Segment 2 Of 2 Previous Hearing Segment(1)
SPEAKERS CONTENTS INSERTS Tables
Page 269 PREV PAGE TOP OF DOC Segment 2 Of 2
Statement of America's Community Bankers Et Al.
The undersigned businesses and trade associations appreciate the opportunity to respond to the Chairman's request for testimony to the Committee on Ways and Means on the revenue-raising provisions of President Clinton's fiscal 1998 budget plan. Specifically, we are testifying in opposition to the Administration's proposals to reduce, eliminate, or otherwise restrict the availability of the dividends-received deduction.
As the list of signers to this testimony demonstrates, a broad range of trade associations and companies believe that these proposals would exacerbate the multiple taxation of corporate income, penalize investment, and mark a retreat from efforts to develop a more rational tax system for the United States.
Rationale for the Dividends-Received Deduction
The history of the dividends-received deduction (DRD) reflects its purpose and role to eliminate or at least alleviate the impact of potential multiple layers of corporate tax. Without the DRD, income would be taxed first when it is earned by a corporation, a second time when the income is paid as a dividend to a corporate shareholder, and finally, a third time when the income of the receiving corporation is paid as a dividend to an individual shareholder. The DRD serves to mitigate the middle level of taxation.
The DRD has been part of the federal law since 1909, when corporate income first became taxable. The deduction was enacted to provide for full deductibility of intercorporate dividends. This 100-percent deduction ensured that income earned by a corporation was not taxed more than once at the corporate level. Over time, the intended effect of the DRD has been eroded.
Page 270 PREV PAGE TOP OF DOC Segment 2 Of 2
The DRD was reduced for the first time in 1935, to 90 percent, and then in 1936 to 85 percent. During this period, the corporate income tax included a surtax applicable to income above a certain level, called the ''surtax exemption amount.'' At the time, there was concern that corporations would attempt to take advantage of multiple surtax exemptions by splitting income among several subsidiaries, each of which would be able to avoid the surtax up to the exemption amount. Subsidiary dividends then could be paid tax-free back to the parent as long as there was a 100-percent DRD. To preclude complete avoidance of the surtax through such ''income splitting,'' the DRD was reduced to 85 percent. The result, for the first time, was a second level of corporate tax imposed on the same earnings (15 percent of intercorporate dividends) before they had left the corporate sector.
Underscoring the rationale that had prompted the earlier cut-back in the deduction, the full 100-percent deduction was restored in 1964 for dividends paid within affiliated groups that elected to use only one surtax exemption. In 1975, the use of a single surtax exemption for an affiliated group became mandatory, so the original rationale for reducing the DRD no longer existed. However, Congress did not act to restore the 100-percent deduction for all corporations. As part of the Tax Reform Act of 1986, Congress reduced the general DRD from 85 percent to 80 percent, a move apparently intended to leave unchanged the effective tax rate on dividends, taking into account the reduced corporate income tax rate under the 1986 Act.
In the Omnibus Budget Reconciliation Act of 1987, the deduction was reduced to 70 percent for dividends received from the stock of corporations in which the receiving corporation owns less than a 20-percent interest. Congress's stated rationale for reducing the deduction was that the prior 80-percent deduction was viewed as ''too generous.'' The legislative history does not explain why precluding a second level of corporate tax (and a third level of tax when the earnings are paid to shareholders) should be viewed as ''generous,'' rather than appropriate tax policy. Of course, the paramount objective of the 1987 Act was to reduce forecasted budget deficits.
Page 271 PREV PAGE TOP OF DOC Segment 2 Of 2
The Administration's Proposals
The Administration's FY 1998 budget includes three proposals relating to the DRD:
• The DRD available to corporations owning less than a 20-percent interest in the stock of a corporation would be reduced from 70 percent to 50 percent.
• The DRD would be eliminated for dividends on certain limited-term preferred stock. Many companies issue this type of instrument as an alternative to higher-cost means of financing their operations.
• The DRD would be eliminated if the recipient corporation does not satisfy modified holding period requirements. This proposal generally would affect companies that have in place programs aimed at managing investment risk.
Movement in the Wrong Direction
The undersigned trade associations and companies believe that the Administration proposals run counter to sound tax policy principles:
The Proposals Would Exacerbate Multiple Taxation of Corporate Income
Most U.S. trading partners have adopted a single level of corporate taxation as a goal and provide some relief from double taxation of corporate income through ''corporate integration'' rules. Unlike the United States, other G7 countries (Canada, France, Germany, Italy, Japan, and United Kingdom) generally exclude from tax altogether dividends received by corporations. Adopting provisions that accentuate the problem of multiple taxation, rather than ameliorating this problem, would harm the international competitive position of U.S.-based corporations.
Page 272 PREV PAGE TOP OF DOC Segment 2 Of 2
The Treasury Department itself, in 1984, recommended that triple taxation of corporate income be eliminated, and double taxation be halved, as part of its blueprint for an ideal tax system. A subsequent Treasury Department report, released in January 1992, documented the substantial economic benefits of integration and the economic distortions caused by the current multi-tiered system of taxing corporate income. The report concluded that any of three proposed ''integration'' prototypes would increase investment in capital stock in the corporate sector by $125 billion to $500 billion and would decrease the debt-to-asset ratio in the corporate sector by 1 to 7 percentage points.
These themes are echoed in recent proposals to restructure the U.S. tax system. While there are considerable differences over how a restructuring of the income tax system should be pursued, there appears to be growing consensus in support of reducing the multiple taxation of corporate income. The various restructuring proposals are grounded in the fundamental rationale that business investment, organization, and financial decisions should be driven by economic and not tax considerations, and that, from a policy perspective, corporate net income should be taxed just like other income once and only once. Any further erosion of the DRD runs counter to the rationale behind these efforts.
The Proposals Would Penalize Investment by Corporations and Individuals
Cutting back on the DRD would increase the cost of equity financing for U.S. corporations, thereby discouraging new capital investment. By contrast, the corporate integration regimes adopted by the other G7 countries do not add to a corporation's cost of financing new investments.
Individuals also would be affected. Many individuals have invested in perpetual preferred equities, which provide a relatively predictable stream of earnings and stability of principal over time. Preferred equities represent a significant portion of many self-directed individual retirement portfolios. The Administration's proposals would have the effect of depressing the market for perpetual preferred stock, thereby decreasing the value of such shares. Individuals thus would see the value of current holdings and their retirement savings diminished.
