soon to address the disruption that the President's Budget proposal has created and allow these projects to move forward.
—————
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Chairman ARCHER. Thank you, Mr. Zahren.
Mr. Sullivan, you may proceed.
STATEMENT OF PAUL SULLIVAN, VICE PRESIDENT AND GENERAL TAX COUNSEL, EXXON CORP., IRVING, TEXAS; AND CHAIRMAN, GENERAL COMMITTEE ON TAXATION, AMERICAN PETROLEUM INSTITUTE
Mr. SULLIVAN. Good morning, Mr. Chairman. My name is Paul Sullivan, and I am vice president and general tax counsel of Exxon Corp. As chairman of the General Committee on Taxation, I am appearing today as a witness for API, the American Petroleum Institute.
I would like to concentrate my remarks on one provision of the administration's budget proposals—the proposal to modify the rules relating to foreign oil and gas income. API opposes the provision.
Under the proposal, so-called deferral would be eliminated, but only for the petroleum industry. That would result in the current taxation of foreign subsidiary oil and gas income before it is distributed by way of dividends. The proposal would also trap foreign oil and gas income in a new basket under section 904(d). Finally, taxpayers who are subject to a foreign income tax and also receive an economic benefit from the foreign country, so-called dual-capacity taxpayers, would only be able to claim a credit for foreign taxes paid if the foreign country has a generally applicable income tax that has substantial application to all types of taxpayers, and then only up to the level of taxation that would be imposed under the generally applicable income tax. These provisions change the basic rules of foreign income taxation, but only for one industry.
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Regarding deferral, let me point out that although U.S. corporations are generally taxed on their worldwide income, there is normally no taxation of the earnings of foreign subsidiaries before they are received in the form of a dividend. This is the same as individual shareholders not being taxed on earnings from companies in which they are shareholders until dividends are paid. Furthermore, in potentially abusive situations, the current law already provides for taxing a U.S. shareholder on all or part of its foreign subsidiary earnings before dividends are distributed. Yet the administration has chosen to make all of the oil companies' foreign subsidiary income subject to current taxation. They would remove the active business income of oil companies from the general business income basket by creating a separate foreign tax credit limitation category for foreign oil and gas income. There is no legitimate reason to do this.
Finally, the unfairness of the dual-capacity taxpayer provision becomes obvious if one only considers the situation where a U.S.-based oil company and a U.S.-based company other than an oil company are both subject to an income tax in a country without a generally applicable income tax. Under the administration's proposal, the U.S. nonoil company would be entitled to the full foreign tax credit for that tax, while the U.S. oil company would be entitled to receive no credit.
Not only are the proposed changes unfair, they significantly impede our ability to compete in the international arena. Strangely, they are in direct conflict with the Clinton administration's own trade policy of global integration. The administration has advocated the removal of trade barriers and promotion of international investment in general. And because of their political and strategic importance, investments by U.S. oil companies in areas around the world have been supported and encouraged by the U.S. Government.
Contrary to those policies, the administration's budget proposals will further tilt the playingfield against the U.S. petroleum industry's foreign exploration and production efforts and will increase or make prohibitive the U.S. tax burden on the petroleum industry's foreign operations. They will not only stymie new investment in foreign projects, but will also change the economics of some of our past investments.
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If U.S. oil and gas concerns wish to stay in business, they must look to replace their diminishing reserves. Currently, our opportunities are seriously restricted in the United States by government policies that put many of the promising prospects off limits to exploration and development. Thus, that replacement must come from outside of the United States.
If U.S. companies cannot economically compete overseas, those foreign resources will still be produced. However, they will be produced by our foreign competitors, without any benefit to the U.S. economy and without U.S. companies, their shareholders, or American workers deriving any direct or indirect income from the foreign production activity.
The home countries of our foreign competitors either exempt foreign source income from taxation or utilize a foreign tax credit regime which truly prevents double taxation. In direct contrast to this, the current U.S. tax system makes it very difficult for U.S. multinationals to compete. The administration's proposals will make it even worse.
Under the administration's proposals, a U.S. company's aftertax return could be one-third less than its foreign competitors. Even if the foreign competitor is unable to match the U.S. company's efficiencies, the U.S. company would still be at a serious competitive disadvantage.
Mr. Chairman, what we need from Congress are improvements in our system that allow U.S. companies to compete more effectively, not further impediments that make it even more difficult and in some cases impossible to succeed in today's global oil and gas business environment.
These improvements should include, among others, the repeal of separate baskets for 10/50 companies, the extension of the carryback and carryforward periods for foreign tax credits, not further restrictions on the carryback as the administration has proposed, and the repeal of section 907.
We thank you for the opportunity to provide our comments on this extremely important issue affecting the continued viability of our industry in the international arena.
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[The prepared statement follows:]
Statement of Paul Sullivan, Vice President and General Tax Counsel, Exxon Corp., Irving, Texas; and Chairman, General Committee on Taxation, American Petroleum Institute
This testimony is submitted by the American Petroleum Institute (API) for the March 12, 1997 Ways and Means hearing on the revenue raising provisions in the Administration's fy 1998 budget proposal. API represents approximately 300 companies involved in all aspects of the oil and gas industry, including exploration, production, transportation, refining, and marketing. The U.S. oil and gas industry is the leader in exploring for and developing oil and gas reserves around the world.
One of the provisions in President Clinton's budget proposal is aimed directly at the foreign source income of U.S. petroleum companies. It seriously threatens the ability of those companies to remain competitive on a global scale, and API strongly opposes it. It is particularly troubling that the Administration would attack the foreign operations of U.S. oil companies in this way, especially when it conflicts with Commerce and State Department initiatives encouraging those same companies to participate in exploration and production ventures in strategic areas around the world.
I. The Provisions
Specifically, the proposal includes the following provisions:
• Effective for taxable years beginning after the bill's enactment, reinvested foreign oil and gas income (''FOGI'') earnings would be taxed before being realized through dividend distributions. FOGI would be treated, instead, as Subpart F income as defined under Code Section 952 (i.e., not eligible for deferral), and trapped in a new separate FOGI basket under Code Section 904(d). FOGI would be defined to include both foreign oil and gas extraction income (''FOGEI'') and foreign oil related income (''FORI'').
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• In situations where taxpayers are subject to a foreign tax and also receive a so-called ''economic benefit'' from the foreign country, taxpayers would only be able to claim a credit for such taxes under Code Section 902 if the country has a ''generally applicable income tax'' that has ''substantial application'' to all types of taxpayers.
Following is a detailed discussion of these changes and their expected effect on the taxation of FOGI.
II. Impact on Global Competitiveness
As noted, the proposed changes to the foreign tax credit (''FTC'') rules for FOGI and the current taxation of foreign subsidiary income before distribution conflict with the Clinton Administration's announced trade policy. The Administration has demonstrated an intention to subscribe to the integration of worldwide trade, with a continuing removal of trade barriers and promotion of international investment (e.g., the GATT and NAFTA agreements). Moreover, because of their political and strategic importance, foreign investments by U.S. oil companies have been welcomed by the U.S. government. For example, recent participation by U.S. oil companies in the development of the Tengiz oil field in Kazakhstan has been praised as fostering the political independence of that newly formed nation, as well as securing new sources of oil to Western nations, which are still too heavily dependent on Middle Eastern imports.
Curiously, given this background, the Administration's proposals will further tilt ''the playing field'' against the U.S. petroleum industry's foreign exploration and production efforts, and will increase, or make prohibitive, the U.S. tax burden on foreign petroleum industry operations. They will not only stymie new investment in foreign exploration and production projects, but also change the economics of past investments. As illustrated below, the proposed changes in the FTC rules can reduce the return on project investments by approximately one-third.
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Proposals to increase the taxation of foreign operations, like other barriers to foreign investments by U.S. firms, are based on several flawed premises. In the case of natural resource extraction and production, the reason for foreign investment is obvious. If U.S. oil and gas concerns wish to stay in business, they must look to replace their diminishing reserves overseas, since the opportunity to do so in the U.S. has been restricted by both federal and state government policy. If U.S. companies can not legitimately compete, foreign resources will instead be produced by foreign competitors, only then without any benefit to the U.S. economy, and without U.S. concerns or American workers deriving any direct or indirect income from the foreign production activity.
There is a general perception that foreign investment by U.S. business is responsible for reduced investment and employment in the U.S. These investments are perceived to be made primarily in low wage countries at the expense of U.S. labor; with such foreign investments also including a shift of Research & Development (''R&D'') spending abroad. However, studies like the 1995 review by the Economic Strategy Institute (Multinational Corporations and the U.S. Economy [1995]) show these claims to be unfounded. Over a 20-year period, capital outflows from the U.S. averaged less than 1% of U.S. nonresidential fixed investment, which is hardly sufficient to account for any serious deterioration in U.S. economic growth. Instead, affiliate earnings and foreign loans, not U.S. equity, have financed the bulk of direct foreign investment.
Furthermore, the principal reason for foreign investment is seldom cheap labor. Rather, the more common reasons are a search for new markets, quicker and easier response to local market requirements, elimination of tariff and transportation costs, faster generation of local good will, and other deep rooted host country policies. In this regard, the bulk of U.S. foreign investment is in Europe, where labor is expensive, rather than in Asia and Latin America, where wages are low. According to a recent study, almost two-thirds of employment by foreign subsidiaries of U.S. companies was in Canada, Japan, and Europe, all higher wage areas (Sullivan, From Lake Geneva to the Ganges: U.S. Multinational Employment Abroad, 71 Tax Notes 539 [4/22/96]). Although some R&D functions have been moved abroad, they make up only 15 % of domestic R&D, and are primarily in areas aimed at tailoring products to local demands. Moreover, two recent studies of the OECD countries conclude that foreign investment is beneficial to employment and incomes in both the home and host countries. (The OECD Countries, Paris [1994]; Trade and Investment: Transplants, Paris [1994]).
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The FTC principle, along with so-called ''deferral'' of taxation of foreign subsidiary earnings until repatriation, make up the foundation of U.S. taxation of foreign source income. The Administration's budget proposals would destroy this foundation of foreign income taxation on a selective basis for foreign oil and gas income only, in direct conflict with the U.S. trade policy of global integration, embraced by both Democratic and Republican Administrations.
III. Foreign Tax Credit—Background
A. The FTC Is Intended To Prevent Double Taxation
Since the beginning of Federal income taxation, the U.S. has taxed the worldwide income of U.S. citizens and residents, including U.S. corporations. To avoid double taxation, the FTC was introduced in 1918 to allow a dollar for dollar offset against U.S. income taxes on foreign income for taxes paid to foreign taxing jurisdictions. The need for the FTC is at least as important today as it was 80 years ago. Also under this regime, foreign income of foreign subsidiaries is not immediately subject to U.S. taxation. Instead, the underlying earnings become subject to U.S. tax only when the U.S. shareholder receives a dividend (except for certain ''passive'' or ''Subpart F'' income). Any foreign taxes paid by the subsidiary on such earnings is deemed to have been paid by any U.S. shareholders owning at least 10 % of the subsidiary, and can be claimed as FTCs against the U.S. tax on the foreign dividend income (the so-called ''indirect foreign tax credit'').
Thus, taxing the U.S. shareholder on all or part of the foreign corporation's earnings, before dividends are distributed, is the exception rather than the rule. In the corporate context, the norm is that although U.S. corporations are taxed on their worldwide income, there is no taxation before realization. Accordingly, the earnings of foreign subsidiaries are taxed only when they are received in the form of a dividend, or on disposal of the subsidiary's stock. This is symmetrical with individual shareholders being taxed on earnings from companies in which they own shares when dividends are declared and paid or the stock is sold.
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B. Basic Rules of the FTC
The FTC is intended to offset only U.S. tax on foreign source income. Thus, an overall limitation on currently usable FTCs is computed by taking the ratio of foreign source income to worldwide taxable income, and multiplying this by the tentative U.S. tax on worldwide income. The excess of FTCs can be carried back 2 years and carried forward 5 years, to be claimed as credits in those years within the same respective overall limitations.
The overall limitation is computed separately for various ''separate limitation categories.'' Under present law, foreign oil and gas income falls into the general limitation category, i.e., for purposes of computing the overall limitation, foreign oil and gas income is treated like any other foreign active business income. Separate special limitations still apply, however, for income: (1) whose foreign source can be easily changed; (2) which typically bears little or no foreign tax; or (3) which often bears a rate of foreign tax that is abnormally high or in excess of rates of other types of income. In these cases, a separate limitation is designed to prevent the use of foreign taxes imposed on one category to reduce U.S. tax on other categories of income.
C. FTC Limitations for Oil and Gas Income
As discussed in this section and D below, Congress and the Treasury have already imposed significant limitations on the use of foreign tax credits attributable to foreign oil and gas operations. In response to the development of high tax rate regimes by ''OPEC'' in the early 1970's, taxes on foreign oil and gas income became the subject of special limitations. These changes also addressed Congress's concern over the confusion between taxes and royalties paid to the host country government. For example, each year the amount of taxes on FOGEI may not exceed 35 % (i.e., the U.S. corporate tax rate) of such income. Any excess may be carried over like excess FTCs under the overall limitation. FOGEI is income derived from the extraction of oil and gas, or from the sale or exchange of assets used in extraction activities.
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In addition, the IRS has regulatory authority to determine that a foreign tax on FORI is not ''creditable'' to the extent that the foreign law imposing the tax is structured, or in fact operates, so that the tax that is generally imposed is materially greater than the amount of tax on income that is neither FORI or FOGEI. FORI is foreign source income from (1) processing oil and gas into primary products, (2) transporting oil and gas or their primary products, (3) distributing or selling such, or (4) disposing of assets used in the foregoing activities. Otherwise, the overall limitation (with its special categories discussed above) applies to FOGEI and FORI. Thus, as active business income, FOGEI and FORI would fall into the general limitation category.
D. The Dual Capacity Taxpayer Safe Harbor Rule
Similar to the treatment of minerals in the U.S. Outer Continental Shelf, mineral rights in other countries vest in the foreign sovereign, which then grants exploitation rights in various forms. This can be done either directly, or through a state owned enterprise (e.g., a license or a production sharing contract). Because the taxing sovereign is also the grantor of mineral rights, the high tax rates imposed on oil and gas profits have often been questioned as representing, in part, payment for the grant of ''a specific economic benefit'' from mineral exploitation rights. Thus, the dual nature of these payments to the sovereign have resulted in such taxpayers being referred to as ''dual capacity taxpayers.''
To help resolve controversies surrounding the nature of tax payments by dual capacity taxpayers, the Treasury Department in 1983 developed the ''dual capacity taxpayer rules'' of the FTC regulations. Under the facts and circumstances method of these regulations, the taxpayer must establish the amount of the intended tax payment that otherwise qualifies as an income tax payment but is not paid in return for a specific economic benefit. Any remainder is a deductible rather than creditable payment (and in the case of oil and gas producers, is considered a royalty). The regulations also include a safe harbor election (see Treas. Reg. § 1.901–2A(e)(1)), whereby a formula is used to determine the tax portion of the payment to the foreign sovereign, which is basically the amount that the dual capacity taxpayer would pay under the foreign country's general income tax. Where there is no generally applicable income tax, the safe harbor rule of the regulation allows the use of the U.S. tax rate in a ''splitting'' computation (i.e., the U.S. tax rate is considered the country's generally applicable income tax rate).
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IV. The Proposal
A. The Proposal Limits FTCs of Dual Capacity TAxpayers to the Host Country's Generally Applicable Income Tax
If a host country had an income tax on FOGI (i.e., FOGEI or FORI), but no generally applicable income tax, the Administration's proposal would result in disallowing any FTCs on FOGI. This would result in inequitable and destructive double taxation of dual capacity taxpayers, contrary to the global trade policy advocated by the U.S.
The additional U.S. tax on foreign investment in the petroleum industry would not only eliminate many new projects; but could also change the economics of past investments. In some cases, this could not only reduce the rate of return, but also preclude a return of the investment itself, leaving the U.S. business with an unexpected ''legislated'' loss. In addition, because of the uncertainties of the provision, it will also introduce more complexity and potential for litigation into the already muddled world of the FTC.
The unfairness of the provision becomes even more obvious if one considers the situation where a U.S. based oil company and a U.S. based company other than an oil company are subject to an income tax in a country without a generally applicable income tax. Under the proposal, only the U.S. oil company would receive no foreign tax credit, while the other taxpayer would be entitled to the full tax credit for the very same tax.
The proposal's concerns with the tax versus royalty distinction were resolved by Congress and the Treasury long ago with the special tax credit limitation on FOGEI enacted in 1975 and the Splitting Regulations of 1983. These were then later reinforced in the 1986 Act by the fragmentation of foreign source income into a host of categories or baskets. The earlier resolution of the tax versus royalty dilemma recognized that (1) if payments to a foreign sovereign meet the criteria of an income tax, they should not be denied complete creditability against U.S income tax on the underlying income; and (2) creditability of the perceived excessive tax payment is better controlled by reference to the U.S. tax burden, rather than being dependent on the foreign sovereign's fiscal choices.
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B. The Proposal Limits FTCs to the Amount Which Would Be Paid Under the Generally Applicable Income Tax
By elevating the regulatory safe harbor to the exclusive statutory rule, the proposal eliminates a dual capacity taxpayer's right to show, based on facts and circumstances, which portion of its payment to the foreign government was not made in exchange for the conferral of specific economic benefits and, therefore, qualifies as a creditable tax. Moreover, by eliminating the ''fall back'' to the U.S. tax rate in the safe harbor computation where the host country has no generally applicable income tax, the proposal denies the creditability of true income taxes paid by dual capacity taxpayers under a ''schedular'' type of business income tax regime (i.e., regimes which tax only certain categories of income, according to particular ''schedules''), merely because the foreign sovereign's fiscal policy does not include all types of business income.
For emerging economies of lesser developed countries, as for post-industrial nations, it is not realistic to always demand the existence of a generally applicable income tax. Even if the political willingness exists to have a generally applicable income tax, such may not be possible because the ability to design and administer a generally applicable income tax depends on the structure of the host country's economy. The most difficult problems arise in the field of business taxation. Oftentimes, the absence of reliable accounting books will only allow a primitive presumptive measure of profits. Under such circumstances the effective administration of a general income tax is impossible. All this is exacerbated by phenomena which are typical for less developed economies: a high degree of self-employment, the small size of establishments, and low taxpayer compliance and enforcement. In such situations, the income tax will have to be limited to mature businesses, along with the oil and gas extraction business.
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C. The Proposal Increases the Risk of Double Taxation
Adoption of the Administration's proposals would further tilt the playing field against overseas oil and gas operations by U.S. business, and increase the risk of double taxation of FOGI. This will severely hinder U.S. oil companies in their competition with foreign oil and gas concerns in the global oil and gas exploration, production, refining, and marketing arena, where the home countries of their foreign competition do not double tax FOGI. This occurs where these countries either exempt foreign source income or have a foreign tax credit regime which truly prevents double taxation.
To illustrate, assume foreign country X offers licenses for oil and gas exploitation and also has an 85 % tax on oil and gas extraction income. In competitive bidding, the license will be granted to the bidder which assumes exploration and development obligations most favorable to country X. Country X has no generally applicable income tax. Unless a U.S. company is assured that it will not be taxed again on its after-tax profit from country X, it very likely will not be able to compete with another foreign oil company for such a license because of the different after tax returns.
Because of the 35 % additional U.S. tax, the U.S. company's after tax return will be more than one-third less than its foreign competitor's. Stated differently, if the foreign competitor is able to match the U.S. company's proficiency and effectiveness, the foreigner's return will be more than 50 % greater then the U.S. company's return. This would surely harm the U.S. company in any competitive bidding.
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D. Separate Limitation Category for FOGI
To install a separate FTC limitation category for FOGI would single out the active business income of oil companies and separate it from the general business income ''basket.'' There is no legitimate reason to carve out FOGI from the general limitation category or basket. FOGEI is derived from the country where the natural resource is in the ground while FORI is derived from the country where the processing or marketing occurs. Moreover, any FORI that is earned in consuming countries and treated like other business income is very likely taxed currently, before distribution, under the anti-avoidance rules for undistributed earnings of foreign subsidiaries.
V. Repeal of So-Called Deferral
A. Background
As stated above, the U.S. exercises worldwide taxing jurisdiction over U.S. persons, including U.S. corporations. However, foreign corporations are not creatures of U.S. law and are thus not subject to US income tax. For various reasons, U.S. companies conduct foreign operations through foreign corporations. These corporations are called controlled foreign corporations (CFCs). The earnings of CFCs are taxed currently only by the host country. They are taxed to the U.S. shareholder only if and when distributed as a dividend.
However, if the US shareholder is suspected of using a foreign subsidiary to actively defer U.S. tax, the Code provides for current taxation of such earnings, imputing a constructive distribution. These rules are found in ''Subpart F'', and the income to the U.S. shareholder from these deemed distributions is conveniently referred to as ''Subpart F income.'' Subpart F income has been viewed by Congress only to exist with respect to passive income or income which can be easily moved to sources with no or low foreign taxes. These rules, referred to as ''anti-deferral'' rules, are portrayed as denying the ''privilege of deferral.'' However, they operate more in the nature of penalty provisions, rather than by conferring or denying a privilege.
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Foreign operations are not placed into foreign subsidiaries merely for tax reasons. Although current taxation of undistributed subsidiary earnings is oftentimes justified by the claim that the taxpayer's choice of operating in the host country through a U.S. company versus a foreign company should not affect the U.S. tax burden, such analysis is flawed. Choice of a foreign corporation as the vessel for doing business in the host country generally is for business reasons, e.g., the utilization of a host country company may be required for natural resources extraction.
B. The Proposal States no Reason for Singling Out FOGI for Subpart F Treatment
As stated above, Subpart F treatment is generally limited to passive income—the source of which can be easily changed, or that is earned in low or no income tax jurisdictions. The Administration's proposal does not indicate the perceived suspect nature of FOGI. It is clear that none of the typical rationales for Subpart F treatment applies to FOGI For example, FOGI is not passive income but, rather, very active income from the exploration, production, refining, and marketing of petroleum and its primary products.
Undistributed earnings of foreign subsidiaries should only be taxed to the U.S. shareholder where foreign earnings can be manipulated as to source or taxing jurisdiction, with a concomitant potential of U.S. tax avoidance. It is the potential for tax avoidance that calls for an exception from the fundamental principle. As active business income, FOGI is derived where and when the natural resource is extracted, refined and marketed.
Moreover, current taxation of foreign subsidiaries' FOGI will exacerbate the differences between the host country and U.S. tax laws. This may result in double taxation, curtailing or crippling the competitiveness of U.S. oil companies. As a general rule, the host country tax burden on a project is greater than the U.S. tax burden. Thus, in an ideal world, even current taxation of a CFC's earnings would not result in an additional U.S. tax burden. However, differences in the host country and U.S. tax laws, such as the timing of cost recovery, and the many restrictions in the U.S. tax credit mechanism, will frequently result in additional U.S. tax even though the cash flow is reinvested in the host country or region.
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VI. Other Revenue Proposals
A. Modification of the Foreign Tax Credit Carryover Rules
For FTCs in excess of the overall limitation, the proposal would reduce carryback periods from two to one year and extend the carryforward from five to seven years. This is based on the perception that carrybacks were associated with increased complexity and administrative burdens, as compared to carryforwards.
The proposal increases the risk of losing utilization of excess credits effectively due to the reduction of the carryback period; this disadvantage is not offset by the extension of the carryforward period. As a substitute for the proposal, the FTC carryover rules should be aligned with the rules applicable to other tax attributes like Net Operating Losses (NOL) and Business Tax Credits (i.e., 3 years carryback and 15 years carryforward, in total 18 years carryover). Liberal carryover periods are of even greater importance for FTCs because of variances in foreign and domestic tax rules which result in timing differences of the foreign and domestic tax incidence, with a mismatch of foreign and U.S. tax under the FTC rules. Finally the fragmentation of the foreign income streams in the 1986 Act into nine or more baskets makes a liberalization in an alignment with the carryover rules for other tax attributes even more imperative.
VII. The Proposals Are Bad Tax Policy
Reduction of U.S. participation in foreign oil and gas development because of misguided tax provisions punitively applied to a single U.S. industry will adversely affect the United States. Additional tax burdens will hinder U.S. companies in competition with foreign concerns. Although the host country resource will be developed, it will be done by foreign competition, with the adverse ripple effect of U.S. jobs losses and the loss of continuing evolution of U.S. technology. By contrast, foreign oil and gas development by U.S. companies increases utilization of U.S. supplies of hardware and technology. The loss of any major foreign project by a U.S. company will mean less employment in the U.S. by suppliers, and by the U.S. parent, in addition to fewer U.S. expatriates at foreign locations.
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Thus, the questions to be answered are: Does the United States (for energy security and international trade reasons, among others) want a U.S. based petroleum industry to be competitive in the global quest for oil and gas reserves? If the answer is ''yes'', then why would the U.S. government adopt a tax policy that is punitive in nature and lessens the competitiveness of the U.S. petroleum industry? The U.S. tax system already makes it extremely difficult for U.S. multinationals to compete against foreign-based entities. This is in direct contrast to the tax systems of our foreign-based competitors, which actually encourage those companies to be more competitive in winning foreign projects. What we need from Congress are improvements in our system that allow U.S. companies to compete more effectively, not further impediments that make it even more difficult and in some cases impossible to succeed in today's global oil and gas business environment. These improvements should include, among others, the repeal of the plethora of separate FTC baskets, the extension of the FTC carryover period for foreign tax credits, and the repeal of section 907.
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Chairman ARCHER. Thank you, Mr. Sullivan.
Ms. MacNeil.
STATEMENT OF C. ELLEN MACNEIL, PARTNER, ARTHUR ANDERSEN LLP; ON BEHALF OF AMERICAN AUTOMOBILE MANUFACTURERS ASSOCIATION
Ms. MACNEIL. Mr. Chairman, thank you for the opportunity to testify on these important issues. My name is Ellen MacNeil, and I am a partner in Arthur Andersen. I am pleased today to represent AAMA, the American Automobile Manufacturers Association and its members—Chrysler Corp., Ford Motor Co., and General Motors Corp. Collectively, these corporations employ more than 700,000 workers throughout the United States, and we believe these businesses will suffer great harm if proposals of the administration's tax package are adopted.
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The American Automobile Manufacturers Association strongly opposes the administration's proposal to repeal components of cost, to modify the net operating loss carryback rules, and to modify the export source rules. I will not address the export source rules because that is the subject of a separate panel.
First, I would like to address the proposed repeal of components of cost. Manufacturers that use components of cost account for the inventories in units of materials, labor, and overhead. The administration's proposal would require inventory to be accounted for in units of finished goods. The administration contends that COC, components of cost, produces flawed information or systematically lowers earnings, and its proposal is predicated on this assumption. However, COC is effectively required by generally accepted accounting principles for many manufacturers, including the American car companies because, for these businesses, it is considered to produce a more accurate measure of income than alternative methods.
Chrysler, Ford, and General Motors have used components of cost for over 50 years to report financial results to their shareholders and to the SEC, as well as to manage their businesses, and this longstanding practice will not be changed. Any accounting change required by this proposal would be made for tax purposes only.
The explanation and analysis of this proposal prepared by the staff of the Joint Committee acknowledges that it is unclear whether it is possible or practical for some taxpayers to change to the method favored by the administration. We emphatically concur. To the extent it is even possible to change from components of cost, the expense and administrative complexity will be staggering in that the affected manufacturers would be required to develop and maintain a separate tax-only cost accounting system for inventories.
The establishment and maintenance of such a dual-inventory system would be enormously expensive and would take years to develop and implement. These are redundant costs that would put American automobile manufacturers and many other affected U.S. manufacturers at a competitive disadvantage in the world market. For these reasons, the American automobile manufacturers urge you not to support the repeal of components of cost.
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In summary, components of cost is the most accurate method for recording inventories for Chrysler, Ford, and General Motors and is effectively required by generally accepted accounting principles. It is unclear whether it is even possible to change to the method favored by the administration. At a minimum, it will result in enormous administrative cost. These nonproductive costs impair U.S. competitiveness in a global market.
Our tax system needs more simplicity, not the increased complexity and unnecessary compliance costs the repeal of cost components would impose.
The administration's proposal to shorten the net operating loss carryback period from 3 years to 1 year would distort the reported income of American car companies and all taxpayers in cyclical businesses. There are sound policy reasons for the 3-year carryback period. This was addressed in the Blue Book to the 1986 Reform Act, ''The rationale for allowing the deduction of NOL carryforward and carrybacks was that a taxpayer should be able to average income and losses over a period of years to reduce the disparity between the taxation of businesses that have stable income and businesses that experience fluctuations in income.''