Page 273 PREV PAGE TOP OF DOC Segment 2 Of 2
A Reduction in the DRD Would Discriminate Against Particular Business Sectors and Structures
The Administration's proposals may have a disproportionate impact on taxpayers in certain industries, such as the financial and public utility industries, that must meet certain capital requirements. Certain types of business structures also stand to be particularly affected. Personal holding companies, for example, are required to distribute their income on an annual basis (or pay a substantial penalty tax) and thus do not have an option to retain income to lessen the impact of multiple levels of taxation.
Companies Should Not Be Penalized for Minimizing Risk of Loss
As a result of the Administration's holding period proposal, the prudent operation of corporate liability and risk management programs could result in disallowance of the DRD. Faced with loss of the DRD, companies may choose to curtail these risk management programs.
No Tax Abuse Is Targeted by the Administration's Proposals
The Administration suggests that some taxpayers may be able to take advantage of the 70-percent deduction in a way that ''undermines the separate corporate income tax.'' To the extent Treasury can demonstrate that the deduction may be subject to misuse, targeted anti-avoidance rules can be provided. The indiscriminate approach of sharply cutting back on the DRD goes beyond addressing inappropriate transactions and unnecessarily penalizes legitimate corporate investment activity simply stated, it's bad tax policy.
Page 274 PREV PAGE TOP OF DOC Segment 2 Of 2
The Administration Has No Convincing Defense for Such a Fundamental Change to Longstanding Tax Policy
The Administration argues that the current 70-percent deduction, for example, ''is too generous.'' Since Congress already has addressed (in OBRA '87) the argument that an 80-percent deduction was ''too generous,'' and responded by reducing the deduction to 70 percent, it is hard to see why only 10 years later the same deduction could again have become ''too generous.''
Conclusion
We urge the Committee not to consider the Administration's proposals to reduce the DRD. A more appropriate approach would be to reduce or eliminate the multiple taxation of corporation income, rather than further accentuate the inefficiencies and inequities of the current system.
America's Community Bankers
American Insurance Association
American Council of Life Insurance
Edison Electric Institute
Financial Executives Institute
National Association of Manufacturers
PSA The Bond Market Trade Association
Securities Industry Association
Page 275 PREV PAGE TOP OF DOC Segment 2 Of 2
U.S. Chamber of Commerce
Aetna Life and Casualty Company
American Bank of Connecticut
American Express Company
American States Financial Corporation
Baltimore Gas & Electric
Bear Stearns & Co., Inc.
B.C. Zieglar & Co.
Chapdelaine Corporate Securities
The Chase Manhattan Corporation
Cinergy Corp.
Citicorp
Colonial Pipeline Co.
Columbia Mutual Insurance Co.
Commonwealth Mortgage Assurance Co.
Cooper Industries Incorporated
Credit Suisse First Boston
Dominion Resources
Entergy Corporation
Erie Insurance Group
Family Farm Insurance Co.
Family Company Group
Flaherty & Crumrine Incorporated
Florida Power & Light Company
Goldman, Sachs & Co.
Page 276 PREV PAGE TOP OF DOC Segment 2 Of 2
Household International
Houston Industries Incorporated
J.P. Morgan & Co. Incorporated
Kansas City Power & Light Company
Lehman Brothers Inc.
Lincoln National Corporation
Merchants Insurance Group
Mercury General Corporation
Merrill Lynch & Co., Inc.
MidAmerican Energy Company
Minnesota Power
Morgan Stanley & Co., Inc.
NYSEG (New York State Electric & Gas Corp.)
Northland Insurance Co.
Phoenix Duff & Phelps Investment Advisers
Pitney Bowes Inc.
Progressive Partners
Salomon Brothers
Spectrum Asset Management, Inc.
Smith Barney
Texaco, Inc.
The Travelers Group
Twenty-First Securities
Wisconsin Power & Light Company
Page 277 PREV PAGE TOP OF DOC Segment 2 Of 2
—————
Statement of Peter Levy, Senior Tax Counsel, Raychem Corp., on Behalf of the American Electronics Association
On behalf of the 3,000 members of the American Electronics Association (AEA), I want to thank you for this opportunity to discuss two provisions in the President's FY98 budget proposal which AEA members believe will have a severe detrimental affect on the high-tech industry if they are enacted. AEA members believe that Congress should oppose any efforts to dilute the Export Source Rule and to pass an Average Cost Basis Method for Determining Gain on Sales of Substantially Identical Securities.
Export Source Rule
The current 50/50 Export Source Rule, which has been in place for more than 75 years, permits companies who manufacture in the U.S. and export abroad to apportion the income due to such exports evenly between U.S. sources and foreign sources. The increased amount attributable to foreign sources helps companies utilize foreign tax credits, thus, avoiding double taxation. By avoiding double taxation, companies can better compete with foreign companies whose tax regimes are generally more export friendly.
In effect, the 50/50 Export Source Rule operates as an incentive for companies to maintain and expand U.S. production facilities, thereby, creating high-paying jobs in the United States. A 1997 report by International Economists Gary Hufbauer and Dean DeRosa reveals that for an adjusted net tax revenue cost of $1.1 billion in 1999, the Export Source Rule will support an additional $30.8 billion in exports and $1.7 billion in additional wages in the United States.
Page 278 PREV PAGE TOP OF DOC Segment 2 Of 2
Efforts to dilute the 50/50 Export Source Rule would both undermine the competitiveness of U.S. companies and create a perverse incentive to move jobs abroad rather than keep them in the United States.
These are jobs that Congress should be working to increase not decrease. A November 1996 study by the Department of Commerce reveals that export-related jobs pay better than others. In fact, jobs supported by high-tech manufacturing exports paid an 18% wage premium over other jobs in the United States.
Average Cost Basis
Employees of high-tech companies often acquire shares in their companies through stock purchase and stock option plans. In fact, many companies actively encourage their employees to become shareholders. An employee may own hundreds of shares that he or she acquired at 10–20 (or more) different prices. Under current law, if an employee acquires stock in the same company at different times and at different costs, he or she may choose to treat each block of stock as a separate investment. For example, an employee can identify a block of shares gifted to a child to fund college, and the basis and holding period of the shares are easily established and tracked.