That rationale continues to be valid. There is no compelling policy reason for the proposal to shorten the carryback period; rather, it is nothing more than a revenue raiser that is unfortunately aimed at businesses that experience economic downturns, and the American automobile manufacturers therefore urge you not to support it.
Thank you.
[The prepared statement follows:]
Statement of C. Ellen MacNeil, Partner, Arthur Andersen LLP; on Behalf of American Automobile Manufacturers Association
The American Automobile Manufacturers Association (AAMA) and its members—Chrysler Corporation, Ford Motor Company, and General Motors Corporation—strongly oppose the Administration's proposals to:
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• repeal the components of cost (COC) inventory accounting method;
• modify the net operating loss (NOL) carryback and carryforward rules; and
• replace the sales source rule (Export Source Rule) with an activity-based rule.
AAMA believes that these three revenue raising proposals would adversely affect U.S. corporations' ability to compete in the world market.
Repealing COC would require many manufacturing corporations to maintain two separate inventory cost accounting systems, one for financial reporting purposes and another for tax purposes. This would create enormous complexities and could greatly increase accounting costs for U.S. corporations. These are costs that overseas manufacturers will not have to incur. Moreover, it is possible that the Administration's proposal would result in a loss of revenue to the Federal government.
Reducing the carryback period for NOLs would reverse a long established Congressional policy of easing the harshness of annual tax accounting on businesses that, because of their riskiness or cyclical nature, experience sharp fluctuations in income.
Finally, replacing the Export Source Rule with an activity-based rule would raise the cost of manufacturing U.S. goods for export thereby adversely affecting both domestic jobs and the U.S. balance of trade. At a time when everyone acknowledges the importance of exports in sustaining growth in the U.S. economy, elimination of the Export Source Rule runs counter to U.S. trade policy and would be unwise.
The growth markets of the future for manufactured products are overseas. It is imperative that U.S. firms are able to compete with overseas manufacturers for positions in these growth markets. The Administration has stated that it supports the export of U.S. manufactured goods. However, the Administration's proposals to repeal COC inventory accounting, to modify the NOL rules, and to replace the Export Source Rule with an activity-based rule would all add unnecessarily to the cost of U.S manufacturers thereby hindering their ability to compete in the world market, and threatening the loss of U.S. jobs and an increase in our trade deficit.
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For these reasons and those listed in the more detailed written material below, AAMA urges rejection of these Administration revenue raisers.
Repeal Components of Cost (COC) Inventory Accounting Method
Background
Manufacturers account for their inventories generally in two different ways. One is the COC method and the other is the Total Product Cost (TPC) method. Under COC, the manufacturer accounts for inventory in terms of units of materials, labor and overhead. Under TPC, the manufacturer accounts for inventory in units of finished goods. Manufacturers can use either method for both last-in-first-out (LIFO) or first-in-first-out (FIFO) inventory cost accounting purposes.
Each of AAMA's member companies has used COC for over fifty years to determine inventories for both internal management and financial statement reporting purposes. The use of COC precedes their adoption of LIFO, and is the underlying method on which our members maintain their cost accounting records. It is not a method that was adopted or changed in conjunction with the adoption of LIFO, nor is it a method that is used only for tax purposes. (For each of our members, the differences between financial statement inventories and tax inventories are differences required by various tax rules. The primary difference is UNICAP. Other minor differences include economic performance and the inability to record reserves for tax purposes. None of the differences between book and tax accounting are specific to or caused by the use of COC.)
It must be emphasized that COC is the fundamental method used by our members to maintain cost accounting records for their manufacturing operations. It is the way that cost information is gathered, recorded and maintained for management purposes, financial accounting, and tax reporting. It is not limited to LIFO computations, and it is not a function of tax reporting. Quite simply, it is the way in which many manufacturers record their costs to manage their businesses.
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Administration Proposal
The Administration would repeal the COC method for LIFO inventory accounting. For taxpayers continuing to use a LIFO method of valuing inventory, the proposal would be applied on a cut-off basis. For a taxpayer switching to FIFO or other method of valuing inventory, the proposal would be applied pursuant to the present-law rules governing such changes in methods of accounting.
Discussion
In 1984, the American Institute for Certified Public Accounting (AICPA) issued a LIFO Issues Paper stating that COC is the preferable method for manufacturers in certain circumstances, including situations where:
1. There is very little finished goods inventory;
2. There are substantial work-in-process inventories;
3. Product lines continually evolve;
4. There is a significant shift between purchased and produced materials;
5. There are changes in manufacturing capacity; and
6. Products are not comparable year to year.
All of the factors outlined in the AICPA position paper are applicable to our members' manufacturing operations. In our industry, the COC method is thus considered ''preferable'' for generally accepted accounting principles (GAAP). Accordingly, regardless of the outcome of the Administration's proposal, our members will be obliged to continue to use COC for financial reporting purposes.
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Analyzing just the first two factors demonstrates why COC is generally considered to be more accurate than TPC in our industry, when inventory is composed mainly of work-in-process. This is so because TPC can only be applied to work-in-process amounts by rough estimates (that is, work-in-process will be deemed to equal 50%, or some other specified percentage, of the cost of finished products). Since COC allows for a far more accurate valuation of work-in-process, it is therefore considered preferable under GAAP.
Our members also use COC for internal management reporting purposes. This is their long-standing business practice and will not be changed. For example, it is common for a plant manager to be responsible for labor and overhead, but not for purchasing because purchasing is usually done centrally. Thus, management uses COC for inventory reporting since different individuals and groups have responsibility for different cost elements within the total inventory cost. TPC is essentially meaningless in this context.
It is axiomatic that businesses would strive to use the most accurate and valid information for management purposes; if COC produced flawed information, or systematically lowered earnings, businesses would not use it to report to their shareholders or for management purposes. COC is not used by businesses because it produces lower earnings; it is used because it produces a more accurate measure of earnings.
The Administration's proposal suggests that COC is flawed in that it does not appropriately account for labor efficiencies and, therefore, should be repealed. In particular, the Administration has stated the following:
The components of cost method, in many cases, does not adequately account for technological efficiencies in which skilled labor is substituted for less-skilled labor or where overhead costs (such as factory automation) replace direct labor costs. The costs of inventories determined by using the total product cost method generally are not affected by such factors.
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Although the labor efficiency, or inefficiency, and the possible effect on overhead is only one of hundreds of subcomputations within the COC method, the Administration's proposal focuses only on this narrow aspect. The Administration's position in this regard misses the point to the extent it expresses a concern that a decrease in labor hours could be replaced by an increase in overhead costs. First, labor decreases may occur for a number of reasons, including buying rather than making certain parts or components in-house. Second, labor hours do not consistently decrease. Labor hours may increase, and therefore, have the opposite effect. In any case, not all users of COC will have labor efficiencies and not all such users base their overhead computation on labor. Therefore, the perceived computational problem does not occur with all users of COC, and does not always produce a benefit. Lastly, COC produces a clear reflection of income and the problems discussed in the Administration proposal are not significant.
The Administration has stated that TPC is not prone to the same problems it perceives exist with COC—that is, that COC artificially understates taxable income. However, TPC has its own anomalies. For example, content changes such as the addition of catalytic converters or safety devices would typically be treated as inflation under TPC and, thus would reduce taxable income. Under COC, content changes are not treated as inflation, and therefore, would not artificially lower taxable income. Forcing taxpayers off COC may well result in less tax revenue for the Federal government.
We do not know how Treasury's revenue estimate for the repeal of COC was developed, but it would be erroneous merely to adjust labor and overhead assumptions. The correct approach would be to recompute the LIFO index for COC taxpayers based on TPC. Several other indicators suggest that the LIFO index would, in fact, be higher rather than lower under TPC. For example, wholesale delivered prices for product groups have shown a greater increase than the COC indexes. In summary, there is a strong likelihood that forcing manufacturers to use TPC could result in a higher inflation index, and thus, a revenue loss.
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As previously discussed, repealing COC would require affected taxpayers to maintain two separate cost accounting systems for inventories. The establishment and maintenance of dual sets of inventory records would be enormously expensive and would add no additional value. Due to the size and complexity of our members' business operations, costs related to additional inventory systems could run into hundreds of millions of dollars and take years to design and implement. Indeed, it would place our members and many other U.S. manufacturers at a competitive disadvantage because of such redundant costs and immense recordkeeping burdens.
When President Clinton first proposed to repeal COC in 1994 to fund GATT, at least a new simplified alternative inventory price index computation (IPIC) was offered in connection with its elimination. Although current law contains an alternative IPIC, it is generally unworkable and biased against large businesses in its current form. The simplified IPIC offered by the President in 1994 could provide a reasonable alternative if COC must be eliminated. However, no such alternative is offered by the Administration in the fiscal 1998 budget proposal.
Conclusion
For all these reasons, we urge you to oppose repeal of COC. It is the most accurate method for computing LIFO inventories for our members, and it is effectively required under GAAP. It is also the standard industry practice for a substantial number of manufacturers. Moreover, the same COC methodology that is used for financial accounting and internal management is also used for tax purposes. The costs to create a second LIFO cost accounting system solely for tax purposes would be staggering. Finally, we suspect that the end result of such a repeal would be an enormous expense to our member companies in producing less accurate and less meaningful results, all with the likely effect of producing less revenue to the government.
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Modify Net Operating Loss (NOL) Carryback and Carryforward Rules
Background
The current three-year carryback period for NOLs has been in place for nearly 40 years, and has served to ease the harshness of annual tax accounting on businesses that, because of their riskiness or cyclical nature, experience sharp fluctuations in income. See e.g., Report of the Committee on Ways and Means, H.R. 8300, 83d. Cong., 2d Sess., at 27 (1954). Moreover, as Congress has emphasized when previously extending the carryback period, the ability to carry losses back rather than forward enables businesses experiencing economic reverses to recover previously paid taxes at the time when losses are incurred, and thus to increase liquid funds at the time they are most needed. See Report of the Committee on Ways and Means, H.R. 13382, 85th Cong., 2d Sess., (1958).
Administration Proposal
The Administration has proposed limiting the carryback period for NOLs from three years to one year, and extending the carryforward period from fifteen to twenty years.
Discussion
The Administration's proposal assertedly would reduce administrative complexity, a rationale that is gossamer thin given the absence of any evidence or testimony of administrative difficulty in connection with NOL carrybacks. Instead, the proposal simply operates as a tax increase on business activity, an increase that is all the more inappropriate because it effectively targets businesses that are engaged in risk-intensive or cyclical activities such as the automotive industry.
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Superficially, the Administration's proposal would extend the total period in which NOLs could be used because of the extended carryforward period. The extension is of virtually no practical significance, however, since a business insufficiently profitable to use a NOL over the present fifteen year carryforward period is unlikely to turn around in an additional five years. In contrast, the reduction in the carryback period has a real and substantial effect. Business cycles often extend for three years or more, leaving cyclical businesses in loss positions for a number of years in succession. Under the Administration's proposal, such businesses will be left having paid tax on income that would have otherwise been offset by losses, at a time when their financial resources are least able to handle an incremental tax burden. The three-year carryback can be crucial to keeping workers employed through a downturn and to funding the eventual recovery.
The rationale for the NOL carryback and carryforward period was recently addressed in 1986 in conjunction with legislation regarding the treatment of NOLs following an ownership change. The General Explanation of the Tax Reform Act of 1986 states:
Although the Federal income tax system generally requires an annual accounting, a corporate taxpayer was allowed to carry NOLs back to the three taxable years preceding the loss and then forward to each of the 15 taxable years following the loss year (sec 172). The rationale for allowing the deduction of NOL carryforwards (and carrybacks) was that a taxpayer should be able to average income and losses over a period of years to reduce the disparity between the taxation of businesses that have stable income and businesses that experience fluctuations in income.
That rationale continues to be sound today.
Conclusion
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There is, in sum, no credible policy justification for shortening the NOL carryback period. To the contrary, the considerable revenue generated by this proposal would, by definition, be a tax on non-existent profits. The practical effect is to force businesses to surrender revenue to the government without regard either to their income or ability to pay. The NOL proposal is simply designed as a revenue raiser without any policy justification.
We strongly urge retention of the three-year NOL carryback period—a rule that has served its original goals well for nearly 40 years.
Replace Export Source Rule With an Activity-Based Rule
Background
Since 1922, regulations under IRC section 863(b) and its predecessors have included a provision that allows the income from goods that are manufactured in the U.S. and sold abroad (with title passing outside the U.S.) to be sourced as 50% U.S. income and 50% foreign income. This Export Source Rule has been beneficial to U.S. manufacturers that export because it increases their foreign source income and thereby increases their ability to utilize foreign tax credits effectively. Because the U.S. tax law limits the ability of companies to get credit for the foreign taxes which they pay, many U.S. multinational companies face double taxation on their overseas operations—that is, they are taxed by both the U.S. and the foreign jurisdiction. The Export Source Rule helps reduce this double taxation and thereby encourages U.S. companies to manufacture in the U.S. for export.
Administration Proposal
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Under the proposal, income from the sale or exchange of inventory property that is produced in the United States and sold or exchanged abroad would be apportioned between production activities and sales activities on actual economic activity.
Discussion
The Administration contends that its proposal would eliminate an advantage that U.S. multinational exporters that also operate in high tax foreign countries have over U.S. exporters that conduct all their business activities in the U.S. However, the Export Source Rule does not provide a competitive advantage to multinational exporters vis-à-vis exporters with ''domestic-only'' operations. Exporters with only domestic operations never incur foreign taxes and thus, are not even subject to the onerous penalty of double taxation.
The Export Source Rule, by alleviating double taxation, encourages companies to produce goods in the U.S. and then to export them. A 1993 Treasury Department study found that if the rule had been replaced by an activity-based rule in 1992, goods manufactured in the U.S. for export would have declined by a substantial amount. A recent study of the rule by Gary Hurfbauer of the Institute for International Economics and Dean DeRosa of ADR International, Ldt. estimates that for the year 1999 alone, the Export Source Rule will account for an additional $30.8 billion in exports, support 360,000 jobs, and add $2.3 billion to worker payrolls. According to the Department of Commerce, export related jobs generally provide a wage premium of 13–15%. Exports are fundamental to our economic growth and our future standard of living. The U.S. is a mature market. As such, U.S. employers must export to markets overseas in order to expand the U.S. economy.
Contrary to Administration assertions, the U.S. tax treaty network is not a substitute for the Export Source Rule. Moreover, the network is far from complete since it is limited to 56 countries. With or without a tax treaty, the real reason most multinational companies face double taxation is that U.S. tax provisions unfairly restrict corporate ability to credit foreign taxes paid against their U.S. taxes. The Export Source Rule helps to alleviate this problem.
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Conclusion
The Export Source Rule is one of the few WTO-consistent export incentives remaining in our tax code. It is also justified on the basis of administrative convenience. In view of the role of exports in sustaining growth in the U.S. economy, supporting higher paying U.S. jobs, and encouraging exports, any attempt to reduce or eliminate the rule is unwarranted. The Administration's proposed effective repeal of the Export Source Rule is inconsistent with its own trade policy as well as the welfare of the U.S. economy, and should be opposed.
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Chairman ARCHER. Thank you, Ms. MacNeil.
Our last witness is Ms. Parks. You may proceed.
STATEMENT OF LINDA PARKS, SHAREHOLDER, JAMES, PARKS, TSCHOPP & WHITCOMB, P.A., MAITLAND, FLORIDA
Ms. PARKS. My name is Linda Parks. I am a CPA and shareholder in the local firm of James, Parks, Tschopp & Whitcomb in Maitland, Florida, and that is just outside of Orlando, Florida.
First of all, I would like to thank the Chairman and the Committee for giving me this opportunity and privilege to come here and comment on the repeal of section 1374 and the proposed liquidation tax on certain C corporations converting to S corporations. I also feel a very strong obligation to be here to represent my colleagues, concerned clients, as well as C corporations at which this proposed legislation is aimed.
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This proposal is part of the 1998 budget which is aimed at doing away with unwarranted tax benefits. Subchapter S is a longstanding, recognizable tax entity through which to conduct business, and what this repeal does is basically it imposes a gain not only to the corporation but to the shareholders when a C corporation converts to S.
I can tell you it will not be a revenue enhancer. If anything, it will immediately do away with, if not significantly deter, conversion to subchapter S.
Let me start by giving a background. In 1958, subchapter S was enacted for the main reason of giving businessowners that desired to conduct their business through corporations, either for tax purposes, business purposes, or otherwise, similar treatment to that of partnerships. In 1982 there was significant reform to subchapter S, not only enabling more corporations to convert to S corporations, but, in fact, to take away a lot of the traps to the unwary.
In 1986 we had the enactment of section 1374. Let me explain what this was all about. It had to do with the repeal of the general utilities doctrine. There was some concern that as a result of this repeal there would be certain corporations that would immediately elect S, sell its assets, and thus do away with the tax. Section 1374 was enacted, and it basically gave a taint to those assets so that if those assets were sold during a 10-year period, there would be a gain recognized.
I need to emphasize that even under section 1374, the tax applies when the assets are sold, thus enabling the wherewithal to pay.
In 1996 there was an incredible change for subchapter S. There were actually 17 amendments to subchapter S fostering a greater neutrality between S corporations and passthrough entities.
I would like to comment that imposing this liquidation tax on C corporations would give these corporations a permanent disadvantage with S corporations and other passthrough entities.
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We have always had the concept of the wherewithal to pay. I want to emphasize once again what this does is it creates a taxable gain, not only at the corporate level but the individual level, before the recognition of any income to pay this tax.
One of the major changes last year had to do with enabling an S corporation to become a member of an affiliated group. What does that mean? Not only can S corporations now own 80 percent or more of C corporations, they can also own 100 percent of S corporations. What this does is it creates a stimulus for mergers and acquisitions by S corporations. Well, what is being proposed now is a deterrent from that activity.
The Treasury has historically supported tax integration. I would like to comment on some of that. In 1977 there was a paper put out that actually came up with several methods to integrate the individual tax system with the corporate tax system. In a report to President Reagan in 1984, there was a comment that double taxation of dividends increases the cost of capital to corporations and reduces the return to individual investors. In a report as recent as 1992, the comment was that the potential for economic gains from integration is substantial. A tax on the appreciation of assets at the time of conversion is counterproductive to the integration of the tax system.
Now, before I comment on this definition of large corporation, I want to make it perfectly clear that I think this proposal should be thrown out in its entirety. But since someone has put a definition on what constitutes large corporation—and I am talking about the $5 million threshold—I feel the need to comment. I am probably an excellent candidate to be arguing this issue. I work out of a small business environment; I would say most of our clients are closely held, family-owned operations. But I want to tell you that there is a misperception that closely held, family-owned equates to small in value.
We do a lot of business valuations, and I can tell you some of our closely held clients have values in excess of $100 million. Five million dollars does not equate to a large corporation.
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In conclusion, I cannot express the importance, once again, in relation to what happened last year not to mention what you did with check the box—it is somewhat indirectly related to this issue—I cannot urge you enough to reject this liquidation tax.
It not only contradicts what we have been trying to do with corporate integration but I think it is detrimental to growth in business and certainly would significantly deter, if not eliminate, conversion by C corporations to S corporation status.
Thank you very much.
[The prepared statement follows:]
Statement of Linda Parks, Shareholder, James, Parks, Tschopp & Whitcomb, P.A., Maitland, Florida
Mr. Chairman and Members of the Committee, I am pleased to have the opportunity to comment on the Administration's proposal to impose a liquidation tax on C Corporations converting to S Corporation status. The proposal is included in President Clinton's Fiscal Year 1998 budget proposals. I commend Chairman Archer and the Committee for its leadership in examining this issue, and appreciate the opportunity to comment on behalf of my fellow practitioners and certain clients.
The proposal from the President's Fiscal Year 1998 Budget would repeal IRC Section 1374, thus imposing a liquidation tax on C Corporations with a value of $5 million or more that convert to S Corporation status. Currently, Section 1374 imposes a tax on built-in gains in assets held by the C Corporation at the time of conversion if and when built-in gain property is disposed of during the ten-year period following the conversion. Under the proposal, a C-to-S corporation conversion would be treated as a liquidation of the C corporation followed by a contribution of the assets to an S corporation by the recipient shareholders, thus triggering an immediate recognition of gain by both the corporation and its shareholders.(see footnote 39)
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We strongly oppose this proposal. It is our belief that the proposed liquidation tax would constitute a significant change in corporate tax law, would contradict sound tax policy and would inappropriately deter, if not eliminate, future C corporation conversions to S corporation status.
We applaud your reforms to Subchapter S enacted as part of the Small Business Job Protection Act of 1996 (1996 SBA). We now, however, find this proposed liquidation tax on C corporations converting to S corporation status contradictory to the cause.
Background
S corporations have been a long-standing, recognized tax entity. In 1958, Congress enacted Subchapter S of the Internal Revenue Code to permit owners of closely-held businesses which had incorporated an entity for business and legal purposes to elect to be treated for tax purposes in a manner similar to a partnership. Although Congress has revised Subchapter S regulation, at no time has it sought to impose a limitation on the economic size of S corporations.
Congress' efforts to modify the S corporation rules in 1982 focused on simplification and removing traps for the unwary. This tax act reaffirmed S corporations as an acceptable form of tax entity and recognized a long-accepted policy to integrate the corporate and individual tax systems for closely-held businesses. Congress implemented a tax on excess passive income for S corporations that were previously C corporations, allaying concerns that personal holding companies could avoid their penalty tax by electing S status. A liquidation tax was not perceived necessary to curtail C-to-S conversions. In fact, a significant purpose of the 1982 act was to encourage more conversions.
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In 1986, as part of the Tax Reform Act, Section 1374 was adopted primarily to prevent a C corporation from avoiding the repeal of the General Utilities doctrine by converting to S corporation status prior to a sale of its business. Hence, Section 1374 provides for a corporate-level tax on any built-in gain when assets owned as a C corporation are sold by an S corporation at anytime during the 10 years after conversion. Prior to 1986 there was a 3-year capital gains tax. In 1986, a determination was made that a 10-year period provided an adequate period for collection of any tax on C corporation gains. Since enactment, it is our understanding that Section 1374 has been effective in achieving its purpose and should not be replaced with a burdensome and ultimately unfair liquidation tax.
The new Subchapter S legislation enacted as part of the 1996 SBA contains 17 separate amendments to Subchapter S, which are designed to foster a greater tax and transaction neutrality between S corporations and other pass-through entities. By nature, S corporations are hybrid entities that include some features similar to flow-through entities while other features follow the corporate model.
Adversely Affects C Corporations and Existing S Corporations
C Corporations Will Be at a Permanent Competitive Disadvantage: The Administration's liquidation tax will leave many small businesses at a competitive disadvantage with partnerships and those that have already converted to Subchapter S status. Under a liquidation tax, C corporations will be allowed to convert to S status only by draining their cash resources to pay the liquidation tax even though they have not disposed of assets. The other alternative is to continue their C status and pay the double layer of federal income tax which is what, invariably, all will do.
Future Subchapter S Elections Will Effectively Be Repealed: Subchapter S is a long-standing filling status permitted by current federal tax law. The tax proposed by the Administration will make almost all future elections prohibitively expensive. This is totally counter-productive in comparison to the new provisions passed in the 1996 SBA. The professional community has long recognized the many eligibility restrictions of Subchapter S. The new legislation attempts to remove some of the impediments, thus paving the way for an increase in Subchapter S elections. The President's proposal would basically create a deterrent to electing such status.
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Imposes Tax Before Assets Are Disposed: At the heart of our tax system is an established concept fundamental to assessing tax. This ''wherewithal-to-pay'' concept holds that income taxes should not be imposed until a transaction occurs in which the taxpayer recognizes income and has the ability to pay. Income from services or from the sale of an asset results in the taxpayer holding monetary value and having the wherewithal to pay a tax on the income recognized. It is not in the best interest of U.S. commerce to impose a huge tax on the liquidation proposed by the Administration on a C-to-S conversion before any assets have been disposed.
A built-in gains tax on appreciation in business assets is already imposed under current law, but only when assets are sold. The Administration's proposal would tax gains on a company's assets while it is still using them in an active trade or business. To pay this tax would greatly diminish business resources at a time when companies may not have the ability to pay. Thus, the proposal penalizes C corporations electing S status by requiring the recognition of gain which has not yet been realized.
Limits Ability of Current S Corporation Growth Through Acquisition: Prior to the 1996 SBA an S corporation had never been permitted to own stock in another S corporation. A second limitation barred an S corporation from owning 80% or more of the stock of a C corporation. The new law now permits such ownership thereby providing a stimulus for mergers and acquisitions by S corporations.
The proposed liquidation tax would impact all current S corporations. An S corporation that desired to grow through a corporate merger transaction with a C corporation would be subject to tax as if the acquired C corporation were liquidated. Such transactions would have prohibitive results, and current S corporations would not have the flexibility that they are now afforded. Additionally, they would be on unequal footing with C corporation counterparts in restructuring and reorganizing transactions. This effect runs counter to the many provisions in the Code that encourage growth and provide tax deferred methods to achieve it.
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Undermines Integration of Federal Income Tax System: The proposal greatly diminishes the ability to mitigate the double tax burden on C corporations' cost of capital. C corporations are burdened with two levels of federal income taxes (once at the corporate level and then again at the shareholder level). S corporations, like partnerships, pay a single level of tax at the ownership level.
Corporate integration is a goal that has historically been supported by the Treasury Department. A comprehensive study released by Treasury at the conclusion of President's Ford's Administration in 1977 outlined several methods to achieve corporate integration. In the Treasury report to President Reagan in 1984, Treasury asserted that ''the double taxation of dividends increases the cost of capital to corporations and reduces the return to individual investors. In 1992, the Treasury Department released the report Integration of the Individual and Corporate Tax Systems, which noted that ''the current two-tier system of corporate taxation discourages the use of a corporate form even when incorporation would provide non-tax benefits such as limited liability for the owners.'' The report further stated that ''the potential economic gains from integration are substantial.''
A tax on the appreciation in business assets at the time of the company's conversion to S corporation status would run directly counter to the effort to integrate the corporate and individual tax systems. Since taxpayers currently doing business as C corporations will effectively be denied the ability to operate under the simplicity of Subchapter S, the proposal only perpetuates the existing two-tier corporate tax system. Thus, it has the perverse effect of locking closely-held C corporations into the double-tax regime.
$5 Million Threshold: The $5 million fair market value threshold for determining the applicability of the tax is far too low a threshold to distinguish between large S corporations and small ones. I practice in Central Florida, a predominately ''small business'' environment. Many of these businesses are prosperous family businesses. The real and personal property in these entities alone are valued at more than $5 million without consideration given to the value of the business operations.
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There already is unrealistic pressure on the task of valuing closely held stock. Do you value the company in a manner used for estate tax purposes or in a manner used for valuing transfers to minority owners, thereby adjusting the value for certain key men, for the lack of marketability and for minority discounts? This proposal would needlessly increase controversies between taxpayers and the IRS over the value of small closely-held businesses.
Under the proposal, a C corporation that is highly leveraged would fare better than one which has substantial equity and very little debt. An S corporation with $10 million in assets and $6 million in debt will be able to make an S election. However, an S corporation with $10 million in assets and no debt will not be able to make an election without incurring liquidation tax. Do we play the game of leveraging the company's assets in order to make an S election? Overall the proposal is arbitrary and designed to put successful C corporations at a disadvantage.
New corporations would have a permanent advantage over existing C corporations in that they could initially make an S election without any restrictions.
Conclusion
On behalf of my fellow practitioners and concerned clients, I urge the committee to reject this proposal. Imposing a liquidation tax on C corporations converting to S corporation status is not only counter-productive and burdensome, but will effectively eliminate future Subchapter S elections. This whole process totally contradicts the emphasis made in the 1996 SBA, i.e., laying the groundwork for more S elections with relaxed compliance.
We find this proposal to be shortsighted in that it will not serve to be a revenue enhancer but rather a deterrent to electing S status. It would be detrimental to business activities and would serve to perpetuate a two-tier tax system that distorts the cost of capital. Rather than advance our tax policy towards an integrated tax system, it moves in the opposite direction. Finally, it represents a drastic change to current law especially when compared to the law as amended by the 1996 SBA.
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Chairman ARCHER. Thank you, Ms. Parks.
I would like to ask each of you the same question I asked the original panel: If you have had an opportunity to look at the 42 tax increases that raise revenue in the President's proposals, are there any of them that you believe are supportable within the framework of good tax policy that make sense for this country?
Mr. Zahren.
Mr. ZAHREN. Well, Mr. Chairman, I am not a securities expert and I do not propose to be one, but I am an entrepreneur and a small investor and several years ago you did change the rules on taxation of commodity trading by the so-called mark-to-the-market at year end. Your suggestion about the selling short against the box provision might similarly be structured so that you recognize the gain or loss when you have an offsetting transaction on a mark-to-the-market type situation at year end.
I could support things like that. I would consider those more closing loopholes or adjustments rather than tax increases.
You also have—and I do not know that it is on the President's list—but you have proposed the elimination of certain benefits to certain types of fuel tax, and so forth. Some of those may be appropriate revenue raisers. I believe we need to make it clear to the American people that our fuel is in short supply and, as we know, many parts of the world have much higher fuel taxes. I come from a State that has 60-cents per gallon fuel tax on our gasoline, and we are very aware of the fact that we are paying a heavy tax to have the privilege of driving our car. But I will willingly pay that as the cost of energy sufficiency in this country.
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Chairman ARCHER. Are you suggesting we raise the gasoline tax, is that what you are saying?
Mr. ZAHREN. No, Mr. Chairman.
I am saying that you suggested limiting the exemption of certain fuels from these taxes.
Chairman ARCHER. Yes. Thank you.
Ms. Parks.
Ms. PARKS. Well, when you first raised this question before I was just about to get ready to raise my hand and talk about a few things and then I thought, Well, maybe I am a neutral person, because I am only arguing this one area. Then I thought to myself, Well, wait 1 minute, before I start voicing an opinion, I do practice in a wide variety of areas and I might be hurting one client versus the other.
So, at this point in time, I would like to defer and give it more thought, and maybe put it on paper at a later time.
Chairman ARCHER. Fine.
I would issue an invitation to all of you that if you think of anything you believe is appropriate in the way of changing tax policy that will raise revenue, please submit that to the Committee in writing. We would be appreciative.
Mr. Sullivan, do you see anything in these 42 topics?
Mr. SULLIVAN. Speaking of the gasoline tax——
Chairman ARCHER. No. That is not in the 42.
Mr. SULLIVAN. I do think that if one looks at the reason for the gasoline tax, which is to support the infrastructure for the roads and bridges and all, that that is where it should go. And I think it is inappropriate to have 4.3 cents of that going to deficit reduction. So, that is a comment I would make there.
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I think there is a tendency, Mr. Chairman, for those of us on the panel to go through those proposals and look for those that have impacts upon our industry. You put your efforts on the ones that do, not the ones that do not, and I think that it would be appropriate to go back and look at those from your question's perspective, rather than just to respond right now.
Chairman ARCHER. Well, you have a most expert tax staff in your organization, and if it is within the ability of time constraints for you to ask them to do an analysis of the 42, and if there are any of them that they think are appropriate, we would like to hear from you.
Mr. SULLIVAN. I would point out the American Petroleum Institute does support a broad-based consumption-type tax. That, of course, is a longer range goal. I think the one thing we should think about here are the things that we are doing and are being proposed in some of these revenue raisers. Do they, in fact, help to get us to a balanced budget and keep us there?
There are two revenue estimates out there on the proposal on the foreign tax credits for our industry, and they are very wide apart. But my expectation is that those proposals are going to raise significant revenue in the short term.
What you have to remember is that our industry is an industry with a very long lead time and horizons, from the point where you explore for oil to the actual production of that oil. And I think what this proposal is going to do in the long term is that the short-term revenue gains are going to be so insignificant compared to the long-term revenue losses as we more or less cede the foreign area to the foreign-based multinational oil companies.
We are not going to be able to compete in that marketplace with these proposals. So, do not do this and it will help you toward a balanced budget and keeping you at a balanced budget.
Chairman ARCHER. With the expertise that each of you has, could you help the Committee evaluate what groups of workers, investors, or consumers in this country benefit from any one of these 42 tax increases?
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I do not see any hands going up.
There is no benefit from any of these 42 tax increases to any group of workers, investors, or consumers?
That is very interesting.
Ms. MacNeil, do you have any support for any of these 42 tax increase provisions?
Ms. MACNEIL. I have not had the opportunity to review them and discuss them with the members of the AAMA. I agree with the comments earlier that just because you have raised corporate taxes does not mean it stops there. The burden ultimately falls on individuals, the workers, the shareholders, the pension plans.
But I would have to review the proposals.
Chairman ARCHER. Mr. Amacher.
Mr. AMACHER. Mr. Chairman, I would tend to agree with Ms. MacNeil that there are more revenue raisers than the issue that I brought up that we could comment on from the perspective of the association, me as an individual, and my employer. And we, of course, would comment on them in a negative way.
They would all, to the extent that they would apply to us, tend to make us less competitive in the retail field in passing those costs along to our customers. And I cannot see, just looking at the list, cursorily here, that there is anything that would be of benefit.
Chairman ARCHER. Thank you very much.
Mr. Rangel.
Mr. RANGEL. Thank you, Mr. Chairman.
Would not all of you agree that the biggest tax cut we have and can obtain for everybody is the elimination of the deficit and the balanced budget, is that not, does not everyone benefit from that?
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Mr. SULLIVAN. I agree.
Mr. RANGEL. And has not the administration been successful in driving down the deficit and keeping down our interest to such an extent that some people would think we got a windfall in terms of increased revenues, is that generally accepted?
My point is going to be that the Chairman asked the previous panel who pays for these tax increases? And following the same lesson, who pays for the jobless, who pays for the homeless, who pays for the unwanted children and the violence and the crime? Who pays for the AIDS and the drugs, who pays for those people locked up in jail? Who pays for it?
Do we not pay for it?
Ms. PARKS We do.
Mr. RANGEL. Why cannot we think of investing in education and productivity? We are clearly those that have been exposed to education. We can look forward to a family that functions.
How could anyone see the budget proposals from the last Congress where 90 percent of the money would come from mandatory programs and discretionary programs that are there to help those people that unfortunately become dependent on the public as helpful?
One way or the other, you are dependent if you are in jail, you are dependent when you are homeless, you are dependent when you are on welfare. We all want tax cuts. Which tax cut would you approve? The Dole tax cut of $500 billion? The Gingrich tax cut of $300 billion?
So, would anyone forfeit the tax cut in favor or reducing the deficit more rapidly?
We would not be talking about these incentives if we were not talking about losing revenue from a tax cut.
Mr. ZAHREN. As a general statement, would I personally pay a little more tax to balance our budget? Yes. But I am also——
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Mr. RANGEL. I did not ask you to pay a little more tax.
Mr. ZAHREN. Well, or, forgo a potential tax cut.
Mr. RANGEL. Exactly.
Mr. ZAHREN. But when you get down to the specific programs you are talking about, Congressman, the judgment calls are very difficult, whether it is education, welfare, what have you.
In your city you have a serious air problem. And you also have the largest landfill in the United States that has a serious landfill gas emission problem. So, both the rich and the poor breathe the bad quality air that comes out of that Staten Island landfill, called Fresh Kills.
And, so, at the expense of—and, again, I am not an expert in all these other 41 of the 42 areas—but at the expense of not keeping the provisions in place for section 29 credits that will allow the Fresh Kills landfill to do something economically viable with their gas, I cannot support that tax increase if the general principle of it is simply going to result in getting closer to a balanced budget.
I am also in favor of the balanced budget amendment which did not get through your counterparts in the Senate. So, I am in favor of a balanced budget and very strongly in favor of it as a small business man and as an entrepreneur.
I have a granddaughter, Emma, and I want her to live in a good environment in the next century but I would forgo both a balanced budget and tax cuts if I thought she was not going to breathe unclean air, not be able to afford energy, and not live in decayed cities that do not get people off of welfare.
I would forgo both a tax cut and a balanced budget to fix those problems. I cannot give you an answer that one is better than the other. They are both needed.
Mr. RANGEL. Well, one is we have a big communication problem. In this room when we discuss welfare reform, when we discuss tax incentives for education, when we start talking about the infrastructure, what is going to adversely affect our ability to remain competitive in the trade arena, we do not find all these people in the room. We do not find people in support of those things. Everyone wants to pay less taxes, including me.
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But the question is, What goes when we are paying a heck of a lot more money for problems we should not have because we do not make the proper investments up front to protect your granddaughter and my children and our grandchildren?
All I am asking is that somehow after this you should share with us what your views are—not only on this issue before you. You would be stupid to say you do not want to pay less in taxes, that is your job. But you have to help us to make determinations as to whether or not we are going to have less investment in our cities, our inner cities, our school structure, and truly what makes our country competitive.
Chairman ARCHER. The gentleman's time has expired and unfortunately we have got a vote on the floor. We have about 5 minutes left to make that vote.
Other Members present feel constrained to have a need to ask questions of this panel. If so, we would ask you to come back, if not, we will excuse this panel. And we will reconvene at 1 o'clock with the next panel.
And thank you very, very much.
[Recess.]
Chairman ARCHER. The Committee will come to order.
Good, we have our witnesses already assembled. That is marvelous.
Welcome to the Ways and Means Committee. I will just repeat briefly, we hope you can summarize your full printed statement within 5 minutes in your presentation and without objection your entire statement will be entered into the record.
We welcome each of you to the Committee and we will be pleased to receive your testimony.
Mr. Oberhelman, would you commence.
STATEMENT OF DOUGLAS R. OBERHELMAN, CHIEF FINANCIAL OFFICER AND VICE PRESIDENT, CATERPILLAR, INC., PEORIA, ILLINOIS; ON BEHALF OF EXPORT SOURCE COALITION
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Mr. OBERHELMAN. Yes, thank you, Mr. Chairman and Members of the Committee. Thank you for this opportunity to discuss the critical importance of retaining the export source rule in its present form and rejecting proposals to replace it with an activity based rule.
Chairman ARCHER. Excuse me, would you mind identifying yourself by giving your full name and who you are associated with?
Mr. OBERHELMAN. My next paragraph, Mr. Chairman.
Chairman ARCHER. Oh, excuse me, I am sorry.
All right, thank you.
Mr. OBERHELMAN. Certainly, Mr. Chairman.
My name is Doug Oberhelman, and I am Caterpillar's chief financial officer and vice president responsible for the administration of accounting, information technology, investor relations, tax, the Treasury Department, of course, and marketing support functions from Peoria, Illinois, where we tend to be a little bit more fiscally conservative. I enjoyed the debate we had this morning.
As you may know, we are based in Peoria, and we are the world's leader in mining and construction equipment markets and a major producer of gas turbine and diesel engines.
Last year, our sales were slightly over $16 billion and we are also one of America's largest exporters. While 75 percent of our assets and people are in the United States, more than one-half of our sales are to overseas customers, and we expect that percentage of sales will grow to about 75 percent by 2010.
Last year, Caterpillar's export sales were a record $5.5 billion, up 7 percent over the previous year. We are very proud of this performance. But we are especially proud of the fact these exports directly supported some 16,500 Caterpillar jobs and approximately 33,000 supplier jobs here in the United States.
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Nationally, more than 11 million jobs or nearly 10 percent of the total U.S. private sector employment are supported by exports. With an increasing amount of our sales activity taking place outside the United States, Caterpillar has a keen appreciation for international tax policy, especially when the issue is double taxation of our income, and that is where the export source rule becomes so critical.
The United States taxes U.S. corporations on their worldwide income, that is income generated from sales and operations inside the United States, as well as income generated from sales and operations outside the United States.
This worldwide taxation approach creates a double taxation situation when foreign income is also taxed by the country in which it is earned.
In an effort to mitigate double taxation of income earned abroad, the United States, like many other countries, allows a credit for income taxes paid to foreign countries with respect to foreign source income, the foreign tax credit.
This provision has worked well since its inception in 1918. In 1921 limitations were placed on foreign tax credits so that companies do not get a dollar-for-dollar credit for foreign taxes paid.
Companies cannot claim credit for foreign taxes paid in excess of the U.S. rate which is 35 percent. In addition, there are numerous other restrictions in U.S. tax law such as interest allocation rules and foreign tax credit baskets which limit the ability of companies to get credit for foreign taxes which they have paid.
As a result, multinational companies often find themselves with excess foreign tax credits. In this case they face double taxation, taxation by the United States and taxation by the foreign country.
The credit a company can receive for foreign taxes paid depends not only on the tax rates in the foreign country but also on the amount of income designated as foreign source under U.S. tax laws. The export source rule treats approximately one-half of export income as foreign source. In many cases, this enables a company to utilize many of its excess foreign tax credits.
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Let me give you an example of how this rule worked to increase exports and support jobs in the United States. It is based on one of the companies in our coalition.
The company manufactures identical products in the United States and in Spain. Upon receiving an order from a customer in Germany, the company had to decide whether to produce the product in the United States and ship it to Germany or produce the product in Spain.
The export source rule was the deciding factor in determining if the product should be made in the United States rather than in Spain. By producing the goods in the United States, the company increased its foreign source income and increased its ability to get credit for foreign taxes paid. This benefit outweighed the additional cost of shipping the product from the United States to Germany.
Gary Hufbauer, a respected economist, who is testifying here today, will be telling you about the sensitivity of plant location decisions to taxes. I do not want to steal his thunder but the findings are compelling.
In a study he authored, he estimates for 1999 alone, the export source rule will account for an additional nearly $31 billion in exports and about 360,000 jobs. And add $2.3 billion—and this is important—to workers' payrolls in the form of export related premiums. They conclude the export source rule furthers the goal of achieving a globally oriented economy with more exports and better paying jobs by way of higher wage premiums.
Mr. Chairman and Members of the Committee, it will come as no surprise to you that just as labor, materials, and transportation are among the costs factored into a production location decisions, so is the overall tax burden.
The export source rule, by alleviating double taxation, helps reduce tax costs and in the process makes U.S. manufactured goods more competitive.
As I have just mentioned, when Caterpillar exports a product from the United States, it is not just Caterpillar that benefits but our employees, the employees of our 11,400 supplier firms, the U.S. economy and, of course, the U.S. Treasury as well.
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When we sell a 793C mining truck, a very large truck used in mining applications around the world, manufactured in Decatur, Illinois, there is a positive ripple effect in our supplier chain. More than 250 individual firms operating in 31 States supply parts and components incorporated into the production of this vehicle. Incidentally, those firms are located in 21 of the 24 States represented by this Committee. At Caterpillar, we consider those 250 suppliers exporters as well.
Unlike the United States, many countries, including Germany and France, principle competitors of ours in our business, permit their corporations to operate in foreign jurisdictions without any risk of double taxation because they simply exclude foreign source income from domestic tax. Companies which call these countries home do not face any risk of double taxation on their overseas operations.
Even countries which tax resident companies on a worldwide basis, similar to the United States, offer their companies more protection from double taxation because they have fewer restrictive rules on the crediting of foreign taxes paid.
Any proposed policy that would make it more difficult for a U.S.-based company to rationalize producing goods here for export, as opposed to producing goods in the eventual markets, should be reevaluated.
The export source rule has evolved into one of the few WTO-consistent export incentives remaining in our Tax Code. For more than 70 years, this rule has worked as originally intended, to avoid endless disputes and problems which would inevitably arise in administering an activity-based rule. Given the acknowledged role of exports in sustaining growth in the U.S. economy, and supporting higher paying U.S. jobs, and the effectiveness of this tax rule at encouraging exports, any attempt to reduce or eliminate the rule is counterproductive and unwise, we think.
The administration has proposed changes to the source rule which are very shortsighted and should be strenuously opposed. Attached to the testimony I am submitting for the record are a list of members of the coalition and a series of short position papers which elaborate upon the benefits of this rule.
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Thank you, Mr. Chairman.
[The prepared statement and attachments follow:]
Statement of Douglas R. Oberhelman, Chief Financial Officer and Vice President, Caterpillar, Inc., Peoria, Illinois; on Behalf of Export Source Coalition
Mr. Chairman, members of the committee, thank you for this opportunity to discuss the critical importance of retaining the Export Source Rule in its present form and rejecting proposals to replace it with an activity-based rule.
My name is Doug Oberhelman. As Caterpillar's Chief Financial Officer, I'm responsible for the administration of Cat's accounting, information technology, investor relations, tax, treasury and marketing support functions.
As you may know, Caterpillar, based in Peoria, Illinois is the world leader in the mining and construction equipment markets, and a major producer of gas turbine and diesel engines.
We are also one of America's largest exporters. While seventy-five percent of our assets and people are in the United States, more than half our sales are to overseas customers. And we expect that percentage of sales to grow to 75 percent by 2010.
Last year, Caterpillar's export sales were a record $5.5 billion—up about 7 percent over the previous year. We're very proud of this performance ... but we're especially proud of the fact that those exports directly supported some 16,500 Caterpillar jobs and around 33,000 supplier jobs here in the United States. Nationally, more than eleven million jobs—or nearly ten percent of the total U.S. private sector employment are supported by exports.
With an increasing amount of our sales activity taking place outside the United States, Caterpillar has a keen appreciation for international tax policy—especially when the issue is double taxation of our income. And that's where the Export Source Rule becomes critical.
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The United States taxes U.S. Corporations on their worldwide income—that is income generated from sales and operations inside the U.S. as well as income generated from sales and operations outside the U.S. This ''Worldwide'' taxation approach creates a ''double taxation'' situation when foreign income also is taxed by the country in which it's earned.
In an effort to mitigate double taxation of income earned abroad, The United States, like many other countries, allows a credit for income taxes paid to foreign countries with respect to foreign source income—the ''foreign tax credit.'' This provision has worked well since its inception in 1918.
In 1921, limitations were placed on foreign tax credits so that companies do not get a dollar-for-dollar credit for foreign taxes paid. Companies cannot claim credit for foreign taxes paid in excess of the U.S. rate ... that is higher than 35%.
In addition, there are numerous other restrictions in U.S. tax law—such as interest allocation rules and foreign tax credit ''baskets''—which limit the ability of companies to get credit for the foreign taxes which they have paid. As a result, multinational companies often find themselves with ''excess'' foreign tax credits. And in this case they face double taxation ... that is taxation by both the U.S. and the foreign country.
The credit a company can receive for foreign taxes paid depends not only on the tax rates in the foreign country, but also on the amount of income designated as ''foreign source'' under U.S. tax laws. The Export Source Rule treats approximately half of export income as ''foreign source.'' In many cases, this enables a company to utilize more of its excess foreign tax credits, thus reducing double taxation.
This rule plays a significant role in Caterpillar's ability to be globally competitive from primarily a U.S. manufacturing base. It does so by increasing our foreign source income and thus increasing our ability to utilize foreign tax credits more effectively. By helping to alleviate double taxation, the Export Source Rule encourages companies like Caterpillar to produce goods in the U.S. and export, which is precisely the tax policy needed to support the goal of increasing exports.
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Let me give you an example of how this rule worked to increase exports and support jobs in the U.S. It's based on the experience of one of the companies in the Export Source Coalition, a group of more than 50 companies and associations opposing changes to this rule.
This company manufactures identical products in the U.S. and in Spain. Upon receiving an order from a customer in Germany, the company had to decide whether to produce the product in the U.S. and ship it to Germany, or to produce the product in Spain.
The Export Source Rule was the deciding factor in determining that the product should be made in the U.S. rather than in Spain. By producing the goods in the U.S., the company increased its foreign source income ...and increased its ability to get credit for foreign taxes paid. This benefit outweighed the additional costs of shipping the product from the U.S. to Germany.
Companies with excess foreign tax credits face double taxation on their overseas operations. Our example demonstrates how the Export Source Rule can be the deciding factor in producing the goods in the U.S. rather than an overseas facility. Because more and more U.S. companies are finding they must have production facilities around the globe to compete effectively, the anecdote I shared is likely to become more and more common. The risk that these companies would shift production abroad if the rule is repealed is significant.
Gary Hufbauer a respected economist who is testifying here today will be telling you more about the sensitivity of plant location decisions to taxes. I don't want to steal his thunder, but the findings are compelling. In a study he authored, along with Dean DeRosa, they estimate for the year 1999 alone, the Export Source Rule will account for an additional $30.8 billion in exports, support 360,000 jobs, and add $2.3 billion to worker's payrolls in the form of export-related wage premiums. They conclude that the Export Source Rule furthers the goal of achieving a globally-oriented economy, with more exports and better paying jobs.
Mr. Chairman and members of the committee, it will come as no surprise to you that just as labor, materials and transportation are among the costs factored into a production location decision, so is the overall tax burden. The Export Source Rule, by alleviating double taxation, helps reduce tax costs ... and in the process makes U.S. manufactured goods more competitive.
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And as I've just mentioned, when Caterpillar exports a product from the United States, it's not just Caterpillar that benefits, but our employees, the employees of our 11,400 supplier firms, the U.S. economy and the U.S. Treasury as well.
Here's a typical example: When Caterpillar sells a 793C mining truck, manufactured in Decatur Illinois there is a positive ripple effect on our supplier chain. More than 250 individual firms operating in 31 states supply parts and components incorporated into the production of this vehicle (incidentally, those firms are located in 21 of the 24 states represented by this committee). At Caterpillar, we consider those 250 suppliers exporters as well.
Unlike the U.S., many countries, including Germany and France, permit their corporations to operate in foreign jurisdictions without any risk of double taxation because they simply exclude foreign source income from domestic tax. Companies which call these countries home do not face any risk of double taxation on their overseas operations.
Even countries which tax resident companies on a worldwide basis similar to the U.S. offer their companies more protection from double taxation because they have less restrictive rules on the crediting of foreign taxes paid.
Any proposed policy that will make it more difficult for a U.S.-based company to rationalize producing goods here for export, as opposed to producing goods in their eventual markets, should be re-evaluated.
The Export Source Rule has evolved into one of the few WTO-consistent export incentives remaining in our tax code. For more than 70 years, this rule has worked as originally intended—to avoid endless disputes and problems which would inevitably arise in administering an activity-based rule.
Given the acknowledged role of exports in sustaining growth in the U.S. economy and supporting higher paying U.S. jobs, and the effectiveness of this tax rule in encouraging exports, any attempt to reduce or eliminate the rule is counterproductive and unwise. The administration has proposed changes to the source rule which are very short sighted and should be strenuously opposed.
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Attached to the testimony I'm submitting for the record are a list of the members of the Export Source Coalition and a series of short position papers which elaborate upon the benefits of this rule to exports and U.S. jobs and the reasons we strenuously oppose proposed changes to the rule.
At this time I would be pleased to answer your questions.
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Attachment1
Export Source Coalition Membership List
Abbott Laboratories
ALCOA
AlliedSignal Inc.
American Automobile Manufacturers Association
American Electronics Association
Applied Materials
Armstrong World Industries
Bison Gear and Engineering Corporation
Cargill, Incorporated
Caterpillar Inc.
Chemical Manufacturers Association
Dana Corporation
Digital Equipment Corporation
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Dover Corporation
Dresser Industries
DuPont
Eastman Kodak Company
Electronic Industries Association
Emergency Committee for American Trade
Exxon Corporation
Ford Motor Company
FMC Corporation
General Electric
General Motors Corporation
Hewlett-Packard Company
Hughes Electronics Corporation
IMC Global Inc.
Information Technology Industry Council
Intel Corporation
IBM
International Paper
Johnson & Johnson
Kimberly-Clark Corporation
Leggett & Platt Incorporated
Lucent Technologies
Merck & Co., Inc.
Medtronic, Inc.
Mueller Industries, Inc.
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National Association of Manufacturers
National Foreign Trade Council
Northrop Grumman
Olin Corporation
Pharmaceutical Research & Manufacturers of America (PhRMA)
Philip Morris Companies Inc.
Pioneer Hi-Bred International
Raychem Corporation
Rayonier
Raytheon Company
Sara Lee Corporation
Sun Microsystems Incorporated
Tandem Computers Incorporated
Textron Inc.
TRW Inc.
United Technologies Corporation
U.S. Chamber of Commerce
3M Corporation
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Attachment 2
Export Source Rule
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Description of the Rule
Since 1922, regulations under IRC section 863(b) and its predecessors have contained a rule which allows the income from goods that are manufactured in the U.S. and sold abroad (with title passing outside the U.S.) to be treated as 50% U.S. source income and 50% foreign source income. This export source rule (sometimes referred to as the ''title passage'' rule) has been beneficial to companies who manufacture in the U.S. and export abroad because it increases their foreign source income and thereby increases their ability to utilize foreign tax credits more effectively. Because the U.S. tax law restricts the ability of companies to get credit for the foreign taxes which they pay, many multinational companies face double taxation on their overseas operations, i.e. taxation by both the U.S. and the foreign jusrisdiction. The export source rule helps alleviate this double taxation burden and thereby encourages U.S.-based manufacturing by multinational exporters.
Administration Proposal
The President's FY1998 Budget contains a proposal to eliminate the 50/50 rule and replace it with an ''activities based'' test which would require exporters to allocate income from exports to foreign or domestic sources based upon how much of the activity producing the income takes place in the U.S. and how much takes place abroad. The justification given for eliminating the rule is essentially that it provides U.S. multinational exporters that also operate in high tax foreign countries a competitive advantage over U.S. exporters that conduct all their business activities in the U.S. In this regard, the Administration prefers the foreign sales corporation rules (FSC) which exempt a lesser portion of export income for all exporters that qualify. The Administration also notes that the U.S. tax treaty network protects export sales from foreign taxation in countries with which we have treaties, thereby reducing the need for the export source rule. As discussed below, both these arguments are seriously flawed.
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The Export Source Rule Serves As an Effective Export Incentive
The export source rule, by alleviating double taxation, encourages companies to produce goods in the U.S. and export, which is precisely the tax policy needed to support the goal of increasing exports. The effectiveness of the rule as an export incentive was examined by the Treasury Department in 1993, as a result of a directive in the 1986 Tax Reform Act. The Treasury study found that if the rule had been replaced by an activity-based rule in 1992, goods manufactured in the U.S. for export would have declined by a substantial amount. The most recent study of the costs and benefits of the rule by Gary Hufbauer estimates that for the year 1999 alone, the export source rule will account for an additional $30.8 billion in exports, support 360,000 jobs, and add $2.3 billion to worker payrolls in the form of export-related wage premiums. The Hufbauer study concludes that the export source rule furthers the goal of achieving an outward-oriented economy, with more exports and better paying jobs.
Increasing Exports Is Vital to the Health of the U.S. Economy
Exports are fundamental to our economic growth and our future standard of living. Although the U.S. is still the largest economy in the world, it is a slow-growing and mature market. As such, U.S. employers must export in order to expand the U.S. economy by taking full advantage of the opportunities in overseas markets. The U.S. is continuing to run a trade deficit (i.e. our imports exceed our exports) of over $100 billion per year. Increasing exports helps to reduce this deficit.
In 1996, exports of manufactured goods reached a record level of $653 billion. Over the past three years, exports have accounted for about one-third of total U.S. economic growth. Today, 96% of U.S. firms' potential customers are outside the U.S. borders, and in the 1990's 86% of the gains in worldwide economic activity occurred outside the U.S.
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Exports Support Better Jobs in the U.S.
According to the Commerce Department, exports are creating high paying, stable jobs in the U.S. In fact, jobs in export industries pay 13–18 percent more and provide 11 percent higher benefits than jobs in non-exporting industries. Exporting firms also have higher average labor productivity. In 1992, value-added per employee, one measure of productivity, was almost 16% higher in exporting firms than in comparable non-exporting firms.
Over the last three years more than one million new jobs were created as a direct result of increased exports. In 1995, 11 million jobs were supported by exports. This is equivalent to one out of every twelve jobs in the U.S. Between 1986 and 1994, U.S. jobs supported by exports rose 63%, four times faster than overall private job growth. Since the late 1980s, exporting firms have experienced almost 20% faster employment growth than those which never exported, and exporting firms were 9% less likely to go out of business in an average year.
Export Source Rule Alleviates Double Taxation
In theory, companies receive a credit for foreign taxes paid, but the credit is not simply a dollar for dollar calculation. Rather it is severely limited by numerous restrictions in the U.S. tax laws. As a result, multinational companies often find themselves with ''excess'' foreign tax credits and facing ''double'' taxation, i.e. taxation by both the U.S. and the foreign country. How much credit a company can receive for foreign taxes paid depends not only on the tax rates in the foreign country, but also on the amount of income designated as ''foreign source'' under U.S. tax law.
For example, for purposes of U.S. foreign tax credit rules, a portion of U.S. interest expense, as well as research and development costs, must be deducted from foreign source income (even though no deduction is actually allowed for these amounts in the foreign country). On the other hand, if the company incurs a loss from its domestic operations in a year, it is restricted from ever using foreign source earnings in that year to claim foreign tax credits.
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These restrictions in the U.S. tax law, which reduce or eliminate a company's foreign source income, result in unutilized or ''excess'' foreign tax credits. The export source rule, by treating approximately half of the income from exports as ''foreign source,'' increases the amount of income designated ''foreign source'' thereby enabling companies to utilize more of these excess foreign tax credits, thus reducing double taxation.