The Administration has proposed that persons who own substantially identical securities would have to average the basis of those shares when computing capital gains upon their sale. Such a change would have a negative impact on the high-tech industry and on the industry's employees. The negative impact flows both from the administrative and tax burdens which result.
Savings and Investment Discouraged—The average cost basis proposal represents a significant increase in administrative burden as well as a tax increase on owners of securities. As such, it would discourage participation in the securities markets by making financial assets relatively less attractive. The high-tech industry would be adversely affected by such a proposal that would raise the cost of capital.
Page 279 PREV PAGE TOP OF DOC Segment 2 Of 2
Preference of Dividend over Growth Stocks—Capital markets would be further distorted because such a provision would make dividend stocks relatively more attractive than growth stocks which predominate the high-tech sector. The reason for this result is that more of the future value for growth stocks would be reflected in the share price than for dividend stocks.
The Administration's proposal would also have an adverse effect on high-tech employees who participate in stock purchase and stock option plans as it would make it more difficult for them to participate in these plans.
First, the administrative burden placed on the employee would be overwhelming. An employee accumulating a position over many years and making gifts to more than one child would need to provide to the recipient information sufficient to establish the basis of the gifted shares. This information would presumably require tracking and disclosing all purchases and dispositions of similar securities from the date of inception of the proposed rule.
Second, the increased tax burden on the employee would also discourage participation in stock purchase or stock option plans. Take the example of a high-tech employee who exercises nonqualified stock options to acquire employer stock at a set price. If, at the time of exercise, the strike price is lower than fair market value (FMV), the employee is required to report as taxable income the difference between the exercise price and FMV. The employee then receives FMV basis in the shares acquired.
Under current law, the newly acquired stock could then be sold immediately to pay the tax on the spread with no further taxable gain.
Under the Administration's proposal, the employee would still pick up as taxable income the difference between the exercise price and FMV. If the employee owns other shares of the company's stock, however, when the shares acquired through the plan are sold, the immediate sale of the shares will have tax consequences. The shares would not have a basis of FMV but the average of the employee's basis in all of the shares he or she owns in the company.
Page 280 PREV PAGE TOP OF DOC Segment 2 Of 2
Example:
Exercise price:$40
FMV:$50
Average basis following exercise:$20
When the option is exercised, the employee must pay taxes, including employment taxes, on $10, the difference between the exercise price and FMV. The employee must also pay taxes when he or she sells the newly acquired shares at $50 (FMV) on the difference between average basis and the current selling price ($50). This is an additional capital gain of $30 per share.
In this example for a taxpayer in the 28% tax bracket or above, the tax imposed, under the President's proposal, on the same day exercise and sale would generate taxes that would exceed the income that the taxpayer would receive on the exercise of the shares. The $10 of ordinary income plus the $30 of capital gain (taxed at 28%) would result in a tax of $11.20, ignoring employment and state income taxes.
The consequence is that many employees would be ''taxed out'' of the opportunity to participate in the employer's stock purchase or option plan, especially those employees who have been with a successful company for a long period of time. The real loser is the high-tech employee.
Furthermore, by penalizing early employees, who often receive stock options to compensate them for leaving secure positions elsewhere, the entire U.S. economy would be a loser too as the proposal would discourage people from going out on their own to start-up a new business.
Conclusion
Page 281 PREV PAGE TOP OF DOC Segment 2 Of 2
Thank you Mr. Chairman for allowing me to share the AEA's opposition to the President's proposals on the Export Source Rule and the Average Cost Basis Method. We believe in a balanced budget; however, it must not come at the expense of premium U.S. jobs. AEA looks forward to working with you and the Committee to find solutions to these issues.
The American Electronics Association (AEA), founded in 1943, is the grassroots voice of the high-tech industry. As the nations largest high-tech trade association, AEA's 3,000 member companies span the spectrum of electronics and information companies, from semiconductors and software to computers and telecommunications systems. Through its 17 local councils and other affiliations, the nonpartisan AEA has an active grassroots network of senior industry executives, provides services and information to its members and the media, and shapes public policy at the state and national levels.
—————
Statement of the American Financial Services Association
I. Summary of AFSA'S Position
The American Financial Services Association (AFSA) strongly opposes the new revenue proposal titled, ''Require Reasonable Payment Assumptions for Interest Accruals on Certain Debt Instruments,'' which in reality seems to be directed toward unbilled, estimated interest on credit card receivables. The provision is an inappropriate departure from tax accrual standards and there is no basis for extending the prepayment assumptions currently applicable (for only limited purposes) to REMIC interests to credit card receivables in order to ''equalize'' the two types of significantly different instruments. AFSA is concerned both with the specific impact of the proposal on the credit card industry as well as the precedent it sets for further departures from long-standing tax law accrual standards. This is not an issue of ''corporate welfare'' or of closing a ''loophole,'' but of whether or not the ''all events'' test can be selectively ignored in an arbitrary fashion purely to raise tax revenues. The proposal is particularly egregious because affected taxpayers are prevented from using ''assumptions'' to charge off losses on credit card receivables (See Attachment). A more thorough discussion of the issue is found below followed by a description of AFSA's membership as required by the request for comments.
Page 282 PREV PAGE TOP OF DOC Segment 2 Of 2
II. Background
Under present law, holders of credit card receivables recognize credit card interest income for tax purposes under the historic ''all events test.'' Accordingly, any interest income that is both fixed and determinable is accrued currently. Any interest income, however, the right to which is contingent upon events outside the taxpayer's control, is not includable in taxable income until all events occur which eliminate the contingency. This rule applies to interest related to a ''grace period'' provided to a credit card customer.
Under a typical grace period arrangement (please see the attached chart), a credit card customer can avoid any finance charge on year-end purchases by paying the outstanding balance on or before the payment due date (i.e., through a 25-day grace period). The customer will owe interest related to the period from the billing date through the end of the year only if the customer fails to pay the outstanding balance before the end of the grace period. As the credit card issuer's right to this ''grace period interest'' is not fixed until the end of the grace period, the issuer is not required to currently accrue any grace period interest which becomes fixed during the subsequent year.