Export Source Rule Helps to ''Level the Playing Field''
The export source rule does not provide a competitive advantage to multinational exporters vis-à-vis exporters with ''domestic-only'' operations. Exporters with only domestic operations never incur foreign taxes and thus, are not even subjected to the onerous penalty of double taxation. Also, domestic-only exporters are able to claim the full benefit of deductions for U.S. tax purposes for all their U.S. expenses, e.g., interest on borrowings and R&D costs because they do not have to allocate any of those expenses against foreign source income. Thus, the export source rule does not create a competitive advantage, rather it helps to ''level the playing field'' for U.S.-based multinational exporters.
Export Source Rule Affects Decision to Locate Production in the U.S.
Just as labor, materials, and transportation are among the costs factored into a production location decision, so is the overall tax burden. The export source rule, by alleviating double taxation, helps reduce this tax cost, thereby making it more cost efficient to manufacture in the U.S. For example, for one coalition member, the export source rule was the determining factor in deciding to fill a German customer order from a U.S. rather than a European facility making the identical product. By allowing half the income from the sale to be considered ''foreign source,'' thereby helping the company utilize foreign tax credits, the export source rule outweighed other cost advantages such as transportation, and American workers filled the customer's order.
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FSC Regime and Treaty Network Not Substitutes for Export Source Rule
If the export source rule is eliminated, the FSC regime will not be a sufficient remedy for companies facing double taxation because of excess foreign tax credits. Instead of using a FSC, many of these companies may decide to shift production to their foreign facilities in order to increase foreign source income. Since more and more U.S. companies are finding that they must have production facilities around the globe to compete effectively, this situation is likely to become more and more common. The risk that these companies (which by definition are facing double taxation because they already have facilities overseas) would shift production abroad if the rule is repealed is significant and not worth taking.
Our tax treaty network is certainly no substitute for the export source rule since it is not income from export sales but rather foreign earnings that are the main cause of the double taxation described above. To the extent the treaty system lowers foreign taxation, it can help to alleviate the double tax problem, but only with countries with which we have treaties, which tend to be the most highly industrialized nations of the world. We have few treaties with most of the developing nations which are the primary targets for our export growth in the future.
Conclusion
While this technical tax rule was not originally intended as an export incentive, it has evolved into one of the few WTO-consistent export incentives remaining in our tax code. It is also justified on the basis of administrative convenience. This 50/50 sourcing rule is working as originally intended to avoid endless disputes and problems which would inevitably arise in administering an activity-based rule.
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Given the acknowledged role of exports in sustaining growth in the U.S. economy and supporting higher paying U.S. jobs, and the effectiveness of this tax rule in encouraging exports, any attempt to reduce or eliminate the rule is counterproductive and unwise. The Administration has proposed cutbacks and changes to the source rule which are very short sighted and should be strenuously opposed.
Sources
Fourth Annual Report of the Trade Promotion Coordinating Committee (TPCC) on the National Export Strategy: ''Toward the Next Century: A U.S. Strategic Response to Foreign Competitive Practices,'' October 1996, U.S. Department of Commerce, ISBN 0–16–048825–7;
U.S. Department of Commerce, Economics and Statistics Administration, Office of the Chief Economist.
Gary C. Hufbauer and Dean A. DeRosa, ''Costs and Benefits of the Export Source Rule, 1996–2000,'' February 1997.
James R. Hines, Jr., ''Tax Policy and The Activities of Multinational Corporations,'' NBER Working Paper 5589, May 1996.
John Mutti and Harry Grubert, ''The Significance of International Tax Rules for Sourcing Income: The Relationship Between Income Taxes and Trade Taxes,'' NBER Working Paper 5526, April 1996.
J. David Richardson and Karin Rindal, ''Why Exports Matter: More!,'' Institute for International Economics and the Manufacturing Institute, Washington, DC, February 1996.
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Attachment 3
Existence of Tax Treaties Is No Reason To Repeal Export Source Rule
The Administration has stated that the U.S. income tax treaty network protects export sales income from tax in the foreign country where the goods are sold and thus protects companies from double taxation. They argue that the export source rule is no longer necessary as a result of this treaty protection.
We strongly disagree that the treaty network is a substitute for the export source rule, but even if it were, the network is far from complete. The U.S. treaty network is limited to 56 countries, leaving many more countries (approximately 170) without treaties with the U.S. Moreover, many of the countries without treaties are developing countries, which are frequently high growth markets for American exporters. For example, the U.S. has no treaty with any Central or South American country.
With or without a tax treaty, under most foreign countries' tax laws, the mere act of selling goods into the country, absent other factors such as having a sales or distribution office, does not subject the U.S. exporter to income tax in the foreign country. Thus, export sales are not the primary cause of the excess foreign tax credit problem which many companies face in trying to compete overseas.
The real reason most multinational companies face double taxation is that U.S. tax provisions unfairly restrict their ability to credit foreign taxes paid on these overseas operations against their U.S. taxes. Requirements to allocate a portion of the costs of U.S. borrowing and research activities against foreign source income (even though such allocated costs are not deductible in any foreign country), cause many companies to have excess foreign tax credits, thereby subjecting them to double tax—i.e. taxation by both the U.S. and the foreign jurisdiction.
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The export source rule alleviates double taxation by allowing companies who manufacture goods in the U.S. for export abroad to treat 50% of the income as ''foreign source,'' thereby increasing their ability to utilize their foreign tax credits. Thus, the rule encourages these companies (facing double taxation as described above) to produce goods in the U.S. for export abroad.
As an effective WTO-consistent export incentive, the export source rule is needed now more than ever to support quality, high-paying jobs in U.S. export industries. Exports have provided the spark for much of the growth in the U.S. economy over the past decade. Again, the existence of tax treaties does nothing to change the importance of this rule to the U.S. economy.
The decision to allow 50% of the income from export sales to be treated as ''foreign source'' was in part a decision based upon administrative convenience to minimize disputes over exactly which portion of the income should be treated ''foreign'' and which should be ''domestic.'' The rule still serves this purpose, and neither the tax treaty network nor the Administration's proposal to adopt an ''activities-based'' test for determining which portion of the income is ''foreign'' and which is ''domestic'' addresses this problem. Moreover, adopting an ''activities-based'' rule would create endless factual disputes similar to those under the section 482 transfer pricing regime.
Tax treaties are critically important in advancing the international competitiveness of U.S. companies' global operations and trade. In order to export effectively in the global marketplace, most companies must eventually have substantial operations abroad in order to market, service or distribute their goods. Tax treaties make it feasible in many cases for business to invest overseas and compete in foreign markets. Foreign investments by U.S.-based multinationals generate substantial exports from the U.S. These foreign operations create a demand for U.S.-manufactured components, service parts, technology, etc., while also providing returns on capital in the form of dividends, interest and royalties.
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Tax treaties are not a substitute for the export source rule. They do not provide an incentive to produce goods in the U.S. Nor do they address the most significant underlying cause of double taxation—arbitrary allocation rules—or provide administrative simplicity in allocating income from exports.
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Attachment 4
The Foreign Sales Corporation (FSC) Rules Complement but Cannot Replace the Export Source Rule
The Export Source Rule allows the income from goods that are manufactured in the U.S. and exported (with title passing outside the U.S.) to be treated as 50% U.S. source income and 50% foreign source income for purposes of determining the foreign tax credit ''limitation,'' i.e., the amount of foreign taxes that may be claimed as a credit against a company's U.S. tax liability. Generally, this limitation on credits is equivalent to the U.S. tax rate (35%) multiplied by net foreign source income of a company. As a result, an increase in the amount of foreign source income causes an increase in the limitation on the amount of creditable foreign taxes. Thus, for companies with unutilized (excess) foreign tax credits, an increase in the amounts of income determined to be ''foreign source'' permits them to use more of these excess credits.
The Foreign Sales Corporation (FSC) rules, on the other hand, provide a smaller export incentive and operates independently from the foreign tax credit regime. A FSC is an entity which is separately incorporated, typically in a jurisdiction where it will not be taxed. U.S. exporters that route sales through their FSC's are entitled to a U.S. tax exemption on a portion of the export profits. The level of the exemption is based on the level of distribution activities performed by a FSC which operates as a ''buy-sell'' company. Alternatively, a FSC can operate as a commission agent, in which case the U.S. exporter can receive up to a 15% U.S. tax exemption on its export profits. Most FSC's operate as commission agents and thus generate a maximum U.S. tax savings of 5.25% (15% × 35% tax rate) U.S. tax benefit.
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There is an interplay between the Export Source Rule and the FSC provisions. A company can pass title offshore on its export sales (and thus qualify for the Export Source Rule) and at the same time route those sales through a FSC. In such case, the company can elect whether or not to claim a FSC benefit.
If FSC benefits are elected (e.g., the 15% exemption), then only 25% of the export income may be characterized as foreign source income under the Export Source Rule (this is the so-called ''FSC haircut''). A company with little or no unutilized foreign tax credits would typically elect the FSC benefit, and thereby generate less foreign source income and consequently a lesser amount of foreign tax credit limitation under the Export Source Rule.
If no FSC benefit is elected, under the export source rule 50% of the export income is characterized as ''foreign source'' thereby allowing the company to utilize more foreign tax credits. Exporters with unutilized (excess) foreign tax credits would normally elect no FSC benefit in order to characterize more income as foreign source.
Many multinational companies find themselves with excess foreign tax credits because of U.S. tax provisions that unfairly restrict their ability to credit foreign taxes against their U.S. taxes, e.g., requirements to allocate a portion of the costs of their U.S. borrowings and research activities against foreign source income (even though such allocated costs are not deductible in any foreign country.) FSC does nothing to address the double taxation caused by the foreign tax credit problems companies face on their overseas operations.
Both the Export Source Rule and FSC are considered consistent with WTO rules.
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Attachment 5
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Other Countries Provide More Favorable Tax Treatment for Companies Doing Business Abroad Than the United States
The complex rules by which the U.S. taxes its companies doing business in foreign jurisdictions put them at a disadvantage when competing abroad. The export source rule is one of the few favorable tax rules which mitigate the harm done by other distortive U.S. tax rules that cause many U.S. multinationals to suffer significant double taxation on income earned from their international operations.
Double taxation occurs when U.S. multinationals pay taxes to both the U.S. and a foreign country on the same income, and the business cost is especially onerous when the foreign tax rate exceeds the U.S. statutory rate. The U.S. taxes worldwide income, but in order to avoid double taxation, allows a credit for foreign taxes paid. However, numerous restrictions and limitations in U.S. tax law often prevent U.S. multinationals from getting a dollar for dollar credit against their U.S. taxes for the foreign taxes paid, and thus the companies are subjected to double taxation.
By contrast, most other countries rarely subject their companies to double taxation on foreign business income. These countries often exempt such income from tax entirely or have less onerous rules for crediting foreign taxes paid. Avoidance of double taxation on foreign business income is essential if U.S. multinationals are to compete effectively in the global marketplace.
Territorial Systems of Taxation—Unlike the U.S., many countries, such as Germany, France and Austria, permit their corporations to operate in foreign jurisdictions without any risk of double taxation because they simply exclude foreign source income from domestic tax, either by statute or through their treaty network. Companies which call these countries home do not face any risk of double taxation on their overseas operations.
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Worldwide Systems of Taxation—Even countries which tax resident companies on a worldwide basis similar to the U.S. offer their companies more protection from double taxation because they have less restrictive rules on the crediting of foreign taxes paid.
U.S. Restrictions on Crediting Foreign Taxes Paid—The U.S. tax laws contain numerous and unique restrictions on crediting foreign taxes paid by multinational companies on their overseas operations. The following are some of the key problem areas:
Foreign tax ''baskets''—Separate foreign tax credit limitations apply for different types or ''baskets'' of income earned by the companies, such as shipping, financial services, passive, high withholding-tax interest, etc. Indeed, there is a separate limitation for income earned by each company which is owned at least 10% but not more than 50% by U.S. shareholders. No other country has such complex and restrictive limitations on the crediting of foreign taxes.
Allocation Rules—The U.S. tax laws require corporations to deduct numerous domestic expenses, such as interest and R&E expenses, from their foreign source income even though they do not actually get a deduction for these costs in the foreign country. The ability of a company to get credit for foreign taxes paid is dependent upon how much foreign source income it has. Therefore, reductions in a company's foreign source income (caused by allocating these domestic expenses to foreign source income) also reduce the amount of credit the company can get for foreign taxes paid. The magnitude of these allocations is unprecedented by international tax norms and one of the main causes of double taxation for U.S.-based multinationals.
Domestic Losses—If the U.S. operations of a multinational company lose money in any given year, this domestic loss reduces or eliminates the company's capacity to claim foreign tax credits in that year. Moreover, this loss in foreign tax credit capacity can not be made up in any other year. Thus, the company is prohibited from ever using foreign earnings in that year to claim foreign tax credits, and double taxation results.
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Other Countries Give Tax Incentives for Exports and Overseas Operations—In addition to bearing the hidden tax costs buried in the details of the U.S. system described above, U.S. companies must also compete with foreign-based companies that are operating under tax laws that frequently offer incentives for exports and encourage their multinationals to invest overseas. Even countries which do not exempt foreign income from tax often enter into so-called ''tax sparing'' treaties which have the same effect. These agreements exempt foreign earnings from tax even when the earnings are ''repatriated'' i.e., brought back to the home country. Many countries also offer incentives such as VAT exemptions for exports.
International Tax Reform—The export source rule is one of the few rules in the U.S. international tax regime which alleviates the double taxation caused by the provisions described above. If any changes to the rule are to be considered, they should be in the context of a comprehensive review of the overall manner in which the U.S. taxes the international operations of businesses and with a view to supporting and fostering the international competitiveness of U.S.-based companies.
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Attachment 6
The Export Source Rule Is Important to Small Businesses
Mueller Industries
Mueller Industries, Inc. headquartered in Memphis, Tennessee, employs 2500 people manufacturing at facilities in California, Maryland, Michigan, Mississippi, Ohio, Pennsylvania, and Tennessee. One plant in Canada was set up 70 years ago and produces approximately five percent of Mueller's output. Mueller exports from the United States to Canada, Mexico, Europe, Central & South America, Asia/Pacific Rim and the Middle East.
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The market for copper tubing in the United States (used, for example, in plumbing and refrigeration) is mature. Thus, Mueller sees long term growth with exports, which now account for approximately 12% of sales and are growing by 10% per year.
As a result of its operations in Canada and the taxes paid on these operations for which Mueller cannot get full credit under U.S. tax laws, they are subject to double taxation, which raises their costs. When they offer product for sale, for example, in Mexico, one of the fastest growing markets for their products, these increased costs make it more difficult to compete. In Mexico they are competing against not only Mexican companies but also companies from South America, Europe and Asia. Mueller currently faces a 9% duty on sales of its product in Mexico, while competing Mexican companies sell duty free into the U.S. Loss of the Export Source Rule would further tilt this un-level playing field against Mueller. Each sale Mueller loses means fewer exports made by American workers.
Bison Gear and Engineering
Bison Gear and Engineering Corporation (The Bison Group) is an Illinois-based company with 200 employees manufacturing electric gear motors. Exports, currently six percent of sales, represent a growing share of its business.
The Bison Group is currently constructing a new manufacturing plant in Illinois, which will require an expanded workforce of 10 percent. In addition to supplying product for the U.S. market, it will provide components for its Netherlands facility, set up last year to better serve the European market. One of the primary reasons Bison chose The Netherlands was its central location with easy access to container shipments of components coming from its U.S. operations. Eventually, Bison plans to open other overseas assembly operations, to be supplied by its U.S. production facilities. Many of Bison's U.S. customers sell their products overseas, as well.
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If the Bison Group cannot get full credit under U.S. tax laws for taxes paid on its overseas operations, its cost of doing business increases, making Bison less competitive. Thus, elimination of the Export Source Rule could impact Bison's future ability to grow its business and create additional U.S. jobs by increasing its tax cost, thereby limiting its ability to achieve an adequate return on investment.
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Chairman ARCHER. Thank you, Mr. Oberhelman.
Our next witness is Mr. Hufbauer.
STATEMENT OF GARY C. HUFBAUER, PH.D., SENIOR FELLOW, INSTITUTE FOR INTERNATIONAL ECONOMICS, WASHINGTON, DC; AND COAUTHOR OF ''COSTS AND BENEFITS OF THE EXPORT SOURCE RULE, 1998–2002''; ON BEHALF OF EXPORT SOURCE COALITION; ACCOMPANIED BY DEAN A. DEROSA, EXPORT SOURCE COALITION
Mr. HUFBAUER. Thank you, Mr. Chairman.
My name is Gary Hufbauer and I am here to summarize the findings of the report conducted by myself and Dean DeRosa for the Export Source Coalition.
The main findings are on this large table to my right.
First, to recall this morning's discussion on terminology, I do not regard the export source rule as a tax preference. Turning now to the effects.
Our report examines the costs and benefits of the rule over a 5-year period, 1998–2002. In order to keep the discussion simple, let me just focus on the year 1999.
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Our estimate of what we call the ''adjusted tax revenue cost'' with the rule in place in the year 1999 is about $1.1 billion. In other words, if the rule was repealed, as the administration has proposed, an additional $1.1 billion would be raised in that year.
To raise that money, the costs imposed on the U.S. economy would be approximately a loss of $30 billion of exports. Let me be more precise. I am not saying the export loss happens instantly, but the long-term effect would be a $30 billion export loss if this rule had not been in place in the years preceding 1999. And we would lose a wage premium on export jobs of about $2 billion.
I want to dwell on that wage premium for just a moment. Export jobs pay better. This is well documented and well advertised. If you examine the figures, the premium is about 12 to 15 percent higher pay in export jobs. These are good jobs in our economy.
And it is because of that wage premium that we calculate a revenue offset figure which the Treasury and the Joint Committee do not incorporate into their calculations—though I urge them to reconsider how they do the calculations. The offset is about $400 million.
To repeat, we are not talking about additional jobs here, we are just talking about the premium on the jobs and the additional tax the government collects on the premium. That is our $400 million offset.
So, taking the Treasury's number or the Joint Committee's revenue number of about $1.5 billion, and subtracting the $400 million, you get about $1.1 billion as the revenue pickup. The losses, again, are $30 billion of exports that support 360,000 jobs. In a full-employment economy, that does not mean new jobs, of course, but it does mean better paying jobs and that is the $2 billion-odd of wage premium.
So, those are our findings. Let me just take 1 or 2 minutes to explain some of the underlying economics which go into these findings.
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One point which I have already made is that export jobs pay better. Exports are one of the most productive sectors of our economy. The second point I would like to emphasize is that plant location is far more sensitive to tax rates than we have customarily thought—and we cite the new research on this point in our report.
This point has implications that go well beyond the export source rule. Briefly, a country which imposes high business taxes will, over a period of time, deprive itself of investment and of export jobs.
Thank you.
[The prepared statement follows:]
Statement of Gary C. Hufbauer, PH.D., Senior Fellow, Institute for International Economics, Washington DC; and Coauthor of ''Costs and Benefits of the Export Source Rule, 1998–2002''; on Behalf of Export Source Coalition; Accompanied by Dean A. Derosa, Export Source Coalition
Mr. Chairman and members of the Committee, my name is Gary Hufbauer, and I am here to summarize the findings of a study conducted by Dean DeRosa and myself, for the Export Source Coalition, on the costs and benefits of the Export Source Rule. With your permission, I would like to submit the complete study for the record.
The Export Source Rule of the Internal Revenue Code of 1986 provides U.S. companies, both large and small, with a mechanism for apportioning their net income from exports between domestic and foreign sources. Broadly, it permits them to attribute about 50 percent of their net export income to foreign sources. Firms that have excess foreign tax credits can utilize the Export Source Rule to ''absorb'' part of those excess credits, thereby alleviating the double taxation of foreign income.
Our report presents our assessment of the costs and benefits of the Export Source Rule for 1998, with projections over the 5-year period 1998–2002. As seen in the accompanying table, our projections indicate that the Export Source Rule supports significant additional U.S. exports and worker earnings all at costs to the U.S. Treasury that are lower than usually estimated. For example, in 1999, for an adjusted net tax revenue cost of $1.1 billion, the United States will ship an additional $30.8 billion of exports and add $1.7 billion to worker payrolls in the form of the export earnings premium. The additional exports will support 360 thousand workers in export-related jobs who in a full employment economy would otherwise be working in lower paid sectors of the U.S. economy.
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The revenue cost estimates are based on the current U.S. Treasury forecasts of the tax revenue gains associated with repeal of the Export Source Rule. The Treasury estimates reflect the likelihood that, if the Export Source Rule is repealed, erstwhile users of the Export Source Rule among U.S. firms would instead turn to a Foreign Sales Corporation. Under the Foreign Sales Corporation legislation, a U.S. exporter can exclude up to 15 percent of its net export income from U.S. taxation. Unlike the Treasury estimates, our adjusted revenue cost estimates also reflect additional tax receipts derived from individual workers who enjoy premium earnings in export-related jobs supported by the Export Source Rule.
The benefits of the Export Source Rule are measured in terms of additional exports, the jobs supported by additional exports, and the premium on worker earnings in export-related jobs. These benefits are assessed using three different analytical approaches from two recent econometric studies, and one older, more traditional, quantitative study. In all cases, we assume that, in the absence of the Export Source Rule and its 50–50 division of export profits between foreign and domestic source income, U.S. firms would instead sell their exports through a Foreign Sales Corporation and exclude up to 15 percent of their export profits from U.S. taxation.
Our findings demonstrate that the Export Source Rule furthers the goal of achieving an outward-oriented economy, with more exports and better-paying jobs. One key to these broad conclusions is the fact that export-oriented industries and jobs are highly productive, partly because U.S. producers and workers engaged in export production face the considerable discipline of highly competitive international markets for traded goods and services. A second key is the sensitivity of plant location to the tax environment. Not right away perhaps, but over a period of years a country that penalizes export production with high taxes will forfeit first investment and then export sales.
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This second point deserves amplification. Recent empirical research by several scholars—Grubert and Mutti, Hines, Kemsley, and Wei—indicates far higher response rates of investment decisions to tax rates than previously believed. The new evidence is summarized in our report. A one percentage point increase in the corporate tax rate (e.g., from 18 percent to 19 percent) apparently induces a decline of 1.5 percent (and perhaps as much as 3 or 5 percent) in investment committed to export and import-competing production. The consequent impact, in terms of lost exports (or higher imports), is much larger than previously believed. The policy implications of the new scholarship extend well beyond the Export Source Rule. Countries that impose high corporate tax rates will significantly erode their competitive position in the world economy.
Costs and Benefits of the Export Source Rule, 1998–2002 by Gary C. Hufbauer and Dean A. DeRosa, A Report Prepared for the Export Source Coalition February 19, 1997, Revised March 13, 1997
Executive Summary
1. U.S. Exports and the Export Source Rule
Continued robust exports by U.S. firms in a wide variety of manufactures and especially advanced technological products such as sophisticated computing and electronic products and cutting-edge pharmaceuticals are critical for maintaining satisfactory rates of GDP growth and the international competitiveness of the U.S. economy. Indeed, it is widely acknowledged that strong export performance ranks among the primary forces behind the economic well-being that U.S. workers and their families enjoy today, and expect to continue to enjoy in the years ahead.
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The Export Source Rule (Section 863(b) of the Internal Revenue Code of 1986) plays an important role in supporting U.S. exports of manufactures and other merchandise, above levels that would otherwise occur. The rule provides U.S. companies, both large and small, with a mechanism for apportioning their net income from exports between domestic and foreign sources. Under the Export Source Rule, U.S. companies attribute about 50 percent of their net export income to foreign sources. Firms that have excess foreign tax credits utilize the Export Source Rule to enlarge their foreign source income and ''absorb'' part of those excess foreign tax credits, thereby alleviating the double taxation of foreign income.(see footnote 40) Under such circumstances, the U.S. exporter will pay no additional U.S. tax on the foreign source portion of its export earnings. Moreover, as a general rule, foreign countries do not tax the export earnings of U.S. firms, so long as the production and distribution activity does not take place within the foreign territory. Of course, the U.S. firm will pay U.S. tax at the normal 35 percent rate on the domestic source portion of its export earnings. The net result, for U.S. firms with excess foreign tax credits that use the Export Source Rule, is to pay a ''blended'' tax rate of 17.5 percent on their export earnings zero percent on half and 35 percent on half.
Those U.S. firms that export can also utilize another provision of the Internal Revenue Code, Section 862(a)(6) enacted under the Deficit Reduction Act of 1984, which allows companies to establish a Foreign Sales Corporation (FSC). The FSC is a successor to the former Domestic International Sales Corporation (DISC). Under the FSC provisions, U.S. firms can conduct their export sales through a Foreign Sales Corporation and exclude a maximum of 15 percent of their net export earnings from U.S. taxation. In this case, the ''blended'' rate is 29.75 percent zero percent on 15 percent of export earnings and 35 percent on 85 percent of export earnings.
This report assesses the costs and benefits of the Export Source Rule for 1998, with projections over the 5-year period 1998–2002.(see footnote 41) The revenue cost estimates are based on the current U.S. Treasury forecasts of the tax revenues associated with the Export Source Rule. (The Joint Committee on Taxation (JCT) has published very similar revenue forecasts.) These revenue cost estimates reflect likely changes in corporate operations in response to a change in the tax laws. Hence, they assume that, if the Export Source Rule is repealed, erstwhile users among U.S. exporters would instead turn to the Foreign Sales Corporation. Our ''adjusted'' revenue cost estimates go one important step further. Namely, they take into account the revenues that would be lost to the U.S. Treasury owing to the loss of premium earnings by manufacturing workers in export-related jobs supported by the Export Source Rule.
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We measure the benefits of the Export Source Rule in terms of additional exports, the jobs supported by additional exports, and the premium on worker earnings. We assess these benefits using three very different analytical approaches. In all cases, we assume that, in the absence of the Export Source Rule and its 50–50 division of export profits between foreign and domestic source income, U.S. firms would instead sell their exports through a Foreign Sales Corporation, and that, to an important extent, they would export less and produce more abroad.
2. Three Approaches to Estimating Benefits
U.S. exports and jobs supported by the Export Source Rule are estimated using three different analytical approaches, first for a base year (1992) and, subsequently, for the 5-year period 1998–2002. The three approaches to estimating benefits of the Export Source Rule are based on the findings of two recent econometric studies of U.S. export levels and investment location behavior in response to tax rates (Kemsley 1997; Grubert and Mutti 1996), and a much older study of the former Domestic International Sales Corporation (DISC) provisions of the U.S. tax law, carried out by the U.S. Department of the Treasury (1983).
Direct Estimates Based on Kemsley Parameters
The first approach to estimating the benefits of the Export Source Rule is based on the findings of Kemsley (1997). The Kemsley sample data, which are compiled from the financial statements of U.S. multinational firms, consist of information on the worldwide assets, U.S. exports, foreign sales, and U.S. and foreign tax rates of 276 U.S. firms during the 9-year period 1984–92. As seen in the upper panel of Table 1, these data may be divided into two sub-samples: data for the companies with ''binding FTC positions'' and data for the companies with ''nonbinding FTC positions.'' The companies with binding foreign tax credit (FTC) positions are companies with excess foreign tax credits. These corporations are assumed to use the Export Source Rule. Under the Export Source Rule, half the profits are characterized as foreign source income, and can be used to absorb excess foreign tax credits, thereby reducing the ''blended'' U.S. tax rate on their export profits to 17.5 percent.(see footnote 42) The companies in nonbinding FTC positions (i.e., without excess foreign tax credits) are assumed to exclude 15 percent of their export profits from U.S. taxation by using a Foreign Sales Corporation (FSC), thereby reducing the ''blended'' U.S. tax rate on their export profits to 29.75 percent.(see footnote 43)
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Kemsley investigated the amount of export sales per company associated with U.S. export tax rules using an econometric equation that includes the ''marginal export tax incentive'' facing companies with binding FTC positions and companies with nonbinding FTC positions as separate explanatory variables. By the design of his econometric analysis, coupled with his assignment of companies predominantly utilizing a Foreign Sales Corporation to the sub-sample of companies with nonbinding FTC positions, Kemsley associated the estimated coefficient on the marginal export tax incentive variable for firms with binding FTC positions with the impact of the Export Source Rule. Based on Kemsley's coefficients, it can be calculated that the Export Source Rule supports $42 million additional exports per company for 140 companies in a binding FTC position.(see footnote 44)
However, this figure is an understatement for an important reason recognized by Kemsley. His data on exports only count exports to unaffiliated foreign buyers. According to a survey by the U.S. Department of Commerce (1996c), exports by U.S. multinational firms to their foreign affiliates accounted for 38 percent of the total exports of these firms in the year 1994 (this proportion has remained practically constant since 1989). Assuming that exports to affiliated foreign firms are impacted to the same extent as exports to unaffiliated firms, the impact per U.S. parent firm can be calculated at $68 million ($42 million divided by 0.62).
Kemsley's figure of 140 companies in a binding FTC position represents an average for the entire period 1984–92. However, for the period after the Tax Reform Act of 1986, Kemsley found that the Export Source Rule had a stronger positive impact on exports. The reason is that, with a lower U.S. corporate tax rate, and with the adoption of various rules that block U.S. firms from crediting foreign taxes, more companies found themselves in an excess foreign tax credit position, and thus more firms made use of the Export Source Rule. Kemsley's data indicate that 74 of his sample firms had a binding FTC position before the Tax Reform Act of 1986, and 173 firms had a binding FTC position after the Act. Even this figure understates the number of firms that rely on the Export Source Rule. Kemsley estimates that his sample firms may account for only 70 percent of all firms that utilize the Export Source Rule. In other words, the ''true'' average number of impacted firms, during the period 1987–92, could be about 247 companies (173 divided by 0.70). Thus, as reported in Table 1, for 1992, the total value of U.S. exports supported by the Export Source Rule can be estimated, based on Kemsley's econometric findings, at $16.8 billion ($68 million per company for 247 U.S. firms).
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Using a rate of 15.5 thousand jobs supported in the U.S. economy per $1 billion of goods exported in 1992, as estimated by the U.S. Department of Commerce (1996b), the number of U.S. jobs supported by the Export Source Rule can be calculated at 260 thousand jobs for 1992. These jobs might not represent additional employment in the current circumstances of the U.S. economy, where the unemployment rate is relatively low. Instead, additional exports may draw already employed workers from other jobs, rather than from the ranks of unemployed workers. Under this assumption which is usually made by JCT and Treasury analysts when evaluating tax changes the Export Source Rule may not be attributed with creating new jobs.
However, the Export Source Rule does shift the composition of output towards more output for export markets and less output for domestic use. The shift of output towards exports can be expected to benefit U.S. workers. There is significant evidence, such as that reported recently by Richardson and Rindal (1996), that both blue collar and white collar workers in exporting firms enjoyed earnings that were about 15 percent higher on average in 1992 than similar workers in non-exporting firms. The U.S. Department of Commerce (1996b) reports an earnings advantage of 12 percent for manufacturing workers supported directly and indirectly by exports in 1994. Hence, a change in the composition of output can be expected to improve the earnings of workers, even if they are drawn from other sectors and not from the ranks of the unemployed. Based on the Department of Commerce earnings premium of 12 percent, and average annual earnings of manufactures workers of just over $30,500 in 1992, the wage and salary premium is $3,660 per worker in that year. For all workers drawn to export-related employment by the Export Source Rule, the aggregate wage and salary premium is estimated at $1.0 billion in 1992. For 1999, the figure rises to $1.7 billion (see Table 4).
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Production Response Approach Based on Grubert-Mutti Parameters
The second approach to estimating the benefits of the Export Source Rule is based on estimates of the location of production facilities in response to different tax rates. Our calculations for this approach rely on the recent econometric findings of Grubert and Mutti (1996). Grubert and Mutti investigate the location of investment abroad by U.S. controlled foreign corporations, typically in manufacturing facilities to support foreign exports to third-country destinations. They are interested in changes in investment location induced by differences in corporate tax rates between foreign countries. Among other findings, the two authors report a statistically significant estimate of 3.0 for the elasticity of total capital invested in individual foreign countries with respect to the foreign tax rate.(see footnote 45) For the purposes of this report, the Grubert-Mutti elasticity estimate of 3.0 is multiplied by the incremental inducement provided by the Export Source Rule, and then applied to total exports per company by the Fortune 50 Top U.S. Exporters (Fortune 1995). The key assumption underlying this calculation is that U.S. export production facilities can be regarded as if they were an additional overseas location for production of tradable goods by U.S. multinational firms. Without the Export Source Rule, firms would shift production abroad: in fact, they would relocate 3 percent of their production facilities abroad for each 1 percent increase in the effective U.S. tax rate.(see footnote 46) Further, it is assumed that a 10 percentage point decrease in U.S. production facilities translates into a 10 percentage point decrease in U.S. exports. Other assumptions should also be noted. We assume that, without the Export Source Rule, companies would ship their exports through a Foreign Sales Corporation. Hence, the calculation of additional exports only reflects the incremental inducement provided by the Export Source Rule, beyond the inducement provided by the Foreign Sales Corporation (12.25 percentage points in the ''blended'' U.S. tax rate). We also assume that only half of the Fortune Top 50 U.S. Exporters are in a binding FTC position. This is based on Kemsley's full sample of company years, which reports half the company-years in a binding position and half in a nonbinding position. Finally, for this calculation, we assume that only these 25 large exporters use the Export Source Rule.
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Applying the Grubert-Mutti parameter estimate, with these supplementary assumptions, leads to the finding that the Export Source Rule supported $1.2 billion additional exports per company, or $31.2 billion additional exports for the 25 large exporters in 1992 (Table 2). With regard to U.S. jobs, the earnings estimates based on the Grubert-Mutti parameters indicate that 482 thousand U.S. jobs are supported by the Export Source Rule. The aggregate earnings premium for U.S. workers attributable to the Export Source Rule is $1.8 billion in 1992. The figure for 1999 is $3.2 billion (see Table 4).
Other Estimates of Production Location
The proposition that higher business taxes can prompt the relocation of production is not new to economics. Ohlin (1933) and Haberler (1936), among other pioneers in the modern theory of international trade and investment, were keenly aware of the impact of taxes. What is new is empirical calculation of the size of the response.
In a recent paper, Hines (1996a) surveyed the empirical literature on the response of U.S. direct investment abroad and foreign direct investment in the United States to different tax rates. While the 20-odd studies (dating from 1981) surveyed by Hines cannot be summarized by a single number, a rough characterization is that a 1 percentage point increase in the effective business tax rate induces a 1 percent decrease in the stock of plant and equipment. In other words, the ''modal study,'' to use an unscientific concept, finds an elasticity coefficient of 1.0.
However, some scholars detect significantly larger effects. Grubert and Mutti estimated an elasticity coefficient of 3.0. In another paper, Hines (1996b) estimates a one percentage point change in a state's tax rate has a 10 percent impact on the state-by-state location of foreign direct investment entering the United States. Finally, in a paper studying the effect of taxation and corruption on direct investment flows from 14 countries to 34 ''host'' countries, Wei (1997) estimates an elasticity of 5 for the impact of the host country's tax rate on inward foreign direct investment by multinational firms.
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To summarize: production location decisions are highly sensitive to effective tax rates. We cannot definitely say that the response rate is 1-for-1, 3-for-1, or higher. In our judgment, a response rate of 3-for-1 (the Grubert-Mutti parameter) may be high, but it is not out of the ballpark.
Textbook Approach Based on Export Elasticity Parameters
The last approach is the familiar textbook approach based on export demand and supply elasticities for estimating the impact of an exchange rate, price, or tax change on exports. Our use of this approach to calculate the benefits of the Export Source Rule is based on the quantitative analysis of the former Domestic International Sales Corporation (DISC) undertaken by the U.S. Department of the Treasury (1983). The DISC was replaced in 1984 by the present-day Foreign Sales Corporation (FSC). The U.S. Treasury (1993) adopted a similar approach to evaluate the FSC in the period 1985 to 1988.
The Treasury studies use simple demand-supply balance models to calculate the impact of tax provisions on U.S. exports. In this approach, familiar price elasticities of demand and supply for exports determine the responsiveness of export sales to changes in after-tax profits. In Table 3, we assume a profit-to-export-sales ratio of 0.12 for exports.(see footnote 47) Also, we assume ''high'' values of the price elasticities of demand and supply for U.S. exports of manufactures,– 10 and 20 respectively, in order to calculate the largest possible impacts consistent with the export elasticities approach.(see footnote 48) Finally, we assume that the Export Source Rule is used by only 25 of the Fortune Top 50 U.S. Exporters (the same assumption made for the Grubert-Mutti approach).
Applying the export elasticities approach to the 25 U.S. exporters indicates that the Export Source Rule supported $228 million additional exports per company in 1992, or $5.7 billion additional exports for the 25 firms (Table 3). With regard to U.S. jobs, the estimates based on the export elasticities approach indicate that about 88 thousand U.S. jobs were supported by the Export Source Rule in 1992. The aggregate earnings premium for U.S. workers attributable to the Export Source Rule was $0.3 billion in 1992. The figure for 1999 is $0.3 billion (see Table 4).
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3. Comparison of Approaches
In our judgment, the export response suggested by the Kemsley findings, about $30 billion in 1999 (see Table 4), best captures the likely long-run contribution of the Export Source Rule to U.S. export performance. The calculations grounded on Kemsley's analysis reflect direct empirical observation. Also, Kemsley explores the impact of the Export Source Rule without imposing a theoretical framework on his econometric equations, and he examines a very large number of companies, pooled across nearly 10 years. Finally, Kemsley also takes into account factors other than tax rules that affect the export performance of different companies.
That said, the calculations grounded on Kemsley's analysis will strike many experts as ''too high.'' The reason for this impression is that the estimated export effects are much larger, relative to the loss of tax revenue, than can be derived by application of the familiar textbook model which relies on export demand and supply elasticities. In our view, the fact that Kemsley's findings cannot be squared with textbook models is a reason for questioning the textbooks, not an argument for discarding Kemsley's results.
Our view is based on two considerations. In the first place, the calculations of additional exports that are grounded on the Grubert-Mutti production response coefficients are even larger than the Kemsley estimates. The Grubert-Mutti production response coefficient of 3.0 is somewhat larger, but in the same range, as production response coefficients estimated by other scholars. The ''modal'' production response coefficient of 1.0 would indicate export effects one-third the size of the figures presented for Grubert-Mutti in Table 4, but still about twice the size of the textbook export elasticities approach.
The second consideration in favor of Kemsley's results is that the textbook demand and supply elasticity model may be better suited to the measurement of responses to ''transitory'' fluctuations in exchange rates and inflation rates, than to ''permanent'' (or at least semi-permanent) changes in tax variables.
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4. Cost and Benefit Forecasts, 1998–2002
Forecasts of the U.S. export and employment-related benefits of the Export Source Rule derived from the three different approaches to estimating the benefits are presented for the 5-year period 1998 to 2002 in Table 4. These forecasts of benefits are based on the estimates for 1992 presented in Tables 1, 2, and 3. Specifically, the export benefit estimates for 1992 are projected forward to the years 1998–2002 using the observed average annual rate of growth of U.S. manufactures exports during 1992–96 (about 9 percent).(see footnote 49) The employment and earnings benefit estimates for 1992 are projected forward using observed average annual rates of growth of both U.S. manufactures exports and U.S. labor productivity during 1992–1996 (about 4 percent for labor productivity).
For 1999, the calculated additional exports attributable to the Export Source Rule range between a high value of $57.1 billion based on the production response approach (Grubert-Mutti parameters) to a low value of $10.4 billion based on the textbook approach (export elasticity parameters). Throughout the 5-year forecast period, the additional exports calculated using the Kemsley parameters fall about equidistant between the estimates found using the other two approaches.
The 5-year forecasts of employment and earnings also reveal the centrality of the jobs and worker earnings calculated using the Kemsley estimates. Thus, in the year 1999, the Export Source Rule is forecast to support central figures of nearly 360 thousand manufacturing jobs and about $1.7 billion in premium wages and salaries for manufacturing workers employed in export-oriented industries.
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Forecasts of the U.S. tax revenue costs attributable to the Export Source Rule for the 5-year period 1998–2002 are also presented in Table 4. These tax revenue forecasts, which are projections by the Treasury (OMB 1997), are supposed to reflect obvious changes in business behavior.(see footnote 50) If the Export Source Rule is repealed, U.S. companies would exclude up to 15 percent of their export profits from U.S. taxation by selling exports through a Foreign Sales Corporation. Accordingly, both Treasury and JCT revenue forecasts reflect an adjustment for greater use of Foreign Sales Corporations.
In our view, the tax revenue forecasts should be further reduced to reflect the additional revenues the Treasury collects from individual workers who enjoy premium earnings attributable to the Export Source Rule. While this is not a ''standard'' adjustment, it is justified by the fact that export jobs pay higher wages and salaries on average than other jobs. Therefore, Table 4 presents forecasts of the appropriate tax revenue offsets and adjusted net U.S. tax revenue for the 4-year period 1999–2002. We start with 1999 because that is the first year when repeal of the Export Source Rule would have its full impact. The revenue offsets are estimated by applying the relevant marginal U.S. income tax rate for individuals (21.5 percent) to the estimates in the table of additional U.S. earnings supported by the shift in output towards export industries as a consequence of the Export Source Rule.(see footnote 51) The adjusted revenue forecasts are calculated to be the standard revenue forecasts minus the revenue offsets.
It is apparent from the estimates presented in Table 4 that the magnitude of the revenue offsets associated with the Export Source Rule depends importantly on which method of estimating U.S. export and employment-related benefits is assumed. Based on the Kemsley estimates of Export Source Rule benefits, the tax revenue offsets are estimated at $0.4 billion in 1999, increasing to $0.5 billion by the year 2002. Based on the Grubert-Mutti estimates of Export Source Rule benefits, the tax revenue offsets are estimated at $0.7 billion in 1999, increasing to $0.9 billion by the year 2002. And finally, based on the textbook elasticities approach, the tax revenue offsets are estimated at $0.1 billion in 1999, increasing to $0.2 billion in 2002.
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The adjusted revenue forecasts provide the most appropriate basis for judging the final budgetary costs of the Export Source Rule to the U.S. Treasury, because the adjusted figures take into account the substantial tax revenues that will be collected from individuals who enjoy premium wages and salaries, so long as the Export Source Rule remains in place. The adjusted revenue forecasts based on the textbook elasticities approach are not much different from the standard Treasury and JCT revenue forecasts. However, the adjusted revenue forecasts based on the Kemsley estimates and the Grubert-Mutti estimates are significantly lower than the standard revenue forecasts about 25 percent lower in the case of the forecasts based on the Kemsley estimates and about 50 percent lower in the case of the forecasts based on the Grubert-Mutti estimates.
5. Conclusions
This report has assessed the medium-term cost and benefits of the Export Source Rule, based on the findings of two recent econometric studies, and the older more traditional textbook approach. Our calculations indicate that, for a plausible range of estimates, the Export Source Rule supports significant U.S. exports, jobs, and worker earnings all at costs to the U.S. Treasury that are lower than usually estimated. For example, in the year 1999, for an adjusted net revenue cost of $1.1 billion (based on Kemsley's estimates), the United States will ship an additional $30.8 billion of exports, support 360 thousand jobs, and add $1.7 billion to worker payrolls in the form of the export earnings premium.
One key to these broad conclusions is the fact that export-oriented industries and jobs are highly productive, partly because U.S. producers and workers engaged in export production face the considerable discipline of highly competitive international markets for traded goods and services. A second key is the sensitivity of plant location to the tax environment. Not right away perhaps, but over a period of years a country that penalizes export production with high taxes will forfeit first investment and then export sales.
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References
Fortune. 1995. ''The Top 50 U.S. Exporters,'' Fortune, November 13, 1995, pp.74–75.
Goldstein, M., and M. Khan. 1985. ''Income and Price Effects in Foreign Trade,'' in Handbook of International Economics, Vol. II, eds., R.W. Jones and P.B. Kenen (Amsterdam: North-Holland).
H. Grubert, and J. Mutti. 1996. ''Do Taxes Influence Where U.S. Corporations Invest?,'' Paper prepared for the Conference on Trans-Atlantic Public Economics Seminar, Amsterdam, Netherlands, May 29–31, 1996 (revised August 1996), mimeo.
Haberler, G. 1936 (Originally published in German, 1933). The Theory of International Trade with its Applications to Commercial Policy (London: William Hodge and Co.).
Hines, J.R. 1996a. ''Tax Policy and the Activities of Multinational Corporations,'' Working Paper 5589, National Bureau of Economic Research, May 1996.
———, 1996b. ''Altered States: Taxes and the Location of Foreign Direct Investment in America,'' American Economic Review 86(5), December 1996.
JCT (Joint Committee on Taxation). 1996. Estimates of Federal Tax Expenditures for Fiscal Years 1997–2001, November 26, 1996
Kemsley, D. 1997. ''The Effect of Taxes on Production Location,'' Columbia University, January 1997, mimeo.
OMB (Office of Management and Budget). 1996. ''Tax Expenditures,'' Budget of the United States Government: Analytical Perspectives, Fiscal Year 1997, February 5, 1996.
———. 1997. Budget of the United States Government, Fiscal Year 1998, February 6, 1997.
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Ohlin, B. 1933. Interregional and International Trade (Cambridge, Massachusetts: Harvard University Press).
Richardson, J.D., and K. Rindal. 1996. Why Exports Matter: More! (Washington, D.C.: Institute for International Economics and The Manufacturing Institute).
Rousslang, D.J. 1994. ''The Sales Source Rules for U.S. Exports: How Much Do They Cost?,'' Tax Notes, February 21, 1994.
Stern, R.M., and J. Francis. 1976. Price Elasticities in International Trade: An Annotated Bibliography (London: Macmillan for the Trade Policy Research Centre).
U.S. Department of Commerce, Bureau of the Census, Economics and Statistics Administration. 1996a. Statistical Abstract of the United States 1996.
———, Economics and Statistics Administration. 1996b. U.S. Jobs Supported by Exports of Goods and Services 19: 83–94, November 1996.
———, Economics and Statistics Administration. 1996c. ''Operations of U.S. Multinational Companies,'' Survey of Current Business, December 1996.
U.S. Department of the Treasury. 1983. The Operation and Effect of the Domestic International Sales Corporation Legislation: 1981 Annual Report, July 1983.
———. 1993. The Operation and Effect of the Foreign Sales Corporation Legislation: January 1, 1985 to June 30, 1988, January 1993.
Wei, S. 1997. ''How Taxing is Corruption on International Investors?'' Kennedy School of Government, Harvard University, January 9, 1997. Mimeo.
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Chairman ARCHER. Thank you, Mr. Hufbauer.
Our last witness on this panel is William Barrett. Your name is not at all unfamiliar to those of us in the Congress today because we enjoy serving with your father and we are delighted to have you before the Committee.
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Mr. Barrett, you may proceed.
STATEMENT OF WILLIAM C. BARRETT, DIRECTOR OF TAX, EXPORT, AND CUSTOMS, APPLIED MATERIALS, INC., SANTA CLARA, CALIFORNIA; ON BEHALF OF EXPORT SOURCE COALITION
Mr. BARRETT. Thank you, Mr. Chairman and Members of the Ways and Means Committee. My name is William Barrett and I am director of tax, export and customs for the Applied Materials, Inc.
Applied Materials is the world's largest producer of semiconductor manufacturing equipment with operations in over 13 countries. We make the machines that make the semiconductors. We are on the bottom of that pyramid. And the company employs over 12,000 people, 9,500 of which are in the United States.
We have manufacturing and R&D facilities in Austin, Texas; Santa Clara, California; we have research and development centers in Korea, Taiwan, Israel, as well as Europe and Japan.
Our 1996 revenues were $4.1 billion, two-thirds of these sales were overseas sales—29 percent to Asia, other than Japan, and Japan was 24 percent; and Europe was 16 percent. I relate this information to illustrate the importance of the global marketplace to the company as well as the relationship between the number of jobs in the United States which are approximately 80 percent and our level of export activity. How did this opportunity come about today to speak to you? I have been in Silicon Valley for approximately 12 years and I am the tax guy in the trenches. I deal with the day to day tax matters, compliance related both in domestic and foreign issues, transfer pricing, managing audits around the world. About 1 year ago I had an opportunity to join a group, a joint public/private effort, called Joint Ventures Silicon Valley, in which we deal with issues that are important to the private and public sector within Silicon Valley.
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I was tasked to join the Federal Tax Committee within that group and for 1997 one of our tasks was to deal with simplification in the foreign area. It was about that time that the foreign source income rule, the export source rule was proposed. And it quickly became a hot topic within the group because it fit clearly within the interests of Silicon Valley companies and repeal would represent an increase in the aftertax costs of doing the export activities.
It also seemed contrary to simplification, which I will get to in 1 minute. When analyzing the export source rule, there are certain characteristics that stand out. First, you only get the benefit from the foreign source income if you manufacture and export. Because we are dealing with Silicon Valley companies, R&D activity is closely associated with manufacturing. So, we have three important components—manufacturing, R&D, as well as export activity.
It also tends to mitigate the negative impact associated with double taxation. The United States taxes income on a worldwide basis and it is taxed a second time when income comes back into the United States in the form of a distribution or dividend. And this rule tends to mitigate the other negative impediments to computing the foreign tax credit such as allocation of U.S. expenses to this foreign income.
I mentioned simplification, and in my mind this rule also helps in the simplification mode because it tends to level the global rate of tax on income taxed both in the United States and overseas to 35 percent. And, therefore, capital investment decisions become easier if you are looking at a 35-percent rate, regardless of where you invest.
Two arguments have been proposed in favor of repealing the rule. From the language of the proposal we hear that U.S. multinational exporters have a competitive advantage over U.S. exporters that conduct all of their business activities in the United States.
The key issue here is the U.S. exporter, without foreign operations, does not pay a foreign tax. So, using the reasoning of the proposal, U.S. multinationals are at a competitive disadvantage because the tax is an increased cost of doing business. And it is only through the foreign source income rule that we can get that rate down to 35 percent.
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There has been an argument put forth that our tax treaties protect us against double tax and, therefore, we do not need the export source rule any more.
Treaties do help when we allocate profits around the world on a transfer pricing basis. That is, which country gets their proper due based on functions performed. Most treaties will then refer to the foreign tax credit mechanism in the United States to mitigate the impact of double taxation.
But in this context, it does not define how to do that. The treaty does nothing in terms of defining how to do that, and the foreign source income rules are a key component to mitigate that double taxation.
Back into the tax trenches. Every year I have a review with our board of directors and we review risks and opportunities, and a key component of that analysis is the analysis of the components of the global tax rate, the worldwide tax rate.
And also over time as our foreign operations have increased, the foreign operations become a bigger component of that rate. The foreign tax credit is a key component in the analysis of the tax rate. If the foreign source income is repealed, the board will ask, Well, why did the tax rate go up? I will have to answer honestly, It was because of the repeal of the foreign source income rule which increases the U.S. tax cost, and the repeal really represented an increase in manufacturing costs in the United States.
This activity will be repeated across boardrooms in America. There will be some companies that are more sensitive to the aftertax rate of return and, as a result, will tend to migrate manufacturing operations offshore.
Other companies like Applied Materials, they may not have a direct response to that but at a minimum, what will happen is our support functions, supporting our customers, which are the chipmakers around the world, that support function is going to move offshore. There will be more foreign activity related to that support activity.
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That concludes my comments, Mr. Chairman, and I appreciate the opportunity.
[The prepared statement follows:]
Statement of William C. Barrett, Director of Tax, Export, Customs, Applied Materials, Inc., Santa Clara, California; on Behalf of Export Source Coalition
Mr. Chairman and members of the Ways and Means Committee, my name is William Barrett and I am Director of Tax, Export and Customs for Applied Materials, Inc. Applied Materials is the world's largest producer of semiconductor manufacturing equipment with operations in over 20 countries. The company is the largest producer of wafer fabrication systems and services for the worldwide semiconductor industry and employs over 12,000 people, with over 9,500 in the United States. In addition to corporate manufacturing facilities in Austin, Texas and Santa Clara, California, Applied Materials maintains research and development centers in Europe and Japan, as well as technology centers in Israel, South Korea, and Taiwan.
Our 1996 revenues were $4.1 billion, a 35-percent increase over 1995 revenues. More than two-thirds of Applied Material's sales in 1996 were overseas: 16 percent in Europe, 15 percent in Asia-Pacific (Taiwan, Singapore, and Taiwan) and 14 percent in South Korea. The North American market accounted for 31 percent.
I recite these statistics to illustrate the importance of the global marketplace to Applied Materials. Our company competes with the world's best every day. One of the tools we use in this intense competition is the export source rule, which we believe contributes to the success of not only Applied Materials, but to many other U.S. exporting companies. Applied Materials believes that the export source rule is sound public policy and should be retained.
The United States high-tech industry is innovative, highly profitable, drives academic institution curriculum and excellence, produces high paying jobs, produces a tremendous volume of exports, and serves as a model to the world. United States Government policies that discourage these U.S. based activities risk impeding very desirable attributes and drivers in the U.S. economy. Government policies that encourage these attributes will obviously promote these attributes.
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Profile of a Typical High-Tech Silicon Valley Equipment Manufacturer
A Silicon Valley high-tech start up company begins with an innovative idea. This idea may or may not have large market potential in the early life cycle of the company. Those companies destined to become successful will either have a product that is ready for the current market or the product idea will create a new market. High-tech products change every 1–5 years because industry innovation and global markets are constantly evolving. Successful companies at each stage of the high-tech food chain must adapt and constantly improve their product lines. High-tech companies that do not adapt or evolve their product lines do not survive.
High-tech is an integrated industry with numerous companies occupying a critical niche. For example, semiconductor equipment companies supply the semiconductor chip companies and the chip makers in turn provide the means for computers to perform complex software functions ranging from number crunching to multimedia. The explosion of the Internet and networking companies that link computers has been a more recent evolution in the high-tech industry. Computer software companies have been both pushing the semiconductor industry as well as adapting new software applications to existing computer capability. At each component stage, companies must keep pace with evolution and product cycles to survive. As these cycles repeat and new products and markets are created, residual markets from prior product cycles remain and as a result, the absolute market size and opportunity increases.
The profile of a high-tech multinational is no different from the above description but for the fact it either competes in or develops markets in multiple countries. To be successful in countries outside the United States, the multinational must understand different markets and adapt its corporate structure to accommodate those markets. A not uncommon profile as product lines evolve and/or the multinational adapts to foreign markets is that specific segments of manufacturing may be located offshore.(see footnote 52) These segments may be older products lines or components of a product that are produced more efficiently offshore. In most cases, newer product lines, and the requisite research and development, remain in the United States and close to development centers.
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Silicon Valley high-tech companies do not structure their global operations solely on the basis of local country tax rates. For example, as high-tech product lines mature, investment in alternate manufacturing sites is a natural process of growth and diversification of risk. However, this statement should not be interpreted to mean tax rates do not play a significant role. An increase in U.S. tax increases the cost of business in the U.S. and if a company is to maintain an after tax shareholder return, it must evaluate lower cost site locations. Populist rhetoric often characterizes U.S. industry as intent on the wholesale migration of manufacturing to offshore locations with the sole purpose of minimizing corporate income tax when in reality, companies are trying to remain competitive in a global market and taxes represent only one, albeit a significant, cost of doing business.
An analysis of a new manufacturing location will involve a comparison of factors such as the following:
• labor skills, consistent with the demands of product technical requirements
• labor productivity
• cost of labor
• cost of land and construction costs
• financial and physical infrastructure (e.g., highway and airport)
• proximity to customers and the market
• protection of intellectual property
• taxes
In reviewing this list, the superordinate goal of generating additional sales revenue and global market share should not be overlooked. Any successful high-tech company is in the business of selling product and increasing financial return to its investors and when taxes reduce potential return, they play an increased roll in the decision making process. A company that makes sensible investment decisions based on after tax returns that improve the ability to competitively price product stands a good chance to improve its market share.
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Administration's Proposal To Repeal the Export Source Rule
President Clinton's FY 1998 budget proposal contains a provision that would eliminate the current export source rule, which allows 50 percent of the income from the sale of goods manufactured in the U.S. and exported to be considered ''foreign source income.'' The proposal would instead source income from export sales under an ''activity based'' standard—effectively eliminating the export source rule. ''Activity based'' sourcing is not defined in the proposal but might be patterned after a current income tax regulation example.(see footnote 53) For U.S. exporters with excess foreign tax credits, the export source rule alleviates double taxation, and thereby operates as an export incentive for U.S. multinationals. The export source rule only applies if companies manufacture goods in the U.S. and export them. In the case of high-tech companies this usually means the company is also performing substantial R&D in the U.S.
The Administration makes the following argument in support of repeal:
This export source rule provides a benefit to U.S. exporters that operate in high-tax foreign countries. Thus, U.S. multinational exporters have a competitive advantage over U.S. exporters that conduct all their business activities in the United States.
There are at least three flaws in this argument. First, companies without foreign operations do not face the double taxation the export source rule is designed to alleviate. Thus, the rule does not create a competitive advantage; it levels the playing field. Double taxation increases the cost of doing business offshore and therefore the multinational with foreign operations becomes less competitive without benefit of the export source rule. Second, a company without foreign operations may be a start-up that has not entered global markets. This new company cannot be compared to a large and well established multinational. As the new company grows into global markets, it too will benefit from the export source rule. Finally, the argument in favor of eliminating the export source rule fails to take into account additional [non-tax] expenses that will be incurred by the multinational with foreign operations. Selling, marketing, administrative expenses associated with a foreign location, and product adaptation to local market, all must be incurred to support the local market. The conclusion is inescapable that establishing foreign operations will produce additional operating costs. Although operating costs will increase with foreign operations, the reality is that a U.S. manufacturing company cannot compete for global market share without establishing offshore operations. The resulting increased global market share increases high paying R&D and manufacturing jobs in the United States.