III. The Administration's Revenue Proposal
Simply stated, the provision in President Clinton's Fiscal Year 1998 budget requiring prepayment assumptions for interest accruals 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 currently in 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. If, in the attached example, the taxpayer assumed, based on experience, that 50 percent of all nominal grace period interest becomes fixed, the taxpayer would, under the budget proposal, have to accrue for 1995, 50 percent of the estimated grace period interest on the $1,000 balance outstanding at December 31, 1995, or $3.50.
Page 283 PREV PAGE TOP OF DOC Segment 2 Of 2
IV. Why the Revenue Proposal's Departure From Tax Accrual Standards Is Inappropriate and Why REMICs Are Not Comparable Instruments
The Treasury Department claims that prepayment assumptions currently applicable to REMIC interests should be extended to credit card receivables in order to ''equalize'' the treatment of these two types of instruments. This goal is misplaced, however, because prepayment assumptions are used under present law only for the limited purpose of accruing discount and premiums on REMIC interests, but are not used for accruing stated interest. Instead, stated interest on debt instruments (including credit card receivables) is accrued under the historic ''all events test'' whereby taxpayers pay federal income tax on taxable income determined by reducing fixed and determinable income by fixed and determinable expenses. A consistent application of the fixed and determinable standard to both income and expenses preserves the integrity and fairness of the system even though some income or expense items may be taken into account at different times for financial statement purposes. Accrual method taxpayers are not entitled to deduct estimates of future expenses (such as bad debts) which, based on experience, are highly likely to be incurred. Predictions of uncertain future events have long been rejected as a basis for tax accounting on both the income and the expense side. In fact, since 1984 the accrual of expenses has been deferred beyond the time that they are fixed and determinable. A further one-sided departure from the historic ''all events test'' will significantly distort taxable income solely for the sake of a one time revenue raiser.
V. Conclusion
Under no circumstances can present law be viewed as a ''loophole'' or as providing ''corporate welfare.'' On the contrary, adopting the proposal in question can only be viewed as a tax increase on a selected group of taxpayers. AFSA believes that the proposal is not only an undesirable departure from well established tax policy, but is also inequitable and one-sided.
Page 284 PREV PAGE TOP OF DOC Segment 2 Of 2
Statement of Representation, the American Financial Services Association
The American Financial Services Association (AFSA) is the trade association for a wide variety of non-traditional, market funded providers of financial services to consumers and small businesses.
AFSA's members fit into four basic categories:
• Diversified Financial Services Companies—These are companies that offer a broad range of financial services and products to consumers nationwide. Many of these members are affiliated with banks or savings and loans.
• Automotive Finance Companies—These companies, frequently referred to as ''captive finance companies,'' provide financing for customers that purchase the manufacturer's products. In addition, many of the companies or their parents have branched out into a range of other financial services, such as credit cards or mortgage lending.
• Consumer Finance Companies—The core business of this membership segment includes: unsecured personal loans, home equity loans, and sales financing (for retailers credit customers). This segment includes companies of all sizes.
• Credit Card Issuers—This membership segment offers bank cards, charge cards, credit cards or private label cards. AFSA members include many of the largest credit card issuers in the U.S.
AFSA members are important sources of credit to the American consumer, providing more than 20 percent of all consumer credit. AFSA members are highly innovative and compete at all levels in the financial services markets. Our members have charged AFSA with promoting a free and open financial services market that rewards the highest level of competitiveness.
Page 285 PREV PAGE TOP OF DOC Segment 2 Of 2
Attachment
The Administration's proposal is inconsistent with past congressional action affecting credit card receivables. AFSA believes that the logic expressed by the Joint Committee on Taxation in its explanation (see below) of the repeal of the deduction for bad debt reserves in the 1986 Act holds equally to grace period interest. The conclusion of the explanation states that if a deduction is allowed prior to the taxable year in which the bad debt loss actually occurs, the tax liability of the taxpayer is understated. Conversely, if grace period interest must be recognized before the right to receive such income by a credit card issuer is actually fixed, its tax liability will be overstated.
Further, the proposal suffers from the same defects that the staff of the Joint Committee on Taxation relied on as the basis for the repeal of the deduction for bad debt reserves in the 1986 Act:
F. Reserve for Bad Debts (Sec. 805 of the Act and sec. 166 of the Code)(see footnote 81)
Prior Law
Prior law permitted taxpayers to take a deduction for losses on business debts using either the specific charge-off method or the reserve method. The specific charge-off method allows a deduction at the time and in the amount that any individual debt is wholly or partially worthless. The reserve method allows the current deduction of the amount that is necessary to bring the balance in the bad debt reserve account as of the beginning of the year, adjusted for actual bad debt losses and recoveries, to the balance allowable under an approved method as of the end of the year. The deduction taken under the reserve method is required to be reasonable in amount, determined in light of the facts existing at the close of the taxable year.
Page 286 PREV PAGE TOP OF DOC Segment 2 Of 2
Worthless debts are charged off, resulting in a deduction under the specific charge-off method, or an adjustment to the reserve account under the reserve method, in the year in which they become worthless. In the case of a partially worthless debt, the amount allowed to be charged off for Federal income tax purposes cannot exceed the amount charged-off on the taxpayer's books. No such requirement is applicable to wholly worthless debts.
Prior law required an actual debt be owed to the taxpayer in order to support the creation of a reserve for bad debts. An exception to this rule was provided for dealers who guarantee, endorse or provide indemnity agreements on debt owed to others if the potential obligation of the dealer arises from its sale of real or tangible personal property.
Reasons for Change
The Congress believed that the use of the reserve method for defining losses from bad debts resulted in the deductions being allowed for tax purposes for losses that statistically occur in the future. Thus, the Congress believe that the use of the reserve method for determining losses from bad debts allowed a deduction to be taken to the time that the loss actually occurred. This treatment under prior law was not consistent with the treatment of other deductions under the all events test. If a deduction is allowed prior to the taxable year in which the loss actually occurs, the value of the deduction to the taxpayer is overstated and the overall tax liability of the taxpayer understated. (emphasis added)
The administration's current revenue proposal applies to credit card issuers' receivables for which the above provision of the 1986 Act repealed the deduction for bad debt reserves. While the repeal of the bad debt deduction in 1986 relied on the ''all events'' test to prevent issuers of credit card receivables from using statistical data for purposes of accruing bad debt deductions, for income purposes the Administration is now willing—for income purposes only—to rely on statistics to require income inclusions with respect to the same credit card receivables.
Page 287 PREV PAGE TOP OF DOC Segment 2 Of 2
—————
Comments by the American Financial Services Association
The American Financial Services Association is pleased to have this opportunity to submit testimony to the Committee on Ways and Means concerning the Administration's revenue proposal that would treat as ''boot,'' certain preferred stock received in a nonrecognition transaction.
The American Financial Services Association opposes the Administration's proposal treating certain preferred stock as ''boot'' in nonrecognition transactions and urges Congress not to adopt such proposal. Such a substantial change in corporate taxation is not appropriate without a formal study regarding (i) the current use of preferred stock in business transactions, (ii) the impact of the Administration's proposal on the business community, and, in particular, on its ability to conduct business transactions efficiently where preferred stock is treated as ''boot,'' and (iii) the macroeconomic effect of the Administration's proposal on the U.S. debt market and on Federal revenues. The American Financial Services Association's comments here, however, will be directed toward the need for Congress to provide transition relief in the event that such proposal is adopted.
Many businesses currently are engaged in nonrecognition transactions, such as reorganizations and recapitalizations, involving preferred stock. These transactions, in many cases, are at some stage in a long process that may have started months earlier, if not longer. Such transactions are complex, sometimes being conducted overseas and generally are subject to regulatory approval. Arranging for financing and deciding on a structure for these transactions can be time-consuming and costly. The use of preferred stock in these transactions is often determined, after careful deliberation, to be the most efficient means for these companies to achieve their business goals.
Page 288 PREV PAGE TOP OF DOC Segment 2 Of 2
Absent transition relief or an appropriate time for adjustment to new rules, the Administration's proposal to treat preferred stock as ''boot'' would turn many of these in-process transactions into taxable events, impacting these economics and undoing much of the laborious efforts of companies in their business planning. It is one thing for our government to carefully consider and reasonably change the rules for taxing corporations and quite another thing for it to make such changes abruptly. Changes in longstanding business practices should not undermine confidence in the overall fairness of our tax system's administration.
The concern we are expressing here is precisely the sentiment that spurred William Archer, Chairman of the House Committee on Ways and Means, and William Roth, Chairman of the Senate Committee on Finance, to issue a joint statement a year ago addressing the effective date of the Administration's budget proposals: ''(S)o as not to disrupt normal market activities and business transactions during this period of deliberation, it is intended that the effective date of any of these legislative proposals that may be adopted by either of the tax-writing committees will be no earlier than the date of appropriate Congressional action.'' The same concern for not disrupting ''normal market activities and business transactions during this period of deliberation'' necessitates appropriate transition relief for persons currently engaging in nonrecognition transactions involving preferred stock and who would be impacted by the Administration's proposal to treat the preferred stock as taxable ''boot.''
Congress should consider the Administration's proposal with due regard for the practical necessities companies face when engaging in complex business transactions. A precedent of omitting transition relief when effecting tax proposals such as one treating preferred stock as ''boot'' would be certain to cause substantial business activity to freeze in the future whenever this or future Administrations issue proposals that potentially could impact such activity.
As a practical suggestion, transition relief could be fashioned in such a way as to grandfather transactions already in process on or after the date of first committee action. The determination of whether a transaction is already in process could be based on evidence that tangible steps have been taken toward arranging for financing or selecting a structure for the transaction. By contrast, requiring the transactions to have closed by the date of the first committee action will fail to address the concerns expressed above.
Page 289 PREV PAGE TOP OF DOC Segment 2 Of 2
We are not unmindful of the difficult budgetary issues confronting the Committee as it considers the Administration's revenue proposals. However, omitting transitional relief in effectuating proposals such as one treating preferred stock as ''boot'' would have harmful and enduring impacts on our business economy.
—————
Statement of the American Land Title Association
The American Land Title Association(see footnote 82) appreciates the opportunity to comment on the Administration's proposal to modify the penalties for incorrect information returns. Our members perform information reporting on real estate transactions, and are concerned about the effect of the proposed penalty provisions on our industry.
Current Requirements
Our industry has fulfilled information reporting requirements for real estate transactions since this requirement, established under Sec 6045 (e), became part of the federal tax law in 1986. Virtually all residential sales and exchanges of real estate are subject to the reporting requirement under current Treasury regulations on IRS prescribed Form 1099–S. In general, under the law, the person handling a real estate closing, such as a title or escrow closing/settlement agent, is required to collect, store, and report:
(a) selected financial information on the transaction including the gross proceeds and, effective in 1992, the real property tax proration amounts, and
Page 290 PREV PAGE TOP OF DOC Segment 2 Of 2
(b) the Taxpayer's I.D. number (Taxpayer Identification Number or TIN), on which the income from the sale will be filed with the I.R.S.
Our industry complies with current requirements to file information in a prescribed format and manner with the IRS and furnish a copy of that information to the taxpayer. Large companies have implemented separate individual systems to institute 1099–S reporting. Small companies, including practitioners who do only a few closings a year, must of necessity use a tax reporting service to send information to the IRS. Some services charge $35.00 a transaction.
We also presently incur substantial penalty costs that are imposed for incorrect filings. Real estate reporting persons are subject to penalties under Secs. 6721–24 for inaccurate reporting of information to the IRS. As a result of the uniform statutory reforms to the civil penalty system in 1989, the IRS submits 1099–S filers to the same automated regimes for penalties applicable to other information return filers. This penalty regime is applicable even though the 1099–S filer usually has limited contact with the taxpayer in question. A taxpayer may well give a 1099–S filer a social security number that does not match to IRS files. The 1099–S filer thus faces two levels of cost at two separate times. First, the filer must complete and transmit the original 1099–S form. Second, several years later the filer must respond to IRS inquires and penalties for a mismatched taxpayer identification number.
These penalties are set at $50.00 per incorrect filing. The penalties imposed by the IRS can be substantial for companies who perform a significant number of closings in the United States, annually approaching several hundred thousand dollars. These companies also have to face the possibility that (1) some individuals may have provided them with incorrect TINS, and (2) there is some margin of clerical error inherent in the volume of transactions filed. Consequently, our companies often face the dilemma that it may be cheaper to pay a fine to the IRS, as opposed to committing staff time to retrieve warehoused files and attempt to track down the seller of a property to check a TIN.