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Tax Treaties Are No Substitute
The Administration has stated that the United States income tax treaty network protects export sales income from tax in the foreign country where the goods are sold and thus protects companies from double taxation. They argue that the export source rule is no longer necessary as a result of this treaty protection.
We strongly disagree that the treaty network is a substitute for the export source rule, but even if it were, the network is far from complete. The United States treaty network is limited to 56 countries, leaving many more countries (approximately 170) without treaties with the United States. Moreover, many of the countries without treaties are developing countries, which are frequently high growth markets for American exporters. For example, the United States has no treaty with any Central or South American country.
With or without a tax treaty, under most foreign countries' tax laws, the mere act of selling goods into the country, absent other factors such as having a sales or distribution office, does not subject the United States exporter to income tax in the foreign country. Thus, export sales are not the primary cause of the excess foreign tax credit problem which many companies face in trying to compete overseas.
The real reason most multinational companies face double taxation is that U.S. tax provisions unfairly restrict their ability to credit foreign taxes paid on these overseas operations against their U.S. taxes. Requirements to allocate a portion of the costs of U.S. borrowing and research activities against foreign source income (even though such allocated costs are not deductible in any foreign country), cause many companies to have excess foreign tax credits, thereby subjecting them to double tax—i.e. taxation by both the United States and the foreign jurisdiction.
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As I explained earlier in my testimony, the export source rule alleviates double taxation by allowing companies who manufacture goods in the United States for export abroad to treat 50 percent of the income as ''foreign source,'' thereby increasing their ability to utilize their foreign tax credits. Thus, the rule encourages these companies (facing double taxation as described above) to produce goods in the U.S. for export abroad.
As an effective World Trade Organization-consistent export incentive, the export source rule is needed now more than ever to support quality, high-paying jobs in U.S. export industries. Exports have provided the spark for much of the growth in the United States economy over the past decade. Again, the existence of tax treaties does nothing to change the importance of this rule to the United States economy.
The decision to allow 50 percent of the income from export sales to be treated as ''foreign source'' was in part a decision based upon administrative convenience to minimize disputes over exactly which portion of the income should be treated ''foreign'' and which should be ''domestic.'' The rule still serves this purpose, and neither the tax treaty network nor the Administration's proposal to adopt an ''activities-based'' test for determining which portion of the income is ''foreign'' and which is ''domestic'' addresses this problem. Moreover, adopting an ''activities-based'' rule would create endless factual disputes similar to those under the section 482 transfer pricing regime.
Tax treaties are critically important in advancing the international competitiveness of U.S. companies' global operations and trade. In order to export effectively in the global marketplace, most companies must eventually have substantial operations abroad in order to market, service or distribute their goods. Tax treaties make it feasible in many cases for business to invest overseas and compete in foreign markets. Foreign investments by U.S.-based multinationals generate substantial exports from the United States. These foreign operations create a demand for U.S. manufactured components, service parts, technology, etc., while also providing returns on capital in the form of dividends, interest and royalties. Tax treaties are not a substitute for the export source rule. They do not provide an incentive to produce goods in the United States. Nor do they address the most significant underlying cause of double taxation—arbitrary allocation rules—or provide administrative simplicity in allocating income from exports.
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Capital Export Neutrality
In an ideal income tax system, income tax would not influence how a company structures transactions or where the company decides to build a manufacturing plant. Investment decisions would be influenced by other economic factors such as those listed above. To eliminate income tax from the investment location decision it would be necessary to structure the system such that the global tax rate on income earned anywhere in the world is no different than the domestic rate of tax. A system patterned after the ''capital export neutrality'' (CEN) concept would achieve this result.(see footnote 54)
The CEN concept holds that an item of income, regardless of where it is earned, will not suffer a global rate of tax higher than the United States tax rate. Dividends received from both high and low tax countries suffer a double taxation first in the country in which the income was earned and second in the United States when received. The credit for foreign tax paid is designed to mitigate this double taxation. The export source rule operates to increase the credit for foreign taxes paid which in turn operates to more closely align the United States tax system with the concept of CEN. With sufficient foreign source income, the global rate of income tax on income earned in high tax countries approaches 35 percent.
A classical tax system that diverges from the CEN concept will increase the importance of income tax in plant location decision making. If the export source rule is repealed, the double taxation of U.S. multinationals that export from the United States will increase and for many high-tech companies this increase in taxes, and corresponding reduction in return to shareholders, will alter plant investment decisions. Many companies will be forced to invest offshore rather than build new plants in the United States to remain competitive and maintain shareholder rate of return. Foreign investment decisions will have a ripple effect within the high-tech industry because the industry is so closely interrelated. For example, a natural consequence of additional offshore investment by a semiconductor manufacturer will be that equipment suppliers will increase their offshore presence to meet the demands of their customers. This dynamic will be repeated in other segments of the industry creating a foreign investment multiplier effect.
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Summary
The United States high-tech industry is innovative, highly profitable, drives academic institution curriculum and excellence, produces high paying jobs, produces a tremendous volume of exports, and serves as a model to the world.(see footnote 55) United States Government policies that discourage these U.S. based activities risk impeding very desirable attributes and drivers in the United States economy. Government policies that encourage these attributes will obviously promote these attributes.
The elimination or scaleback of the export source rule will have a negative tax impact on U.S. multinationals that export U.S. manufactured product. For many companies this will result in a tax disincentive to manufacture in the United States vis-à-vis other countries with lower tax rates and is contrary to a ''capital export neutrality'' model which holds income tax should play a minor role in plant location decision making. Repeal of the export source rule would elevate the importance of taxes in offshore plant location decision making, and is contrary to tax simplification within a ''capital export neutral'' model.(see footnote 56)
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Mr. MCCRERY [presiding]. Thank you.
We have a vote on the floor, followed by 5-minute votes, so my suggestion is that we try to ask one question each, our most important question. Actually, Mr. Barrett, you just answered mine which is—and if either of the other witnesses disagree I would like for you to chime in—but my question was going to be, Do you think, as a result of the passage of the administration's proposal, that we would see U.S. businesses moving some of their operations offshore, and you just said that that would be a logical result. Do the other two of you agree with that?
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Mr. OBERHELMAN. Yes, I would agree that over time that is a likely scenario.
Mr. MCCRERY. And with them, of course, would go the American jobs——
Mr. OBERHELMAN. The wage premium for those export jobs that my colleague to my right has discussed.
Mr. MCCRERY. OK. Mr. Levin.
Mr. LEVIN. Mrs. Thurman has been waiting. So, I will simply ask a question and ask you not to answer it now and then yield to Mrs. Thurman.
The Secretary was here a few weeks ago and we raised this issue with him and he indicated he thought that the availability of foreign sales corporations and the existence of tax treaties obviated the need or changed much the situation from the original passage of the export source rule. So, let me yield to Mrs. Thurman, and if any of you have any thoughts on that, we would appreciate your input.
Mr. MCCRERY. Mrs. Thurman.
Mrs. THURMAN. Thank you.
Mr. Oberhelman, since this is my first year here and I am not a tax attorney, some of this seems a little crazy to me. I have heard everything you said an expert source rule supports like the WTO, better jobs in America, better productivity, and all those effects you said would occur.
However, it is hard for me to think that the President, who has, in fact, supported all of these issues in the past, probably to objections of some people within this Congress—we are getting ready to debate things like fast track and things of that nature, which I am sure you are supportive of—and he is out there doing those debates.
There is something wrong with this debate we are having today. Why would the President suggest a revenue raising source that seems to be totally different from what he believes is happening right in America?
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He is substituting the source rule with an activity-based tax. Yet, I hear nothing being said about why that would not complement what is going on, and I know I am getting into a long discussion here but I need to understand your reasoning.
Mr. OBERHELMAN. Yes. I guess my flippant response would be, We do not understand why the administration is doing it either. But let me continue, just the same. The problem we have with activity-based accounting is it is very subjective. And when we move into something like that there is always an argument, we have been there before on other issues where it is your opinion versus mine.
And there is really no formula approach to that and I guess maybe I would make a short answer like that and defer to the other two on the panel.
Mr. BARRETT. My fear in the activity-based reference to that is that it has not been defined, as you point out, which is scary to me. Being a tax person, we do not know what to expect. There is some case law that would suggest for a lot of high-tech companies that the result will be no foreign source income.
Mrs. THURMAN. So, to some degree, you cannot say with certainty that what he has proposed may be adversary to what your ideas are today?
Mr. HUFBAUER. Could I briefly address that?
There is a tremendous disjuncture. The reason the export source rule is in this hodge-podge of tax proposals is that it has been listed as a tax expenditure for many years in the budget. The administration just went down the list of tax expenditures and put together a number which was large enough to cover the spending side and the tax cut side of its agenda.
Not a lot of thought went into it. It was just a disjuncture, not recognizing that the whole WTO agenda and the whole export market access agenda are totally at odds with what is happening over here in the tax law.
And then the administration advanced these ad hoc explanations about the treaties and the foreign sales corporation to respond to Congressman Levin's question. And they are just wrong. The treaties do not compensate, and the foreign sales corporation offers about 10 percentage points less benefit. Our calculations reflect the assumption that corporations would alternatively use the foreign sales corporation and we still get a large adverse impact.
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Mr. MCCRERY. Mr. Christensen.
Mr. CHRISTENSEN. Mr. Chairman, because of time I wanted to say to you first of all, welcome to the Committee and it is good to see another Nebraskan around here.
From your point of view, have you done any examination concerning the export source rule to the current status of the activity-based rule the President has suggested? How would that affect your company if you have run the numbers?
Mr. BARRETT. Based on the evidence I do have, and it is with reference to a couple of cases that have been settled in the area, and that is, again, we do not have any definition on what activity based is.
Mr. CHRISTENSEN. Right.
Mr. BARRETT. But, assuming the worst, and they use something like that, like this case law, then we would get zero, zero foreign source income.
Mr. CHRISTENSEN. And two-thirds currently, you said two-thirds of your——
Mr. BARRETT. Two-thirds of our sales are export.
Mr. CHRISTENSEN [continuing]. Are export?
Mr. BARRETT. That is correct.
Mr. CHRISTENSEN. And under the activity-based rule, your company would receive zero?
Mr. BARRETT. Would most likely not benefit at all.
Mr. CHRISTENSEN. At all?
Mr. BARRETT. Right.
Mr. CHRISTENSEN. A $4 billion company and high-tech industry.
Mr. BARRETT. A $4 billion company, that is right.
Mr. CHRISTENSEN. Zero benefit from that activity based.
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Mr. BARRETT. I may be a bit cynical in that regard but I have seen reference, activity-based sourcing in the context of these two cases.
Mr. CHRISTENSEN. As you learn more about activity source basing and as we learn more about the President's proposal, I would be interested in listening to your written testimony and looking at your written testimony as a followup to see if there is and what is the significance of the difference of the two rules and the two ideas.
Mr. BARRETT. I would be happy to do that.
Mr. CHRISTENSEN. Thank you.
Thank you very much, gentlemen, for a very compelling testimony.
[Whereupon, at 1:34 p.m., the hearing was adjourned.]
[Submissions for the record follow:]
Statement of the Ad Hoc Coalition of Utilities for Capital Formation
The Administration's Fiscal Year 1998 Budget includes a proposal to deny interest deductions on certain debt instruments that are widely used by the electric utility industry and others.(see footnote 57) The Coalition strongly opposes this proposal on the grounds that it would increase the cost of capital to the industry, slowing investment and inhibiting international competition. Moreover, the proposal would restrict the financing options available to the electric utility industry at a time when this industry requires flexibility to adjust to an increasingly deregulated and competitive global marketplace. The Administration's proposal represents an arbitrary departure from established tax principles, and inappropriately relies on non-tax accounting considerations to justify its result. For these reasons, the proposal should be rejected to preserve the ability of electric utilities and others to raise flexible low-cost capital.
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Summary of the Administration's Proposal
The Administration's proposal would reclassify debt as equity if the debt has a term of more than 15 years, and is not shown as indebtedness on the separate balance sheet of the issuer. The proposal would only apply to corporations that file annual financial statements with the Securities and Exchange Commission (''SEC''), and the relevant balance sheet is the balance sheet filed with the SEC. The proposed effective date is for instruments issued on or after the date of first committee action.
I. The Administration's Proposal Would Affect Debt Instruments Widely Used by Electric Utilities
Electric utilities have issued debt instruments widely known as ''Capital Securities,'' in the form of Monthly Income Preferred Shares'' (''MIPS''), ''Quarterly Income Preferred Shares'' (''QUIPS''), and ''Trust Originated Preferred Securities'' (''TOPrS''), to strengthen balance sheets and provide flexibility in meeting capital requirements. While it is clear that Capital Securities meet all the requirements to be classified as debt under current law, the Administration's proposal would treat MIPS, QUIPs, and TOPrS as equity, with the result that issuers would be denied deductions for interest payments on these instruments. The effect of denying deductions for corporate earnings paid out to investors is to subject the payments to multiple levels of taxation (once in the hands of the corporation and again when paid to the investor). In turn, multiple taxation raises financing costs to the issuer.
A. Background: In View of Increasingly Competitive Markets, Electric Utilities Require Maximum Flexibility in Financing Options
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1. Electric utilities are in the midst of a revolutionary process to transform a government-regulated system to a competitive marketplace. In 1992, Federal legislation (the Comprehensive National Energy Policy Act) opened the electric utility industry to increased competition at the wholesale level by requiring electric utilities to share their transmission lines with other utilities. The 1992 Federal law left authority over retail competition to the states. At last count, 47 of the 50 states were considering some form of deregulation of their electric utility industries. Even in advance of state action, however, retail competition has been spurred by companies acting as brokers of interstate electricity sales (''power marketers''). In 1992, there were only eight power marketers; today there are about 250.(see footnote 58) Further, many argue that additional Federal legislation may be required to allow states to implement policies they enact (e.g., repeal of the Public Utility Holding Company Act that governs utilities operating in more than one state). It is clear that the electric utility industry is facing a fundamental change in the regulatory system.
2. The electric utility industry must be afforded maximum flexibility to prepare for handling the transition costs associated with deregulation. In preparing for the potential benefits of deregulation B increased customer choice and lower prices for electricity B electric utilities will face costs associated with building new infrastructure, developing new services, and reorganizing to meet competition. Further, there is an on-going and public debate about the electric utility industry's ability to recover the ''strandable'' costs of investments that were made to meet regulatory obligations, with the expectation that regulation would provide an opportunity for full cost recovery. These strandable costs represent a potential loss in asset value of investments that may become uneconomic as the result of deregulation.
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B. Electric Utilities Have Utilized Capital Securities To Help Issuers Maintain Investment Grade Credit Ratings
Typically, Capital Securities are issued to outside investors by a special purpose entity. In the case of TOPrS, for example, a company utilizing these instruments issues debt obligations to a trust that, in turn, issues trust securities (i.e., TOPrS) to investors. The transaction is structured in this way to improve the attractiveness of the securities to the public. The borrowing between the trust and the company is subordinated to the company's other debt, has a stated maturity, and bears a market rate of interest that is equal to the return on the securities issued to the trust's outside investors. Although the company usually has the option to defer interest payments for up to five years without going into default, the company is unconditionally obligated to pay interest to the trust, out of which the trust pays a return to the outside investors.
Capital Securities are characterized as ''minority interest'' (rather than debt) for non-tax accounting purposes, although the status of the obligations as indebtedness is clearly disclosed in a footnote to the company's balance sheet as debt. Also, for purposes of determining its overall credit rating, the borrower receives more favorable treatment from rating agencies then it would for the issuance of senior debt. Very generally, the favorable treatment by rating agencies is due to the relatively long term (usually 30 or 40 years), subordination, and the borrower's ability to defer interest payments for a period of time. For Federal income tax purposes, however, it is clear that Capital Securities qualify as debt, the interest on which is deductible.
II. The Administration's Proposal To Treat MIPS, QUIPS, and TOPrS As Equity Represents a Radical Departure From Accepted Tax Policy
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A. The Internal Revenue Service (''IRS'') Has Reviewed and ''Approved the Treatment of Capital Securities as Debt
Under case law, as properly summarized by the IRS in Notice 94–47, the characterization of an instrument as debt or equity depends on all surrounding facts and circumstances; no particular factor is viewed as conclusive.(see footnote 59) Notice 94–47, which adopts the approach of the case law as a matter of policy, sets forth the following factors to be considered in classifying a security as debt or equity:
• whether there is an unconditional promise to pay a sum certain at a fixed date that is in the reasonably foreseeable future;
• whether the holders possess the right to enforce payment of principal and interest;
• whether the holders have the right to participate in management;
• whether the issuer is thinly capitalized;
• whether there is identity between holders of the instrument and stockholders of the issuer;
• whether a label has been placed on the instrument by the parties; and
• whether the instruments are intended to be treated as debt or equity for non-tax purposes.
Application of Treasury's test establishes that Capital Securities possess all the critical attributes of debt. First, they all have definite terms of maturity. In cautioning against unreasonably long maturities in Notice 94–47, the IRS indicated that the reasonableness of an instrument's term (including that of a relending obligation or similar arrangement) is determined under a facts-and-circumstances test, including the issuer's ability to satisfy the instrument. In this regard, Capital Securities are typically issued by well-established companies that are likely to remain in business throughout the term of the obligation. Second, investors have full creditor rights upon default, and default can force an issuer into bankruptcy or liquidation. Third, holders have no rights to participate in management. Fourth, issuers are not thinly capitalized. Fifth, if interest is deferred, investors must impute interest income as is the case with other debt instruments, but not equity. Sixth, the markets price the instruments as debt instruments B giving investors a debt return, not an equity return. Lastly, the instruments are senior to all preferred equity.
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Significantly, Notice 94–47 was published in response to the issuance in significant volume of the instruments now referred to as MIPS. Thus, the IRS specifically reviewed instruments ''that are designed to be treated as debt for federal income tax purposes but as equity for regulatory, rating agency, or financial accounting purposes.'' Notice 94–47 simply gives notice that the status of instruments such as MIPS will be scrutinized on audit. We believe that Notice 94–47 sets forth an appropriate standard of review. Notably, Notice 94–47 did not identify the accounting treatment of Capital Securities as a concern; rather, the IRS singled out only two ''equity features'' of ''particular interest:'' an unreasonably long maturity and an ability to repay principal with the issuer's stock. Even in the case of an instrument with those two features, however, the notice did not resort to a formalistic classification.
B. How Credit Rating Agencies or Accountants View a Security Should Have No Bearing on Its Classification for Federal Income Tax Purposes
The concerns of credit rating agencies and the SEC are very different from those of the IRS. Rating agencies and the SEC are focused on determining the likelihood of the issuer defaulting, while the IRS normally concerns itself with distinguishing debt from an equity security whose return represents a participation in the profits and risks of the business enterprise. Given the different objectives of the IRS and rating agencies and the SEC, the label attached by the latter should have no bearing on the tax classification. Indeed, to illustrate the vagaries inherent in basing tax consequences on non-tax labels, consider the fact that at least one national rating agency has announced that it will rate Capital Securities as bonds, and not quasi-equity.(see footnote 60) Moreover, as noted above, in a bankruptcy proceeding, Capital Securities are senior to equity.
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Regarding the proposal's reliance on accounting practices to determine the tax treatment of Capital Securities, it is interesting to note that the Administration took the exact opposite approach in certain other provisions included in its FY1998 Budget. Specifically, the Administration has proposed to repeal the ''lower of cost or market'' method of valuing inventory,(see footnote 61) notwithstanding the fact that this method has been long-accepted as a generally accepted accounting principle and has been allowed by Treasury regulations since 1918.(see footnote 62) The staff of the Joint Committee on Taxation's analysis of this proposal correctly points out the often separate principles underlying tax and financial accounting treatment.(see footnote 63) Similarly, the Administration would repeal the components-of-cost inventory accounting method,(see footnote 64) despite the fact that this method ''is accepted (and in some cases, favored) under ... GAAP ... applicable to the preparation of financial statements.(see footnote 65)
Not only is the Administration's overall budget proposal internally inconsistent with respect to the deference to be accorded to financial accounting treatment, in the case of the proposal to deny interest deductions there is no reasoned tax policy basis for referencing the financial accounting treatment of affected instruments.
IV. The Administration's Proposal Would Inhibit the International Competitiveness of American Corporations
By limiting the financing options of U.S. corporations, the Administration's proposal would limit their ability to invest in new plant and equipment. A reduction in investments would have an adverse impact on economic growth and the international competitiveness of U.S. businesses. In this regard, it should be noted that no other major industrialized country has adopted such restrictive and arbitrary limits on the deductibility of interest. Ironically, if the Administration's proposal is enacted, foreign issuers would remain free to access the U.S. capital markets using Capital Securities. Thus, U.S. corporations would be generally disadvantaged vis-a-vis their foreign competitors. In the case of electric utilities, which are just beginning to compete in the global market, any proposal that raises the cost of capital will make it more difficult for the industry to weather difficult financial times and more likely for the industry to be forced into radical cost cutting measures.
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Conclusion
The Administration's proposal to deny interest deductions on Capital Securities represents an unjustifiable tax increase on businesses and investors, based on a convenient but ill-advised reliance on non-tax accounting principles with no basis in tax policy. Moreover, particularly in the case of electric utilities, the enactment of this proposal would exacerbate competitive pressures already affecting U.S. businesses that require flexibility to compete in the global marketplace.
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Statement of the Ad Hoc Coalition on Intermarket Coordination
This statement is submitted by the Ad Hoc Coalition on Intermarket Coordination, a coalition of the nation's options exchanges and their clearing firm, in connection with the March 12, 1997 hearing on revenue-raising provisions in the Administration's Fiscal Year 1998 Budget. The participants in the Coalition are the American Stock Exchange, the Chicago Board Options Exchange, the Pacific Stock Exchange, the Philadelphia Stock Exchange, and The Options Clearing Corporation. The four exchanges are the only U.S. exchanges on which options on individual equity securities are traded.
Overview
The Administration's 1998 Budget includes two proposals of concern to the Coalition. One of the proposals, known as the ''constructive sale'' proposal, is often described as being targeted against the short-against-the box transaction and, specifically, the ability of taxpayers under present law to use that transaction to defer recognition of gain. Press reports have publicized certain specific transactions in which taxpayers have been able to defer gain for long periods of time and ultimately to avoid any income tax on their gain. The legislative proposal included in the Administration's 1998 Budget, however, goes far beyond what is needed to stop such transactions and would fundamentally change long-standing tax principles by requiring recognition of gain (but not loss) on stock, bonds and other financial instruments when taxpayers engage in various risk-reduction (i.e., hedging) strategies, including short-term hedging strategies involving the use of exchange-traded options. The vague language of the proposal also raises significant line-drawing questions, particularly with respect to options transactions.
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If Congress decides to enact legislation along the lines of the Administration's proposal, Congress should ensure that the legislation is narrowly crafted so as to affect only those transactions that are determined to be abusive. Otherwise Congress raises the serious risk of adversely impacting legitimate hedging transactions. In other words, Congress must balance the competing concerns of preventing abusive transactions while protecting legitimate hedging activities.
As explained more fully below, the exchanges recommend that if ''constructive sale'' legislation is enacted, it should include the following provisions:
• The ''constructive sale'' rule should not apply to short-term hedges that have the potential to defer gain for at most a single taxable year.
• The ''constructive sale'' rule should be limited to short-against-the-box transactions that would otherwise result in long-term (i.e., more than one year) deferral and other specific transactions that are determined to be close substitutes for such transactions.
• Treasury could be given prospective regulatory authority to apply the ''constructive sale'' rule to other transactions as long as appropriate guidelines and safe harbors are provided in the statute or committee reports.
• Listed options should be excluded from the definition of ''appreciated financial positions'' that are subject to the ''constructive sale'' rule.
The second proposal addressed by these comments is the proposal to deny the dividends received deduction (''DRD'') to a corporation that has hedged its risk of loss with respect to dividend-paying stock around the time of the dividend. The proposal appears to reflect a novel view of the function of the DRD that is at odds with the long-standing policy against imposing multiple layers of corporate-level tax on the same income. The Coalition believes that current law adequately prevents ''dividend stripping'' and other tax-motivated transactions relating to the DRD and that it is inappropriate to impose multiple layers of corporate-level tax on the same income simply because the owner of stock has hedged its risk around the time that a dividend is paid.
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Background
The options exchanges play an important role in the nation's economy. One of their most important functions is to permit individuals and firms that do not want to bear certain risks—particularly short-term risks—to transfer those risks to others who are more willing to bear them. In the words of the Securities and Exchange Commission, exchange-traded options: ''provide a means for shifting the risk of unfavorable short-term stock price movements from owners of stock who have, but do not wish to bear these risks, to others who are willing to assume such risks in anticipation of possible rewards from favorable price movements.''
SEC, Report of the Special Study of the Options Markets, House Committee on Interstate and Foreign Commerce (Committee Print 96–IFC3) 96th Cong. 1st Sess. 1 (1979). See also Miller, ''Financial Innovations, Achievements and Prospects,'' 4 J. of Applied Corp. Fin. 4, 7 (1992) (options and futures markets provide ''efficient risk sharing'').
The existence of options markets also tends to enhance the liquidity of the underlying markets. The options markets afford an efficient and cost-effective means of adjusting an investment's risk/return characteristics and provide market participants with the ability to create more diverse risk/return alternatives. These features tend to make participation in the underlying markets more attractive to a greater number of participants, thus increasing the liquidity in those markets.
The utility of the options markets is evidenced by the substantial volume of transactions on the options exchanges. In 1996, for example, 198.9 million options contracts on individual equities were traded on the options exchanges, with each contract representing 100 shares of stock. The average daily volume for the year was 783,000 contracts. The total option premiums for the year amounted to $67.8 billion.
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Discussion
I. The Short-Against-the-Box Proposal
The Administration's proposal would require gain recognition on an ''appreciated financial position'' held by a taxpayer whenever the taxpayer (i) enters into a transaction with respect to ''substantially identical property'' that ''substantially eliminates the risk of loss and opportunity for gain'' on such position ''for some period'' or (ii) enters into any other transaction that is marketed as being ''economically equivalent'' to such a transaction. These transactions are referred to as ''constructive sales.'' Under the Administration's proposal, purchasing a put option or writing a call option on substantially identical property constitutes a constructive sale if the option is ''substantially certain'' to be exercised.(see footnote 66)
The broad language of the Administration's proposal goes much further than changing the tax treatment of the short-against-the-box transaction. It would appear to reach many risk-reduction transactions—including short-term hedges—that are not tax-motivated, are clearly not ''abusive,'' and do not result in long-term deferral of gain. The proposal fails to focus on whether the transaction results in a significant deferral of gain, which is the essence of the transactions that have attracted so much press attention.
In addition, the vagueness of the language used in the Administration's proposal raises significant line-drawing questions for hedging transactions that significantly reduce, but do not eliminate, risk of loss and opportunity for gain. The line-drawing questions are perhaps most significant for transactions involving the use of options, particularly exchange-traded options. The uncertainty created by the proposed language will cause investors and traders to refrain from non-tax-motivated investment and hedging transactions because of the tax risk, leading to costly and undesirable market distortions and inefficiencies. Creating this type of uncertainty in the markets is clearly inappropriate in the absence of some Congressional finding that the options markets are being used by taxpayers to engage in transactions that are determined to be ''abusive.''
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The comments that follow discuss more specifically these and other concerns raised by the Administration's proposal and set forth recommendations for limiting the scope of the proposed legislation.
A. Characteristics of Listed Options—Exchange-traded options (also known as ''listed'' options) have a number of characteristics that the Coalition believes should be taken into account in evaluating the potential application of the Administration's proposal to options transactions. In many respects, these characteristics distinguish option transactions from the short-against-the-box transaction.
First, conventional listed options, which represent the vast majority of exchange-traded options, have a maximum term of nine months.(see footnote 67) These options are generally used to hedge short-term risks or to generate investment income and gains. Since they are of limited duration, these options cannot be used to eliminate risk of loss and/or opportunity for gain for an indefinite period (or until death), as is the case with the short-against-the-box transaction. Thus, even though a taxpayer may reduce his or her risk during the term of the option, entering into the option transaction affords no protection from risks for the period beyond the term of the option.
Although a taxpayer could conceivably enter into a series of options transactions, one after the other as each option expires or is closed out, doing so would not be an efficient means of obtaining tax deferral. This is true for the following reasons:
• If the value of the hedged stock declines and the value of the option increases, the gain that was in the stock will essentially shift over to the option, and the gain on the option will be recognized at or before the time the option expires. Thus, the taxpayer cannot have any assurance of deferring gain recognition through a series of option transactions.