Page 291 PREV PAGE TOP OF DOC Segment 2 Of 2
Administration Proposed Increase in Information Reporting Penalties
The Administration is proposing to increase the penalty for failure to file information returns correctly on or before the August 1 from $50.00 for each return to the greater of $50.00 or 5 percent of the amount required to be reported correctly but not so reported. The $250,000 maximum penalty for failure to file correct information returns during any calendar year ($100,000 with respect to small businesses) would continue to apply under the proposal.
The Administration proposal also applies an exception to this increase where substantial compliance has occurred. The proposal provides that the exception would apply with respect to a calendar year if the aggregate amount that is timely and correctly reported for that calendar year is at least 97 percent of the aggregate amount required to be reported under that section of the Code for the Calendar year. If the exception applies, the present-law penalty of $50.00 for each return would continue to apply.
Administration Proposal on Capital Gains on Owner-Occupied Housing
We are optimistic that the actual 1099–S reporting burden will be reduced if the Administration's proposal, or a Congressional alternative to modify capital gains on home sales is enacted. Current law allows taxpayers to rollover capital gains on sale of a principal residence into a more expensive residence under Sec. 1034, and under Sec. 121, taxpayers can exclude $125,000 of capital gains on a sale if they are over 55. The Administration is proposing to exclude $250,000 per individual, and $500,000 for a married couple, for capital gains on a home which has been held for two years. The proposal allows each transaction to be discrete from the previous ones, so there is no need to track rollovers. An accompanying reduction in the reporting requirements could substantially reduce the number of 1099–S's that need to be filed.
Page 292 PREV PAGE TOP OF DOC Segment 2 Of 2
Effect of Proposal on Real Estate Reporting Persons
Even if the number of filings were concomitantly reduced with a reduction in the capital gains tax on home ownership, the Joint Committee on Taxation in their ''Description and Analysis of Certain Revenue-Raising Provisions contained in President's Clinton Fiscal Year 1998 Budget Proposal Prepared for the House Ways and Means Committee, March 11, 1997 notes that: ''Imposing the [increased information reporting} penalty as a percentage of the amount required to be reported might be viewed as disproportionately affecting businesses that file information returns reporting gross proceeds.''
This analysis of course applies to our industry. Further, with respect to real estate reporting, as noted above, the gross proceeds reported have little relationship to the amount of income ultimately reported on the income tax return. Further, Joint Tax has also noted that ''Critics of present law [regarding taxation of capital gains on sale of home proceeds] observe that because the tax can be avoided through deferral (Sec. 1034) and the one-time exclusion (Sec. 121) little revenue is collected on the sale of principal residences. (See Joint Committee on Taxation Staff Description (JCS–4–97) of Tax Treatment of Capital Gains and Losses, Scheduled for March 13 Senate Finance Committee Hearing, issued March 12, 1997.)
In addition, the title insurance industry is in a unique position with respect to TIN reporting requirements. As noted above, under the Internal Revenue Service Regulations under Sec. 6045(e), (Reg. Sec. 1–6045–4(1)(1)(I) et seq., the real estate reporting person is required to request a TIN from the transferor at or before the time of closing. The regulations further provide that if the reporting person does not receive a TIN from the transferor, the reporting person will not be subject to any penalties regarding failure to report such TIN so long as the reporting person made a good faith effort to obtain the TIN. Regs. 1–6945–4(l)(2). Further, enormous penalties might be imposed under the new regime for errors contributing to a failure to file. For example, a transaction might be incorrectly misclassified as a corporate transaction, for which filing is not required, Reg. 1–6045–4(d)(2)(I), and a penalty based on the gross proceeds could be imposed.
Page 293 PREV PAGE TOP OF DOC Segment 2 Of 2
A strong possibility exists that a company could comply with the regulations for information reporting, but would be subject to substantial penalties. Consequently, our industry is caught in a never-never land where, in consonance with regulations, we have made a good faith effort to solicit an individual seller's TIN and categorized a transaction in compliance with the regulations for information reporting. Nevertheless, we could well be subjected to substantial penalties, imposed two years after that transaction when the IRS enforcement division, based on a list of incorrect TIN's discovered through computer matching, and have penalties imposed for incorrect filings. Based on current industry experience, it is infeasible to meet ''de minimis standards.'' Our companies have consequently relied on the ''reasonable cause'' regulations, to demonstrate that they have a solicitation process in place, and attempt to abate penalties under the ''reasonable cause'' standards. As mentioned previously, it is often more cost effective from a business perspective, though patently unfair, to simply pay the penalty. Further, while the preservation of the reasonable cause basis under the new proposal is helpful, the new safe-harbor standard for ''substantial compliance'' based on irrelevant information such as correct reporting of 97 percent of an aggregate amount required to be reported for the calendar year, would be egregious.
We believe that the Congress should require significant evidence that there is non-compliance of information filing to justify imposing substantial penalties for incorrect TINS or other errors on tax information returns, which, standing alone, contribute minimally to a tax determination. It would seem that some alternative means to the current proposals could be found rather than imposing unfair burdens on filers for information that is, at best, of marginal use to the government.
We would be pleased to work with the Committee to arrive at such a different system.
Page 294 PREV PAGE TOP OF DOC Segment 2 Of 2
—————
Statement of John E. Chapoton and Thomas A. Stout, Jr., Counsel, Vinson & Elkins L.L.P. on the Administration's FY 1998 Budget Proposal To Modify the Net Operating Loss Carryback and Carryforward
Vinson & Elkins is a law firm with offices in Washington, D.C. We submit the following comments on behalf of a group of commercial banks that includes Bank of America, Bank of Boston, Chase Manhattan Bank, Citibank, First National Bank of Chicago, Fleet Financial Corporation, Norwest Corporation, Mellon Bank, and Wells Fargo.
We urge the Committee to reject the proposal contained in the Administration's 1998 Budget to shorten the period for the carryback of net operating losses to one year. It represents bad tax policy as well as bad economic policy, and it has a particularly pernicious effect on the banking industry. We fear that this proposal may not receive the attention from the business community it deserves because of the relative economic prosperity of the last few years, which has lessened immediate concern about the NOL carryback. This concern would quickly return in the event of an economic downturn.