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• Alternatively, if the value of the stock increases, and the value of the option declines, the taxpayer will have to invest a greater amount of capital to replace the option and maintain the same level of protection.
• Each time the taxpayer entered into a new options transaction, he would create a new straddle under Code section 1092. Gains on any such options would be taxed when the options are closed out or expire, while losses on such options would be deferred under the straddle rules.(see footnote 68) Thus, over time the taxpayer would be ''whipsawed'' with respect to gains and losses on the options. In addition, under Code section 263(g) the taxpayer would have to capitalize any interest and carrying charges allocable to the positions in the straddle.
• Each time the taxpayer enters into a new options transaction, he would incur additional transaction costs.
Second, unlike a short-against-the-box transaction, which completely eliminates upside and downside risk, conventional listed options can never completely eliminate such risk. For example, writing a deep-in-the-money call may reduce downside risk (as well as upside potential), but the taxpayer still bears the risk that the stock may drop below the strike price of the option.(see footnote 69) Even in the recent bull market, one can point to numerous examples of steep declines in the values of individual stocks over relatively short periods of time. Unlike a short-against-the-box transaction, a deep-in-the-money call does not protect an investor against such risks. Similarly, a taxpayer who purchases a deep-in-the-money put with respect to stock that he holds still has an opportunity for gain if the stock price rises above the strike price of the put.
In addition, a taxpayer who hedges a stock with exchange-traded options continues to receive any dividend on the stock and has no obligation to make any comparable payments to another party. Thus, the taxpayer continues to receive the economic return attributable to the dividend, and he bears the risk that the dividend may decrease (as well as the potential benefit from an increase in the dividend).(see footnote 70)
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Third, options transactions that may be covered by the proposal are entered into for non-tax reasons. The options transaction that comes closest to a short-against-the-box transaction is known as a ''forward conversion,'' which consists of (i) long stock and (ii) a long put and a short call with the same strike price and the same expiration date. A forward conversion comes very close to eliminating downside risk and upside potential during the life of the options. Nonetheless, the principal use of forward conversions is in a non-tax-motivated arbitrage strategy that locks in small profits based on price discrepancies in the stock and options markets.(see footnote 71) These arbitrage transactions would take place even if there were no tax system.
Similarly, a taxpayer who wants to hedge his stock (whether appreciated, depreciated or flat) may purchase a put to protect against perceived short-term risk. In order to finance the cost of the put, the taxpayer may write a call and use the premium received for the call to pay for the put. For example, if a stock is trading at $42, a taxpayer might purchase a put at $40 for $2 and write a call at $45 for $2. The $2 premium received for the call would pay for the cost of the put. This transaction, which is known as a collar, is engaged in simply to hedge short-term risk at little or no cost and would be utilized even if there were no tax system. Nonetheless, it may be covered by the Administration's Proposal because the taxpayer may be viewed as retaining only limited downside risk and upside potential.
Fourth, exchange-traded options are standardized contracts, and the exchanges specify the strike price of an option and the date of expiration in accordance with their rules. An option is traded on an exchange only if the exchange authorizes trading in that option. Thus, listed options cannot be customized to suit an individual taxpayer's situation.(see footnote 72)
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For example, consider a taxpayer who wants to write a deep-in-the-money call. Under the rules that govern the listing of options, the exchanges do not create deep-in-the-money options. Rather, listed options are created at strike prices that are very close to the current price of the stock.(see footnote 73) Although options can become deep-in-the-money over time as a result of price movements in the stock, the extent to which a listed option can become deep-in-the-money is limited by the life of the option and the volatility of the stock. For example, for a stock trading at $48 in June, the exchanges might create new options with strike prices of $45 and $50 expiring in February of the following year. If the stock goes up to $100 by the following January, these $45 and $50 February options will still be listed for trading on the exchange. However, a stock whose value has increased by such a great amount in such a short period of time is a very volatile stock, and thus its market value could change so rapidly that deep-in-the-money options may not substantially eliminate risk of loss of opportunity for gain.
Fifth, the vast majority (roughly 90%) of exchange-traded equity options are closed out or expire unexercised. Taxpayers who use options as hedges generally continue to hold their stock after they close out the option or the option expires. Entering into the hedge is not simply a prelude to disposing of the stock. These hedges are thus distinguishable from the types of options transactions apparently envisioned by the Administration's proposal, which consist of selling a call or buying a put that is substantially certain to be exercised. That language seems to reflect the view that such options should be treated as constructive sales because they are in effect a forward sale, i.e., the taxpayer has entered into a transaction that will result in the sale of an asset at a certain price but is able to defer the recognition of the gain for tax purposes. This analysis does not apply to hedges where the taxpayer continues to hold the asset after the option expires or is closed out.
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Finally, unlike the short-against-the-box transaction, which is a well-defined transaction, the types of options transactions that are potentially subject to the Administration's Proposal are highly uncertain (i.e., the transactions are not well-defined). The Administration's Proposal would apply to certain options if they are ''substantially certain'' to be exercised or if the options ''substantially eliminate'' risk of loss and opportunity for gain ''for some period.'' None of these terms has any precise meaning. Moreover, as acknowledged by Treasury representatives in several public presentations, the determination of whether a particular option transaction is covered by the statute may depend on the volatility of the underlying stock, which cannot be determined in advance with any degree of certainty. In addition, since stocks have varying volatility, a transaction might substantially eliminate risk of loss and opportunity for gain on a stock with low volatility but the same transaction would not do so for a stock with higher volatility. Indeed, since the volatility of a stock can vary over time, a transaction might constitute a constructive sale of the stock at one point in time but the same transaction might not be constructive sale of the same stock at a different point in time.
Applying such vague standards to options transactions would create unacceptable uncertainty in the markets.(see footnote 74) Vague standards will cause taxpayers to refrain from engaging in non-tax-motivated transactions because of a fear that they may unknowingly trigger gain recognition in an appreciated stock position, which will lead to costly and undesirable market distortions and inefficiencies.
B. Application of the Administration's Proposal to Short-Term Hedges.—Although the Administration's proposal appears to be a response to press reports of transactions that have been entered into to obtain long-term deferral of taxable gain, the proposal is drafted so broadly that it would appear to apply to short-term hedges as well. Indeed, Treasury representatives have stated publicly that a hedge that lasts only one day would be treated as a ''constructive sale'' under the proposal if the hedge substantially eliminated risk of loss and opportunity of gain for that day. Such an extreme approach is plainly unnecessary in order to prevent taxpayers from obtaining long-term deferral of gain though tax-motivated transactions and it would significantly restrict the ability of taxpayers to engage in legitimate short-term hedging transactions without having to worry about whether they will be deemed to have sold their stock for tax purposes.
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Representative Kennelly has introduced a bill (H.R. 846) that while similar in most respects to the Administration's proposal, would not trigger gain in an appreciated position if the taxpayer closes out the ''constructive sale'' transaction before the end of the taxable year. This change represents a step in the right direction because it properly places the focus on whether there is a deferral of gain, which is the practical issue with which Congress should be concerned. However, while the bill would protect short-term hedges that are closed out within the taxable year, it would trigger gain recognition if the hedge remains open over the end of the year. Yet the types of short-term risks that lead investors to hedge with options (such as an upcoming earnings report) can occur at any time. We fail to see why a short-term hedge that is otherwise legitimate becomes illegitimate simply because it happens to span the end of a single tax year.
Congress can prevent taxpayers from obtaining long-term deferral of gain (and ultimate avoidance of any tax on that gain) while at the same time protecting legitimate short-term hedges by adopting an approach that does not require gain recognition as long as the hedge does not result in a deferral over the end of more than one year. Adopting a rule that triggers gain simply because a hedge spans the end of a single taxable year will unavoidably impact legitimate short-term hedging transactions that are not tax-motivated.
Recommendation: The Coalition believes that any hedging transaction that is closed out in 12 months or less should not be treated as a constructive sale. These hedges cannot result in deferral of taxable gain for more than a single year. Adopting such a rule will protect short-term hedges without permitting taxpayers to obtain long-term deferral of taxable gain.
C. Application of the Administration's Proposal to Longer-Term Hedges With Options.—Although conventional listed options, which represent the vast majority of all exchange-traded options, can have a life of at most nine months, there are two categories of exchange-traded options, known as LEAPS and FLEX equity options, that can have a life of up to three years. While these options cannot be used to obtain the long-term deferral that can be obtained with the transactions that have attracted so much media attention, they can be used to shift risk for a period of longer than one year.
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The vague language in the Administration's proposal could be interpreted to apply to transactions involving these types of options. However, these options transactions are entered into for legitimate risk-shifting purposes and to the best of the knowledge of the exchanges are not being used as substitutes for the short-against-the-box transaction. Moreover, these options cannot be used to completely eliminate risk of loss and opportunity for gain. Rather, they can be used to transfer varying degrees of risk for periods of up to three years, with the taxpayer retaining risk for periods beyond the term of the options.
Recommendation: Because these options are used in legitimate, investment-oriented risk-shifting transactions and because of the potential chilling effect that the proposal's vague language could have on transactions involving these options, the Coalition strongly recommends that any application of the ''constructive sale'' proposal to these options be addressed through prospective Treasury regulations that could be issued if it becomes apparent that taxpayers begin to use these options to defer gains. Appropriate statutory or committee report language should make clear that only extreme situations closely resembling an actual sale could be subject to the regulations. Appropriate safe harbors should also be specified in the statute or committee reports. These safe harbors should include the following:
• A ''collar'' would not be treated as a constructive sale if there is at least a 10% spread between the strike price of the put and the strike price of the call.
• A long put or short call would not be treated as a constructive sale if it is not more than 25 percent in the money. Thus, for example, if a stock is trading at $100 per share, a taxpayer could write a call at $75 per share without triggering gain in the stock.
D. Options as Appreciated Financial Positions.—The Administration's proposal defines an appreciated financial position as including not only direct interests in stock, but also positions with respect to stock, including an option on the stock. If a taxpayer purchases a call option on a stock and the call increases in value, the call would be an appreciated financial position. If a taxpayer then enters into a transaction that substantially eliminates the risk of loss and opportunity for (additional) gain on the call, the gain on the call would be recognized.
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As explained above, a listed option has a limited life that is set by the exchange pursuant to its rules. In order for an option to appreciate to any significant extent, some time must pass after it is initially entered into, and thus appreciated options positions will have an even shorter remaining life until expiration. Since any gain on the option will generally be recognized by the time the option is scheduled to expire, it seems unnecessary to treat such options as appreciated financial positions.
The taxpayer will recognize any gain on the option when he closes out the option or the option expires unexercised.(see footnote 75) The taxpayer cannot avoid recognizing that gain by entering into a new options transaction. There is also no way that the term of an exchange-traded option can be extended.
It is also possible that the option will be exercised. Situations in which the option might be exercised fall into two categories, neither of which would be efficient from a tax-deferral perspective. First, if the appreciated option is a long put or a short call, the exercise of the option would force the taxpayer to sell the stock and any gain on the option would generally be taxed as part of such sale. Second, if the taxpayer's option position consists of a long call or a short put, the taxpayer could either exercise the call or be assigned on the put, with the result that he would have to purchase the underlying stock. While in these situations any gain on the option would effectively be rolled into the stock, a taxpayer would not pursue this strategy to obtain deferral of gain in the option because (i) as compared with the relatively small cost of the option, he would need to make a significant capital investment to acquire the stock, (ii) he would incur additional transaction costs on the purchase of the stock as well as on a subsequent sale of stock, and (iii) he would take on the risks of owning the stock.
Treating exchange-traded options as appreciated financial positions will also create some peculiar and undesirable results. For example, taxpayers holding stock frequently write calls, particularly qualified covered calls,(see footnote 76) with respect to stock that they hold. Writing covered calls is viewed by many as a conservative investment strategy that entails giving up the opportunity to benefit from an increase in the value of the stock during the life of the option in return for a more predictable return. If a taxpayer writes a qualified covered call and the underlying stock declines in value, the taxpayer will have a gain in the short call position.(see footnote 77) If the taxpayer then purchases additional shares of the stock, he may be entering into a ''constructive sale'' of the short call since, depending on the facts, the newly acquired long stock could be viewed as substantially eliminating the risk of loss and opportunity for gain on the short call. This inappropriate treatment could apparently apply even though the taxpayer's motivation was simply to acquire more of the stock (e.g., under a ''dollar cost averaging'' investment strategy).
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A related problem arises from the fact that the Administration's proposal apparently would apply to each separate position regardless of whether that position is part of a larger position. In the above example, the purchase of additional shares actually increases the taxpayer's risk as compared with the original combined position of the long stock and short call. Yet the Administration's proposal would appear to focus only on whether the acquisition of the additional stock reduces risk of loss and opportunity for gain on the short call. The fact that the short call was part of a larger position that includes the (original) long stock would apparently be disregarded.
Stating the problem more generically, options strategies generally involve multiple positions. If a taxpayer enters into an options transaction that entails multiple positions and then enters a transaction that could be viewed as substantially eliminating opportunity for gain and risk of loss with respect to one of those positions (assuming that the position, viewed in isolation, has appreciated and ignoring the fact that the position is part of a larger position), the taxpayer would apparently have made a constructive sale of that position and (presumably) could not take into account unrealized losses on other positions that are part of the larger position. Such a fragmented approach to combined positions is clearly inappropriate, yet it is difficult to see how the problem could be addressed without substantial administrative complexity—both for taxpayers and the IRS.
Treating listed options as within the scope of appreciated financial positions will also create an additional realm of complexity in determining whether one or more options transactions ''substantially eliminate'' risk of loss and opportunity for gain on other options positions. The combinations of positions that are possible are much greater than when the appreciated financial position is a direct interest in stock, as is the case in the short-against-the-box transaction. In addition, there is a serious risk that the IRS would match up a taxpayer's positions in ways other than the taxpayer intended.
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Finally, unlike the case of the short-against-the-box transaction, no tax-motivated transactions have been identified that are being entered into to defer gain on appreciated options positions. In the absence of any perceived abuse, options should not be treated as ''appreciated financial positions'' under the proposal. To do so would unnecessarily inject uncertainties and a high probability of inappropriate results into the options markets.
Recommendation: For all of the foregoing reasons, the options exchanges believe that listed options, as well as other indirect interests in stock that have limited lives, should be excluded from the definition of an appreciated financial position. Given the limited terms of these instruments and the absence of any perceived abuse in this area, excluding them from the scope of appreciated financial positions should not have any material effect on the revenue expected to be raised by the proposal
II. Holding Period Requirement for the DRD
Under current law, a corporation is not eligible for the DRD with respect to stock unless the corporation holds the stock for at least 46 days.(see footnote 78) For this purpose, any day that is more than 45 days after the date on which the stock goes ex-dividend is not taken into account. In addition, the corporation's holding period is reduced for periods in which the corporation has reduced its risk of owning the stock by entering into various transactions. See Code § 246(c). Once the corporation has satisfied this holding period requirement, the corporation is eligible for the DRD with respect to dividends on the stock without regard to whether the corporation has reduced its risk of loss with respect to the stock around the time of any particular dividend.
The holding-period requirement of current law is designed to prevent ''dividend-stripping'' transactions in which a corporation would purchase stock shortly before the ex-dividend date and sell the stock shortly after that date. In the absence of the holding-period requirement, the corporation would receive dividend income eligible for the DRD and generate an offsetting short-term capital loss on the sale of the stock, which (all else being equal) would decline in value by roughly the amount of the dividend. This capital loss could be used to reduce unrelated capital gain. By requiring the corporation to hold the stock for more than 45 days, and by excluding for this purpose any days on which the taxpayer has reduced its risk, this rule requires a corporation to bear market risk associated with owning the stock for a sufficiently long period to make dividend stripping unattractive.
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Current law includes various other rules designed to prevent ''tax arbitrage transactions'' relating to the DRD. For example, no DRD is allowed with respect to a dividend if the corporation has an obligation to make related payments with respect to positions in substantially similar or related property. See Code § 246(c)(1)(B). Thus, a taxpayer that sells short against the box cannot claim the DRD for any dividends it receives during the period of the short sale because it has an obligation to make ''in lieu of dividend payments'' to the stock lender. Another rule requires basis adjustments in stock when a corporation receives certain extraordinary dividends with respect to that stock unless the corporation has held the stock for a period of two years.(see footnote 79) See Code § 1059. Yet another restriction is found in section 246A, which denies the DRD for debt-financed portfolio stock in order to prevent taxpayers from both claiming the DRD and deducting interest expense with respect to debt that finances the holding of the dividend-paying stock.
The Administration's proposal would take the current rules that are designed to prevent dividend-stripping and apply them with respect to each dividend. Thus, in order to be eligible for the DRD with respect to a dividend, the corporation would be required to hold the stock—unhedged—for at least 46 days around the time of the ex-dividend date.
The proposal represents a policy change that is difficult to justify. It would deny the DRD to a long-term holder of stock simply because it hedged its risks at a time proximate to a dividend payment. Other than as part of a package to reduce the benefits of the DRD, along with the Administration's proposal to reduce the DRD on portfolio stock from 70% to 50%, we see no rationale for the proposal. The effect of the proposal is to exacerbate the triple-tax problem that the DRD is intended to minimize. While the issue of whether to continue the longstanding policies that underlie the DRD is certainly a matter for Congress to decide, we do not believe that the fact that a corporation happens to hedge its risk over a dividend date is a reasonable basis for subjecting the earnings distributed by the dividend to multiple layers of full corporate tax.(see footnote 80)
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The fact that a taxpayer has reduced its risk of loss with respect to a stock does not mean that it is not the tax owner of the stock. Thus, in the absence of some abuse of the tax system or some inappropriate tax arbitrage, the fact that the taxpayer has reduced its risk is not a sufficient reason for denying it the benefits of ownership. This principle is evidenced by the treatment of holders of municipal bonds. The fact that a taxpayer that holds a municipal bond has hedged its risk with respect to the bond, say by purchasing a put on the bond, does not mean the interest that it receives on the bond is no longer tax-exempt.
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Statement of the Alliance of American Insurers
The Alliance of American Insurers urges the Ways and Means Committee to oppose several of the proposals in the revenue provisions of the Administration's fiscal year 1998 budget. These would (1) reduce the corporate dividends-received deduction from 70 percent to 50 percent; (2) reduce the net operating loss carryback period from three (3) years to one (1) year; and (3) increase the penalty for filing incorrect information returns from $50 per return to the greater of $50 or five (5) percent of the amount required to be reported. The Alliance of American Insurers is a national trade association of over 260 property/casualty insurance and reinsurance companies that do business in all 50 states and the District of Columbia.
• Dividends-received deduction—The corporate dividends-received deduction ensures (partially, since the deduction is for only 70 percent of dividends received) that investment income from stock of non-controlled corporations is not subject to triple taxation. The Administration's proposal would have a particularly severe impact on property/casualty insurers, which (1) hold a far higher proportion of their assets in investments than do non-financial corporations, and (2) invest as an industry over 10% of their assets in the stock of non-controlled corporations.
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• Net operating loss carryback—Reduction of the NOL carryback from three years to one year severely limits a taxpayer's ability to spread the effects of loss years to profitable years and properly reflect the economic results of its activities in taxable income over a period of years. The proposed limitation would particularly harm property/casualty insurers that suffer catastrophic losses, to which P/C insurers are particularly susceptible. Enactment of this provision could contribute to reduced availability and affordability of insurance in catastrophe-prone areas.
• Increase in information reporting penalty—This proposal has the potential to disproportionately punish inadvertent clerical errors. Again it would have a particularly harmful effect upon insurance companies, many of which file millions of information returns annually. Insurers often make payments to service providers with whom they have one/time relationships, and therefore little or no control over the correctness of the information provided to them, which may be subject to misspellings, transpositions and other unintentional mistakes. It is unjust to impose such an onerous penalty for these types of errors. Insurers have made substantial progress in correcting information reporting errors, and we see no demonstrated need for this proposal.
If the Administration's proposal to define ''captive'' insurers is seriously considered, the Alliance also urges that pooling and reinsurance arrangements between insurance companies be excluded from the coverage of this provision. These arrangements are frequently used, help insurers to conduct the insurance business more efficiently, and are very different from the types of arrangements at which the captive proposal is directed.
The Alliance of American Insurers would like to thank the Committee for this opportunity and stands ready to assist the Committee as it moves forward on the FY98 budget.
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Statement of America's Community Bankers
Mr. Chairman and Members of the Committee, America's Community Bankers appreciates this opportunity to submit testimony for the record of the hearing on the revenue raising provisions in the Administration's fiscal year 1998 budget proposal. America's Community Bankers is the national trade association for 2,000 savings and community financial institutions and related business firms. The industry has more than $1 trillion in assets, 250,000 employees and 15,000 offices. ACB members have diverse business strategies based on consumer financial services, housing finance and community development.
ACB wishes to focus on two provisions included in the Administration's budget that will have a particular adverse impact on financial institutions. The first provision would treat the election by a ''large'' corporation to be taxed under Subchapter S of the Internal Revenue Code as a liquidation. ACB requests that this provision should be rejected by the Committee because it will severely limit the availability of the Subchapter S election for most corporations and eliminate the option altogether for most of our stockform members that otherwise might make the election. At a minimum, this provision should not trigger the taxation of the pre-1988 Section 593 loan loss reserves of savings institutions and savings banks.
The second provision would modify the carryback and carryforward period for net operating losses. ACB requests that the limitation of the loss carry back period to one year should not apply to banks and savings institutions because of the special regulatory accounting rules to which they are subject.
Repeal of Section 1374 for ''Large'' Corporations
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Under the Administration's budget proposal, section 1374 would no longer apply to corporations that have a value of more than $5 million. The repeal of section 1374 would apply to Subchapter S elections that become effective after January 1, 1998. Section 1374 was enacted by the Tax Reform Act of 1986 in order that taxpayers could not avoid the repeal of the General Utilities rule (see General Utilities v. Helvering, 296 US 200 (1935)) that was one of the primary achievements of the 1986 Act. Under the General Utilities rule, a corporation could avoid corporate level tax on appreciated property by distributing such property to its shareholders. Section 1374 was enacted in lieu of the kind of liquidation tax now being proposed by the Administration. Section 1374 provides that the ''built-in'' gain on appreciated assets held by a corporation that makes a Subchapter S election will be triggered where the assets are disposed of within 10 years of the election. Ten years, though an essentially arbitrary period, is long enough to indicate conclusively that the taxpayer did not have a tax avoidance motive on these amounts for making the election.
The current Administration proposal first appeared in the President's Seven-Year Balanced Budget Proposal, published in December 7, 1995. It provides that a ''large'' regular corporation—with a value of more than $5 million—electing to become a Subchapter S corporation or merging into one will be treated as if it were liquidated, followed by the contribution of the assets its shareholders received in exchange for their stock to the S corporation. The proposal would impose taxation on any appreciated assets held by the corporation and would tax the shareholders as if they had sold their stock and reinvested the proceeds in the new Subchapter S entity.
Although as a general matter, enactment of the Administration's proposal would probably make the Subchapter S election too expensive for many existing corporations, including commercial banks, the proposal would impose a particular and prohibitive tax liability on the typical savings institution or savings bank (thrift). In effect, Congress will have made only a hollow gesture towards making Subchapter S status available to thrifts.
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Last year Congress advanced the ongoing process of financial modernization by making it possible for thrifts to change to commercial bank charters or to diversify their lending activities to diminish risk created by concentrated lending and to better serve their communities. This was accomplished by requiring all thrifts to ''recapture'' into taxable income their loan loss reserves accumulated after 1987, except to the extent necessary to create an opening reserve balance for those ''small'' thrifts permitted to remain on the experience reserve method. The threat of subjecting the remaining, pre-1988 reserve accumulation to recapture upon a charter change or a diversification of the institution's loan portfolio was dispelled. Recapture of the pre-1988 reserve will still occur, however, where the thrift liquidates or otherwise distributes the capital accumulated using the special thrift subsidy reserve method that had been in existence since 1952 but that was repealed by Congress last year. Almost any established thrift that is forced to recapture the capital accumulated between 1952 and 1987 from the special thrift reserve method would suffer a huge cut in its capital and a likely regulatory capital shortfall, given the importance of the previous deductions permitted under the method.
Although in Notice 97–18, published in the Internal Revenue Bulletin 1997–10 on March 10, 1997, the Internal Revenue Service distinguished the pre-1988 reserves of a thrift from the experience reserves subject to recapture as a section 481(a) adjustment, there can be little doubt that the pre-1988 reserves satisfy the definition of a built-in gain in section 1374(d)(5) of the Internal Revenue Code.
ACB concurs with other commenters that the Administration's proposal to repeal 1374 is not sound tax policy. The taxation of excess passive income, as well as the 10-year holding period requirement to avoid the taxation of built-in gains, limits the ability of corporations to avoid tax by making a Subchapter S election. The proposed repeal of section 1374 for large corporations would eliminate the realization concept to such an extent that a corporation may be unable to pay the required tax without an actual liquidation of the assets of the business. This proposal would contravene one of principal purposes of the amendments to the Subchapter S provisions made in 1982 and 1996—to increase the attractiveness and availability of the Subchapter S election.
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At a minimum, however, ACB strongly requests that, if the Committee were to agree with the Administration on the need to impose liquidation treatment on certain Subchapter S conversions, an exception be created to avoid the recapture of the pre-1988 loan loss reserves of thrifts. The very purpose of the amendments to the reserve recapture rules made last year was to limit the circumstances in which reserve recapture will be imposed. It is inconsistent to create a new situation in which recapture will be imposed. The Administration's proposal will force many eligible thrifts to make the Subchapter S election on a rush basis, rather than be effectively foreclosed after the 1998 calendar year. The provision creates a trap for the unwary thrift that could have a devastating impact on its capital. This proposal will raise little, if any, revenue from the thrift industry if their pre-1988 reserves are made subject to recapture under it.
Modification of the Net Operating Loss Carryback and Carryforward Rules
The Administration proposes to reduce the NOL carryback period from three years to one, while extending the carryforward period from 15 years to 20 years. The diminution of the carryback period would not apply, however, to REITs, specified liability losses, excess interest losses, and corporate capital losses. The treatment of NOLs is intended to mitigate the impact of the annualization of taxable income under a progressive rate system by smoothing the resulting fluctuations. The ability to use a loss immediately by means of a carryback is obviously more valuable than the ability to carry it forward against possible future income.
While the loss of carryback years will adversely impact most taxpayers, at least at some point, given the cyclical nature of most businesses, the impact is particularly severe on financial institutions because of the very conservative nature of the rules used to determine their solvency by their regulators.
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Financial Accounting Standards Board Statement (FASB) 109 provides the rules for reconciling ''temporary differences'' between the income statement and the tax return on the balance sheet. The tax deduction attributable to an NOL, to the extent that it cannot be used up in carryback years, may be treated as an asset, specifically a ''deferred tax asset'', to the extent that it is probable that it will provide a benefit on a future tax return. The deferred tax asset is offset by a ''valuation allowance'' to create an asset value that reflects the probability that the business will be sufficiently profitable in the future to make use of the tax asset.
FASB 109, as adapted for use by the banking regulators to determine the capital adequacy of a bank or thrift, has been made particularly conservative with respect to the creation of deferred tax assets that are dependent upon future taxable income. The maximum allowable amount of such deferred tax assets is the lesser of the amount that is usable based on taxable income projected one year ahead or 10 percent of ''Tier 1'' capital. (A uniform adaptation of FASB 109 was developed jointly by the OCC, the Federal Reserve, the FDIC, and the OTS. See e.g., section 325.5(g) of the FDIC Regulations.)
Given the stringent limitations on the period for projected future taxable income, the loss of two carryback years could have a particularly severe impact on the regulatory capital of financial institutions. The resulting possibility of the need for corrective action by the institution or for intervention by the regulator could be disruptive in many communities, as well as offsetting the revenue projected to be raised by the proposal from financial institutions. Given the disproportionately harsh impact this proposal will have on the operations and, possibly, the solvency of many financial institutions, ACB asks the Committee to recognize the necessity of excepting financial institutions, just as the Administration did for REITs, assuming the Committee is unwilling to reject the proposal altogether.
Once again, Mr. Chairman, ACB is grateful to you and the other members of the Committee for the opportunity you have provided to make our views known on the Administration's tax proposals. If you have any questions or require additional information, please contact Jim O'Connor at 202–857–3125 or Brian Smith at 202–857–3118.