The net operating loss carryback is not a ''loophole'' or ''corporate subsidy'' in any sense of those terms. Its purpose is to prevent taxation before economic income is earned.
The federal income tax is necessarily based on an arbitrary annual accounting convention. Business income may, however, fluctuate over a somewhat longer period. The most obvious example is a business affected by the business cycle, the duration of which may be several years. The current upturn in the business cycle, which ironically has reduced concern about the Administration's proposal, is now in its fourth or fifth year. A downturn can last just as long or longer.
Page 295 PREV PAGE TOP OF DOC Segment 2 Of 2
The impact of a serious economic downturn can be particularly hard on banks, as it was during the banking crisis of the late 1980's. And for banks, the Administration's proposed limitation on the carryback period presents a special problem. Capital provides banks protection against unanticipated losses. In difficult economic times, bank capital provides a cushion against extraordinary losses on loans and other business operations. A bank's ability to claim the tax benefit of a loss is an important means of conserving this capital in difficult economic times. If banks are denied the ability to carry back losses and obtain refunds for previously overpaid taxes—as they would under the Administration's proposal—they will be deprived of an important source of bank capital at the time when it is most needed. In effect, they will be forced in troubled times to lend needed bank capital to the federal government, in the form of prepaid taxes.
Furthermore, tax law changes made in 1986 deprived banks of the ability to deduct provisions made for bad debts using the reserve method. As a practical matter, this change also limited the ability of banks to spread losses associated with the write-off of bad debts taken in one year over a longer period of time. This 1986 change further exacerbates the hardship the Administration's proposal would work on banks.
For purposes of accounting for bank capital, bank regulatory agencies in general will recognize the potential tax benefit associated with a net operating loss—or any other deferred tax asset—only with respect to income that is available for carryback under tax law, and, at most, with respect to income in the year immediately following the loss, if any is reasonably anticipated. Any carryover of more than one year for tax purposes is therefore meaningless for purposes of determining regulatory capital. The carryback is therefore of crucial importance.
The carryback is so important to the banking industry, in fact, that during the banking crisis of the late 1980's, Congress permitted banks for a time to continue to carry back loan losses for ten years instead of the usual three. The effect of the President's proposal is to shorten the effective regulatory carryover/carryback period for banks from four years to two (one back and one forward). During difficult economic periods for banks, the result will be to further reduce bank capital.
Page 296 PREV PAGE TOP OF DOC Segment 2 Of 2
More generally, the purpose of the net operating loss carryback is to prevent income tax from being charged before the taxpayer has earned economic income. A simple example illustrates the point. If a company earns income of 10 in year 1, has no income or loss in year 2, and experiences a loss of 10 in year 3, it has earned no economic income. A net operating loss carryback operates to eliminate the tax imposed under the annual accounting convention in year 1. Without a carryback, the company would be required to pay tax on the year 1 income even though it has not yet earned any economic income.
Under current law, corporations are permitted to use net operating losses in a taxable year to offset income in the three preceding years. The Administration has proposed a reduction in the carryback period for net operating losses from three years to one year. In the example, application of the proposed rule would result in payment of income tax when the taxpayer has earned no economic income.
To operate correctly, the net operating loss carryback ought to have no limitation. Any limitation on the carryback—including the three-year limitation of current law—causes an arbitrary imposition of tax before economic income is earned. The Administration's proposal makes the present situation worse. It is an insufficient answer to extend the net operating loss carryforward. As in the case of the carryback, any limitation on the carryforward is arbitrary and unjustified. Moreover, the taxpayer must remain in business and earn income 15 or 20 years in the future to obtain a refund, then worth far less than a current refund.
The Administration says the purpose of its proposed shortening of the carryback period is to reduce the complexity and administration burden associated with carrybacks. This claim is hollow. Existing law permits taxpayers to elect to relinquish the carryback. Therefore, any burden incurred by the taxpayer is entirely voluntary. No ''relief'' such as that proposed by the Administration is needed.
In short, there is no tax policy reason to further limit the net operating loss carryback period. The Administration's proposal should be seen for what it is, a revenue-raising measure, and in this case one applied to taxpayers that are least able to bear it—those taxpayers that are experiencing losses.
Page 297 PREV PAGE TOP OF DOC Segment 2 Of 2
We submit that the Administration's proposal to reduce the net operating loss carryback to one year is ill-considered. The Committee ought to reject it.
John E. Chapoton
Thomas A. Stout, Jr.
Vinson & Elkins
1455 Pennsylvania Avenue, NW.
Washington, DC 20004
202–639–6500
Counsel for Bank of America, Bank of Boston, Chase Manhattan Bank, Citibank, First National Bank of Chicago, Fleet Financial Services, Mellon Bank, Norwest, Corp., and Wells Fargo & Co.
—————
Statement of Bear, Stearns & Co., Inc.
Summary
Two revenue raising provisions in the Administration s Fiscal Year 1998 Budget would penalize legitimate hedging transactions and adversely affect the financial markets. One provision imposes constructive sale treatment on certain appreciated financial instruments and another provision modifies the holding period rules for the dividends received deduction (the ''DRD''). We join a diverse group of companies and industry representatives (including the Securities Industry Association and a coalition of the nation s leading options exchanges, and with respect to the DRD, the American Bankers Association and the DRD Working Group) that oppose these provisions.
Page 298 PREV PAGE TOP OF DOC Segment 2 Of 2
The scope of the constructive sale legislation is so overbroad that it covers many bona fide hedging transactions and puts a ''chill'' on a broad range of other non-tax motivated hedging transactions. We believe that narrowly drafted legislation can target potential abuses (e.g., entering into a long-term, short-against-the box transaction to obtain a step-up in basis at death) without adversely affecting legitimate hedging transactions and the financial markets. We also believe that the proposed DRD changes move in the wrong direction—i.e., by imposing increased triple taxation of corporate earnings rather than a single level of taxation. Current law is entirely adequate to ensure that the DRD is available only for economic investments.
Constructive Sale Provision
The proposal would treat a taxpayer as having made a constructive sale of an appreciated stock, debt instrument or partnership interest when the taxpayer ''substantially eliminate[s]'' both risk of loss and opportunity for gain ''for some period.'' There is no definition or guidance as to what triggers a constructive sale either in terms of: (1) what constitutes ''substantial'' elimination of risk of loss and opportunity for gain, or (2) what is the relevant ''period'' for such elimination. The provision appears to trigger a tax even if an investor hedges for only one day and thereafter retains all potential risk of loss and opportunity for profit.