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| America's Community Bankers |
| 900 Nineteenth St., NW, Suite 400 |
| Washington, DC 20006 |
| March 26, 1997 |
Mr. A.L. Singleton
Chief of Staff
Committee on Ways and Means
U.S. House of Representatives
1102 Longworth House Office Building
Washington, DC 20515
Re: Revenue Provisions in the Administration's 1998 Fiscal Year Budget Reduction of the Net Operating Loss Carryback Period
Dear Mr. Singleton:
America's Community Bankers presents this additional testimony for the record of the March 12, 1997, hearing on the revenue raising provisions in the Administration's fiscal year 1998 budget proposal. This submission supplements our testimony submitted to the Committee on the day of the hearings. America's Community Bankers is the national trade association for 2,000 savings and community financial institutions and related business firms. The industry has more than $1 trillion in assets, 250,000 employees and 15,000 offices. ACB members have diverse business strategies based on consumer financial services, housing finance and community development.
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Reduction of the Net Operating Loss (NOL) Carryback Period
The Administration proposes to reduce the NOL carryback period from three years to one, while extending the carryforward period from 15 years to 20 years. (The diminution of the carryback period would not apply, however, to REITs, specified liability losses, excess interest losses, and corporate capital losses.) ACB's previous submission focused on the particularly adverse impact that the loss of carryback years under the proposal would have on the capital of insured depository institutions in the years that they generate NOLs. This effect of the Administration's proposal will exaggerate and accelerate the effect of any downturn in the business cycle on financial institutions. The current submission will focus on a less apparent impact of the Administration's proposal that is immediate and universal. Enactment of the NOL proposal would cause both of these impacts because of its conjunction with the conservative implementation by the banking regulators of the GAAP rules created to account for income taxes that are set out in Financial Accounting Standards Board Statement (FASB) 109.
FASB 109 enhanced the ability of firms, in general, to represent as assets on their balance sheets currently the economic value of future tax benefits. These ''deferred tax assets'' can arise from two sources. The first is a ''tax carryforward,'' arising from excess credits, as well as excess deductions resulting from an NOL in the current year, to the extent that either cannot be used in the carryback years. The second source is ''temporary differences'' that result from giving effect to a transaction or situation earlier or later on the tax return than on the financial statements. Where the difference between the tax and GAAP rules causes a tax deduction to be taken later than the date it is reported as an expense on the financial statements, a ''deductible temporary difference'' has been created.
The deferred tax asset is the amount of tax reduction created by a tax carryforward or a deductible temporary difference, calculated at the tax rate applicable or expected to apply when the deduction or credit is used. One example of a deductible temporary difference is created by the annual addition to a loan loss reserve on the financial statements of a ''large'' bank, as defined by section 585(c)(2) of the Internal Revenue Code. Such an institution is no longer permitted to anticipate loan loss deductions by means of the reserve method on its tax return, but must await an actual charge-off. The amount of the reserve addition expense represents a future tax benefit to the extent of the future charge-off.
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Conversely, where a tax deduction is available earlier than the corresponding income statement expense, the amount by which taxable income will exceed financial statement income is a ''taxable temporary difference.'' The most commonly cited example of a taxable temporary difference arises from the use of an accelerated depreciation method on the tax return and straight-line depreciation on the financial statements. The taxable temporary difference gives rise to a deferred tax liability, which is the amount of the resulting tax increase calculated at the rate applicable to the return on which the income is reported.
The banking regulators have circumscribed the use of net deferred tax assets in computing regulatory capital. ''Tier 1'' capital, total assets, and risk-weighted assets of a financial institution must be reduced under the rules for determining capital adequacy to the extent that deferred assets, as determined under FASB 109, exceed the lesser of taxable income projected one year ahead or 10 percent of Tier 1 capital. (See e.g., section 325.5(g) of the FDIC Regulations.) Despite the requirement of FASB 109 that an offsetting valuation allowance must be set up under GAAP to reflect the probability that the business will not be sufficiently profitable to use a deferred tax asset, the reluctance of the regulators to permit the use of deferred tax assets, attributable to tax benefits extending for more than one year, to create capital is understandable.
In the case of deferred tax assets attributable to deductible temporary differences, the refusal of the regulators to permit institutions that are historically and currently profitable to create an asset representing taxes prepaid beyond one year, despite the high probability of profitable future years, is more difficult to justify. It is a source of growing frustration because the banking industry, over the past 10 years, has experienced a steady increase in deferred tax assets attributable to deductible temporary differences because of a growing divergence between increasingly conservative regulatory accounting policies and tax law changes designed to raise revenue by accelerating income and deferring expense recognition (of which the NOL proposal is yet another example.)
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The loss of the two carryback years under the Administration's proposal represents a threat to the regulatory capital of the banking and savings institution industries—unrelated to, but, possibly, in addition to any current reduction of capital caused by an inability to carry back NOLs. (As is noted in our earlier testimony, the NOL carryback reduction will also cause a different reduction in capital for those financial institutions that experience NOLs when the business cycle turns.) This predicted loss of capital is unique to financial institutions and results from the combination of two provisions in the bank regulatory capital regulations. The first, already mentioned, is the provision preventing even the soundest and most profitable institutions from projecting more than one year's taxable income to sop up the deferred assets arising from the deductible temporary differences that reverse in that year, as well as an NOL and tax credit carryforwards. In contrast, an industrial or commercial company that is strong and historically profitable might not be affected currently by the proposed substitution of carryforward years for carryback years. Such a company could plausibly argue to its auditors that it should be able to project the full amount of its deductible temporary differences and, thus, avoid any immediate impact from a loss of carryback years.
The other regulatory provision at issue permits taxes paid in carryback years to be included in valuing the future benefit represented by deferred tax assets. While FASB 109 requires a deferred tax asset to be reduced by a valuation account to the amount that is likely to be realized based on projected taxable income in the permissible carryforward period and while the banking regulations require the portion of a deferred tax asset whose realization requires future income in excess of what can be projected for one year ahead to be deducted from capital, both FASB 109 and the regulations permit deferred tax assets to be recorded without limit to the extent of the taxes paid in the permissible carryback period. The relevance of the carryback years is obvious, indeed definitional, with respect to the valuation of ''tax carryforward assets'' (NOLs and tax credits).
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In the case of deductible temporary differences, which, by definition, are book/tax differences that, in the abstract, will reverse automatically within a definite future period, the relationship to the waxing and waning of a statutory carryback period may not be immediately apparent. The relationship arises from the fact that the reversal of a deductible temporary difference creates a deduction and if there is an excess of them next year, for example, a benefit NOL will be created that can be carried back to recover taxes paid in the current and prior years (at least under current law). For banks, the severity of the one-year carryforward limitation in the regulatory computation of capital enhances the importance of the carryback period (as well as any offsetting taxable temporary differences), because any resulting excess deferred tax assets are deducted from capital.
The interaction of FASB 109, the bank capital rules, and the Administration's proposal may be best understood by an example. Assume that a sound and historically profitable bank has booked net deferred tax assets of $25 under FASB 109. (They arise from, among other items, loan costs and other current book expenses required to be capitalized for tax purposes, additions to a loan loss reserve that the bank is not permitted to maintain for tax purposes, and securities identified as held for investment under section 475 of the tax code, but marked to market under FASB 115.) The $25 of net deferred tax assets (before any required reduction) is equivalent to 5% of Tier 1 capital. From 1993 to 1996, the institution was profitable and paid $5 of federal tax for each year. As the result of a one year projection that it does at the end of each quarter, the bank has determined that for the 1997 calendar year (the most recent projection) it will have $15 of taxable income. The bank is a calendar year taxpayer and it projects that it will owe $5 of federal tax for 1997.
Under these facts and the three-year carryback period of current law, the banking regulations would permit only $20 of the net deferred tax assets to count as Tier 1 capital. The bank is permitted to count the $15 that can be realized from the taxes paid in the three carryback years, well as the taxes projected to be due for 1997. If the Administration's proposal is enacted this year and two carry back years are eliminated, Tier 1 capital must be reduced by $10 to account for the loss of the carryback years. Thus, only $10 of the amount of the net deferred tax assets of $25 would count as Tier 1 capital.
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Given the large and growing amounts of deferred tax assets currently being carried by many banks and savings institutions, it is likely that, if the Administration's NOL proposal is enacted, a number of these institutions may suffer a significant loss of capital. As a result many of the affected institutions may be required to adjust their lending activities to limit small business loans in favor of ''bullet-proof'' loans and some may become subject to the prompt corrective action provisions of the law or come under the supervision of their regulators. Given the immediate reduction of bank and savings institution capital that will occur if the Administration's NOL carry back reduction is enacted, ACB asks the Committee to recognize the necessity of excepting financial institutions, just as the Administration did for REITs, assuming the Committee is even willing to enact this ill-advised proposal in any form. Recent history documents the effects on the taxpayers and the Treasury when financial institutions become under-capitalized and Congress should be wary of precipitating such situations again.
Once again, Mr. Chairman, ACB is grateful to you and the other members of the Committee for the opportunity you have provided to make our views known on the Administration's tax proposals. If you have any questions or require additional information, please contact Jim O'Connor at 202–857–3125 or Brian Smith at 202–857–3118.
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Next Hearing Segment(2)
(Footnote 1 return)
Boris I. Bittker and James S. Eustice, Federal Income Taxation of Corporations and Shareholders, para. 5–05, at 5–38, n. 172 (6th ed. 1996).
(Footnote 2 return)
Budget of the U.S. Government, Fiscal Year 1998, ''The Analytical Perspectives,'' p. 48.
(Footnote 3 return)
Representative Bill Archer, ''Let's Make a Deal, Mr. President,'' The Washington Post, January 26, 1997, p. C1.
(Footnote 4 return)
Staff of the Joint Committee on Taxation, Estimated Budget Effects of Revenue Provisions Contained in President's FY 1998 Budget Proposal (JCX–8–97), February 27, 1997, p. 4.
(Footnote 5 return)
The proposal to ''eliminate dividends-received deduction for certain preferred stock'' was first released in August 1996 with a proposed ''date-of-enactment'' effective date.
(Footnote 6 return)
Senator William V. Roth and Representative Bill Archer, Press Release, ''Archer, Roth Statement on Treasury Revenue Provision Effective Dates,'' March 29, 1966.
(Footnote 7 return)
PSA The Bond Market Trade Association (formerly the Public Securities Association), ''Statement of the Public Securities Association to the Committee on Ways and Means, U.S. House of Representatives, on Tax Proposals in the President's 1997 Budget,'' May 15, 1996.
(Footnote 8 return)
Internal Revenue Service, Notice 94–47.
(Footnote 9 return)
See, for example, U.S. Department of the Treasury, Integration of the Individual and Corporate Tax Systems: Taxing Business Income Once, January 6, 1992.
(Footnote 10 return)
''Fixed-rate capital securities'' is a collective term referring to any of several types of financing instruments which have many of the characteristics of junior subordinated debt. Certain fixed-rate capital securities are also known as trust-preferred securities, debt-equity hybrid instruments, capital securities and preferred debt. They also go by a number of proprietary names such as Capital Trust Pass-Through Securities (TruPS), Trust-Originated Preferred Securities (TOPrS) and Monthly Income Preferred Securities (MIPS).
(Footnote 11 return)
Department of the Treasury, General Explanation of the Administration's Revenue Proposals, February 1997, p. 36.
(Footnote 12 return)
Ibid, page 40.
(Footnote 13 return)
Ibid, page 42.
(Footnote 14 return)
Ibid, page 40.
(Footnote 15 return)
Ibid, page 38.
(Footnote 16 return)
Internal Revenue Service, Revenue Procedure 72–18.
(Footnote 17 return)
Letter from the Honorable Robert Rubin, Secretary of the Treasury, to the Honorable Mitch McConnell, U.S. Senator, April 23, 1996.
(Footnote 18 return)
Letter from the Honorable Bill Archer, Member of Congress, to the Honorable Phil English, Member of Congress, January 19, 1996.
(Footnote 19 return)
Ibid.
(Footnote 20 return)
See, for example, letter from the Honorable Max Baucus, U.S. Senator, the Honorable Orrin Hatch, U.S. Senator and 33 other members of the Senate to the Honorable Robert E. Rubin, Secretary of the Treasury, March 6, 1996, letter from the Honorable Nancy Johnson, Member of Congress, and 12 other members of Congress to the Honorable Bill Archer, Member of Congress, December 15, 1995, and letter from the Honorable Kenneth E. Bentsen, Member of Congress, to the Honorable Robert Rubin, Secretary of the Treasury, January 10, 1996.
(Footnote 21 return)
Department of the Treasury, page 44.
(Footnote 22 return)
Source: Federal Reserve Board.
(Footnote 23 return)
Department of the Treasury, idem.
(Footnote 24 return)
Department of the Treasury, General Explanations of the Administration's Revenue Proposals (February 1997) (''Treasury Green Book''), p. 36 (proposal to ''deny interest deduction on certain debt instruments'').
(Footnote 25 return)
Treasury Green Book, p. 38 (proposal to ''defer deduction for accrued but unpaid interest on convertible debt'').
(Footnote 26 return)
Treasury Green Book, p. 40, 41, 42 (proposals to: ''reduce dividends-received deduction to 50 percent,'' ''modify holding period for dividends-received deduction,'' and ''deny dividends-received deduction for preferred stock with certain nonstock characteristics'').
(Footnote 27 return)
Treasury Green Book, p. 46 (proposal to ''require average cost-basis for securities'').
(Footnote 28 return)
Treasury Green Book, p. 52 (proposal to ''require reasonable payment assumptions for interest accruals on certain debt instruments'').
(Footnote 29 return)
Treasury Green Book, p. 62 (proposal to ''require gain recognition on certain distributions of controlled corporation stock'').
(Footnote 30 return)
The proposal to further restrict the DRD suffer from a comparable defect—the holder loses a portion of the DRD but the issuer is not given a partial interest deduction.
This same point applies to the proposal to accelerate interest accruals on certain pools of debt. Why is it that taxpayers should be required to use a method that maximizes income—but not be permitted to use that same method in computing bad debt writeoffs?
(Footnote 31 return)
Why is it that financial accounting treatment should control in this context, but not control in the context of 50-year debt and OID convertible debt? Why is it that 15 years is a trigger in this context, but 40 years is a trigger in other contexts?
(Footnote 32 return)
The administration's proposal never says who has this ''view.'' The fact that more than 70 percent of the outstanding issuances are never converted, and the fact that these instruments are treated as debt for financial accounting, rating agency, and regulatory purposes, suggest that the administration's ''view'' is not widely shared. To the contrary, all of the objective evidence demonstrated that OID convertible debt is ''viewed'' as debt.
Moreover, if the way an instrument is ''viewed'' should control its tax treatment, would Treasury recommend that fixed term, investment grade preferred stock be treated as debt?
(Footnote 33 return)
As I note below, this is an area where a change in the tax law may be warranted. The problem is that the administration's proposal in its current form is the worst of two worlds: it would hit what it should miss, and miss what it should hit.
(Footnote 34 return)
The only stated rationale for the proposal, which would deny interest deductions to the borrower while taxing interest income to the investor, is that the instrument is ''viewed as equity.'' As noted above, this assertion is manifestly wrong as a factual matter and has absolutely no foundation in tax policy.
(Footnote 35 return)
This proposal should be particularly troublesome for those who view the capital gains tax as nothing more than a tax on inflationary gains and a tax on increases in expected future income—income that, if recognized, will be taxed again.
(Footnote 36 return)
In addition to the substantive problems with this proposal discussed above, the administration's proposed effective date is essentially retroactive. Any proposal in this area should not apply to binding agreements, public announcements, SEC filings, IRS ruling requests (or any other event that indicates taxpayers have incurred significant expense in reliance on current law) made prior to the date of appropriate congressional action.
(Footnote 37 return)
The Securities Industry Association brings together the shared interests of more than 760 securities firms throughout North America to accomplish common goals. SIA members—including investment banks, broker-dealers, specialists, and mutual fund companies—are active in all markets and in all phases of corporate and public finance. In the United States, SIA members collectively account for approximately 90 percent, or $100 billion, of securities firms' revenues and employ about 350,000 individuals. They manage the accounts of more than 50 million investors directly and tens of millions of investors indirectly through corporate, thrift, and pension plans. (More information about SIA is available on its home page: http://www.sia.com.)
(Footnote 38 return)
This figure is from the Joint Committee on Taxation's revenue estimate. The Treasury Department estimates that these provisions would raise $7.3 billion over the same 6-year period.
(Footnote 39 return)
The proposal would apply to subchapter S elections that are first effective for tax years beginning after January 1, 1998, and to acquisitions such as a merger of a C corporation into an existing S corporation after December 31, 1997.
(Footnote 40 return)
Excess foreign tax credits can arise from various circumstances: higher rates of corporate taxation abroad than in the United States; U.S. interest, and research and experimentation allocation rules that attribute a share of these expenses to foreign source income; U.S. rules that effectively recharacterize domestic losses as foreign source losses in some circumstances; U.S. rules that create hermetic ''baskets of income'' so that foreign taxes on one type of foreign income cannot be attributed to another type of foreign income, etc.
(Footnote 41 return)
Our projections of costs and benefits are made on a calendar year basis, even though, strictly speaking, our projection of tax revenue costs refer to U.S. fiscal years.
(Footnote 42 return)
A company could be in a ''partially binding FTC position''—i.e., the company could have excess FTCs, but in an amount less than the additional FTC ''capacity'' generated by the Export Source Rule. In those cases, the blended effective tax rate would be higher than 17.5 percent. Our study does not take such intermediate case into account.
(Footnote 43 return)
This assumption probably overstates the tax benefits of the FSC, since many companies are not able to exclude the full 15 percent of export profits.
(Footnote 44 return)
To make this calculation, we assume that the ''blended'' U.S. tax rate component of the marginal export tax incentive (METI) variable for firms with binding FTC positions rises from an average value of 17.5 percent with the Export Source Rule to an average value of 29.75 percent without the Export Source Rule. The hypothetical increase in U.S. taxation of export earnings, 12.25 percentage points, or 0.1225, is multiplied by the average ratio of foreign pretax income to foreign sales (ES in Kemsley's notation), or 0.106 for firms with binding FTC positions, to obtain the relevant value for Kemsley's ME variable, namely 0.013. This value of MET is multiplied by the estimated coefficient for the regression variable FTCBIND*METI, 2.437, and also multiplied by mean foreign sales for firms in a binding FTC position, $1,332 million, to obtain an estimate of additional exports resulting from the Export Source Rule, namely $42 million (0.0130 × 2.437 × $1,332 = $42). The methodology is spelled out in footnote 23 of Kemsley's paper.
(Footnote 45 return)
An elasticity coefficient indicates the percentage change for variable X in response to a 1.0 percent change in variable Y. In this case, an elasticity of 3.0 means that total capital invested in a foreign country is increased 3 percent for every 1 percentage point increase in the profitability (per unit of output) of production in the country attributable to lower corporate taxation in the country.
(Footnote 46 return)
The 3-for-1 response rate reflects an average across a large number of firms. Some companies will not shift any production in response to a tax change, other companies will shift big segments of production.
(Footnote 47 return)
This figure is based on the following considerations. According to FSC data for 1985, 1986, and 1987, the ''combined taxable income'' of parent U.S. corporations and their FSCs averaged about 0.08 of export sales (U.S. Treasury, 1993). We think export profits in those years were depressed by the very strong dollar. According to data collected by Kemsley (1997) over the 9-year period 1984-92, foreign pretax income averaged about 0.12 of foreign sales for his full sample of firms. In our judgment, this figure better reflects the profit-to-export sales ratio now prevailing for U.S, firms.
(Footnote 48 return)
The reason we calculated ''upper bound'' estimates for the export elasticity approach was to discover whether there was an overlap with the production response approach. There was not. Estimates of long-run price elasticities of demand and supply for U.S. exports, compiled from the econometric findings of a number of investigators, are presented in table 5. It will be seen that the figures we use are at the upper end of econometric findings. High values for price elasticities (–10 for demand and 20 for supply) imply a ''multiplier'' of 6.0. This multiplier relates the proportional change in export sales to the tax-induced change in export income (expressed as a percentage of export sales) attributable to the Export Source Rule. Even a multiplier as large as 6.0 does not yield trade effects that are as big as those suggested by the production response approach.
(Footnote 49 return)
The historical and projected values of U.S. total and manufacturing exports are presented in table 6.
(Footnote 50 return)
Projections of ''tax expenditures,'' which are regularly reported by the administration and Congress (e.g., OMB (1996) and JCT (1996)), are typically greater in magnitude than tax revenue forecasts and provide the basis for projecting tax revenues. However, tax expenditure forecasts assume that business firms do not change their behavior in response to a change in tax law. Hence, they do not take into account the recourse that U.S. firms utilizing the 50–50 division of export profits between domestic and foreign course income under the Export Source Rule have to excluding up to 15 percent of their export profits from U.S. taxation by selling exports through a Foreign Sales Corp. For discussion on how tax expenditures are estimated by the U.S. Department of the Treasury and further discussion of the difference between tax expenditure and tax revenue estimates, see Rousslang (1994) and JCT (1996) respectively.
(Footnote 51 return)
We estimate the relevant marginal tax rate in the following manner. In 1998, average manufacturing earnings will be about $38,100 per worker (table 4). The average premium of 12 percent for workers directly and indirectly supported by exports would put their average earnings at $42,700. Currently, a marginal Federal tax rate of 28 percent applies to married couples with taxable income above $36,000 and to single persons with taxable income above $22,000. Below those cutoff amounts, the marginal tax rate is 15 percent. Taking into account deductions and exemptions, we assume that half of the workers supported by exports pay marginal tax rates of 28 percent and half pay 15 percent. The relevant ''average marginal tax rate'' is thus 21.5 percent (28 + 15 divided by 2).
(Footnote 52 return)
A successful company locates offshore to increase its global sales revenue and market share. Often, this ráison d'étre is lost in political rhetoric. If a company is less competitive in the global marketplace (i.e., does not increase its global market share) because of higher taxes, that company will naturally evaluate where it places manufacturing and R&D capability. Similarly, import tariffs will influence global investment patterns. For example, the European Union in 1992 effectively placed a European manufacturing content requirement through imposition of duties on non-European manufactured semiconductors. United States and Asian semiconductor manufacturers now dominate the European semiconductor industry, which illustrates how investment decisions can be altered to reduce government imposed costs of doing business.
(Footnote 53 return)
Treas. Reg. § 1.863–3(b)(2) Ex. 1. The Tax Court in both Phillips Petroleum Co., 97 TC 30 (1991) and Intel Corp., 100 TC 616 (1993) found that the fact pattern in the regulatiion example did not apply to the facts of these cases. The facts in these cases are typical of most exporters and therefore, under current law ''activity based'' sourcing as described in Ex. 1 would rarely produce an foreign source income. The result, using and ''activity based'' model, would be zero percent foreign source income on exported U.S. manufactured product, which increases the global tax burden on this income.
(Footnote 54 return)
CEN is also referred to as a classical tax system. In addition to the United States, Japan and the United Kingdom loosely base their tax systems on this concept. An alternative concept is ''capital import neutrality'' (CIN). Under CIN, the global rate of tax on foreign income does not exceed the foreign tax rate. In other words, under CIN income earned outside the home country is not taxed in the home country, when received as a dividend or when the foreign operation is sold. ''Territorial'' based tax systems are patterned after the CIN concept. The Netherlands and France apply the ''territorial'' concept. Germany, Canada, and Australia apply the concept pursuant to income tax treaty with certain trading partners. For a detailed description of these principles, see Factors Affecting the International Competitiveness of the United States, prepared by the Joint Committee on Taxation (JCS–6–91), Part III.
(Footnote 55 return)
Studies have documented the impact exports have in job creation. Hufbauer and DeRosa project that in 1999, exports will increase $30.8 billion and $2.3 billion of additional wage income. In addition, the effect of the rule and the exports it generates will support 360,000 workers in export-related jobs, which also tend to be higher paying jobs (Costs and Benefits of the Export Source Rule, 1998–2002, Gary Hufbauer and Dean DeRosa, February 19, 1997.) In Silicon Valley, it is estimated that over 125,000 jobs were added from 1992 through 1996. Also, in 1996 average real wages, after accounting for inflation, grew about 5.1 percent compared to a wage increase of less than 1 percent at the national level (Joint Venture's Index of Silicon Valley 1997, prepared by Joint Venture: Silicon Valley Network). The Joint Venture study also reported that in 1995, Silicon Valley exports grew 30 percent to $35 billion.
(Footnote 56 return)
As income earned offshore increases as a result of additional foreign plant investments, history suggests complicated tax laws will be introduced in an attempt to tax this income before it is remitted back to the United States, contrary to efforts toward a more simplified income tax mode. PFIC and subpart F, as it relates to operating income earned from related party sales, are examples of this type of legislation.
(Footnote 57 return)
See, ''General Explanation of the Administration's Revenue Proposals,'' (''Green Book'') Department of the Treasury (February 1997) at page 36.
(Footnote 58 return)
''Power Brokers,'' National Journal, 11/30/96, page 2594, at page 2595.
(Footnote 59 return)
Notice 94–47 , 1994–1 C.B. 357.
(Footnote 60 return)
''Fitch to Rate New Securities as Bonds,'' Wall Street Journal (December 6, 1996).
(Footnote 61 return)
See, page 77 of the Green Book.
(Footnote 62 return)
See, ''Descriptions and Analysis of Certain Revenue-Raising Provisions Contained in the President's Fiscal Year 1998 Budget Proposals,'' prepared by the staff of the Joint Committee on Taxation (March 11, 1997) (JCX–10–97) at page 72.
(Footnote 63 return)
Id.
(Footnote 64 return)
See, page 78 of the Green Book.
(Footnote 65 return)
JCX–10–97 at page 75.
(Footnote 66 return)
See, section 9512 of the President's 1997 Budget Bill. While legislative language embodying the proposal has not been released this year, the Treasury Department's description of the proposal is the same as last year in all relevant respects. See Department of the Treasury, General Explanations of the Administrations Revenue Proposals (Feb. 1997) at p. 49.
(Footnote 67 return)
As discussed below, two much more limited categories of exchange-traded options, known as LEAPS and FLEX equity options, have terms of up to 3 years.
(Footnote 68 return)
The applicability of the straddle rules is apparently one of the reasons that options are not viewed as an efficient means of deferring gains. See Kleinbard and Nigenhuis, Short Sales and Short Sale Principles in Contemporary Applications, 53d N.Y.U. Institute of Taxation § 17.01 (1) n.3. (1995) (''Options transactions seem to be less attractive to investors'' as a tax deferral strategy than short-against-the-box and equity swap transactions in part because of the straddle rules.) The straddle rules do not apply to a short-against-the-box transaction. See Code § 1092(d)(3).
(Footnote 69 return)
In addition, the holder of the call may exercise it at any time. Thus, a taxpayer who writes a deep-in-the-money call cannot count on the call remaining outstanding until its expiration.
(Footnote 70 return)
See, J. Hull, Options, Futures, and Other Derivative Securities, pp. 140–141 (2d ed. 1993).
(Footnote 71 return)
Because of transaction costs, these arbitrage profits can be captured only by large traders, stock specialists, and market makers.
(Footnote 72 return)
The recently introduced FLEX equity options permit the parties to the option contract to specify certain terms.
(Footnote 73 return)
See, e.g., CBOE Rule 5.5, Interpretations and Policies .02. See generally Hull, supra, pp. 139–140.
(Footnote 74 return)
The importance of certainty to the markets is illustrated by the existence of the ''qualified covered call rules'' in section 1092(c)(4), which provide mechanical tests for determining whether writing a covered call creates a straddle. Similarly, Congress clarified the rules for ''securities lending transactions'' in section 1058 so that taxpayers could have certainty as to whether a transaction would be treated as a sale. Congress provided this clarification because it recognized that securities lending transactions contribute to the liquidity of the securities market. See S. Rep. No. 95–762, 95th Cong. 2d Sess. 5 (1978), reprinted in 1978 U.S.C.C.A.N. 1286, 1290.
(Footnote 75 return)
As noted above, roughly 90 percent of exchange-traded options are closed out or expire unexercised.
(Footnote 76 return)
A qualified covered call is an exchange-traded call option that satisfies certain mechanical tests under section 1092. Qualified covered calls are not subject to the general straddle rules.
(Footnote 77 return)
Even if the stock price stays flat, the passage of time will give rise to gain in the short call position.
(Footnote 78 return)
The holding period requirement is 91 days in the case of certain preferred stock.
(Footnote 79 return)
An amendment included in the Balanced Budget Act of 1995 and in the President's 1998 Budget would require immediate gain recognition with respect to stock in the case of certain extraordinary dividends.
(Footnote 80 return)
Moreover, the section 246(c) rules apply if a taxpayer has merely diminished its risk of loss. A taxpayer may retain substantial risk and still not acquire holding period in the stock under section 246(c). While such a strict rule may be appropriate to prevent dividend stripping, it seems unduly broad in the context of the current proposal, which applies to taxpayers that have already satisfied the section 246(c) holding period requirement for one or more dividend cycles.