The basic problem with the proposed legislation is that covers a broad range of legitimate hedging transactions and is not targeted to potentially abusive transactions. As a starting point, it must be stressed that management and reduction of risk for both businesses and investors should be encouraged and not penalized. Legislation which triggers tax on an appreciated financial position as a result of a non-tax motivated hedging transaction is simply bad tax policy.
Page 299 PREV PAGE TOP OF DOC Segment 2 Of 2
Another major problem is the difficulty in applying the proposal s trigger of ''substantially eliminate'' both risk of loss and opportunity for gain. There are no meaningful objective criteria that an investor or his tax advisor can use to determine whether a transaction will result in a constructive sale. Accordingly, the proposed statutory framework is patently unworkable.
Because of the sweeping scope of the proposed legislation, taxpayers who enter into a broad range of hedging transactions with respect to appreciated financial positions will be unable to determine whether such hedges trigger tax. These taxpayers will be reluctant to enter into legitimate, non-tax motivated hedging transactions because of the fear of triggering a current tax.
The chilling effect of the proposed legislation will have a negative impact on the stock and option markets. Many investors hedge a particular stock or all or a portion of a portfolio because of an economic event with respect to a specific company or general market conditions. The proposed legislation will likely cause many of these investors to choose to maintain their risk exposure rather than risk payment of a tax. The decrease in investor participation in the financial markets (especially the stock and options markets) will result in wider spreads and greater volatility in option and stock pricing. Ultimately, this will lead to less liquidity in the markets.
We also oppose the retroactive effective date of the proposal. Under long-standing, well-settled tax law, short-against-the-box and other transactions covered by the proposal do not give rise to a taxable event. Taxpayers who have relied on this law should not be subject to a retroactive change of law, nor should they be required to incur the cost of unwinding existing positions in order to avoid a constructive sale.
The proposed legislation represents a dramatic change to current law. We urge Congress to carefully consider the impact this change would have on hedging practices and the financial markets. We believe that narrower legislation can address potential abuses that may exist under current law without impacting legitimate hedging transactions or adversely affecting the financial markets.
Page 300 PREV PAGE TOP OF DOC Segment 2 Of 2
DRD Holding Period
The Administration would also modify the DRD holding period rules and would deny the DRD to a corporate shareholder that diminishes risk of loss within 45 days of the stock s ex-dividend date. The proposed change to the DRD holding period rules should not be enacted because it would have several major negative effects: (1) impose increased triple taxation of corporate earnings while many of the United States major trading partners have moved to a system of single taxation of corporate earnings; (2) reduce participation in the options markets, resulting in increased volatility; and (3) increase the cost of capital for preferred stock issuers, especially in industries such as utilities in which preferred stock comprises a significant component of the capital structure. Finally, the proposed legislation is unnecessary because current law is adequate to ensure that the benefit of the DRD is available only for economic investments (as opposed to tax-motivated investments) in which the investor bears risk of loss for a meaningful period.
The United States has maintained its historical system of taxation whereby a corporation pays income tax on its corporate earnings and shareholders pay an additional tax upon distribution of earnings in the form of dividends. To minimize triple taxation of corporate earnings, U.S. corporations are allowed a 70–80% dividends received deduction for dividends received from other U.S. corporations.
The U.S. system of taxing corporate earnings should be compared to the tax systems of many of the United States major trading partners such as Canada, England, France, Germany, Australia and New Zealand. These jurisdictions have an integrated system of taxation whereby corporate earnings are essentially subject to a single level of taxation. See January 1992 Report of the Department of the Treasury on Integration of the Individual and Corporate Tax Systems Taxing Business Income Once.
Page 301 PREV PAGE TOP OF DOC Segment 2 Of 2
By further limiting the availability of the DRD, the proposed legislation would increase the imposition of triple taxation on corporate earnings. Such triple taxation would result from a corporate tax being paid by the distributing corporation, a corporate tax paid by the recipient corporation, and a shareholder level tax. The proposed change to the DRD would result in a 74% tax on corporate level earnings before factoring in the additional cost of state and local taxes.
Example 1: A U.S. corporation (''Corporation A'') earns $10000 and pays a U.S. federal income tax of $3500 on such earnings (35% tax rate). Corporation A distributes all of its earnings on a current basis and accordingly will distribute $65 to its 1% U.S. corporate shareholder (''Corporation B''). Corporation B has held the Corporation A stock for three years and plans to continue to hold the Corporation A stock for the indefinite future. However, Corporation B is concerned about the impact of a particular event on Corporation A and accordingly has purchased the right to put the Corporation A stock for 95% of its current fair market value in six months. Under the proposed change, Corporation B would not be eligible for the DRD and would pay a tax of $22.75 on such dividend (35% tax rate). Corporation B is owned by 10 individuals who are subject to tax at the highest U.S. marginal federal income tax rate of 39.6%. Such individual shareholders would collectively receive $42.25 in dividends and pay a collective tax of $16.73. Accordingly, such individual shareholders would collectively receive after-tax cash of $25.52; an effective tax rate of 74.5% on corporate earnings.(see footnote 83)
The proposed legislation would also have a negative impact on the options markets. Market conditions often cause corporate investors to use various hedging techniques, especially through the use of options, to hedge a particular stock or all or a portion of a portfolio of stocks. These hedging transactions include cost-less collars (i.e., the purchase of an out-of-the-money put and the sale of an out-of-the-money call), the purchase of put options, and the sale of an ''in-the-money'' call that is more than one strike price in the money (i.e., non-qualified covered calls). The following examples are illustrative market-driven hedging transactions:
Page 302 PREV PAGE TOP OF DOC Segment 2 Of 2
Example 2: Corporate investor purchases shares of Corporation X stock on July 13, 1996 for $50. On November 1, 1996, the stock price has dropped to $43/share and the investor believes that the stock price will rebound to $50 but does not want to take the risk of significant further decline. To limit its future loss while retaining the upside, the investor purchases a June 1998 $40 put for 3 7/8 and sells a June 1998 $50 call for 3 7/8 (i.e. the investor has the right to put the X stock at $40 and has sold the right to call the X stock at $50). Under current law, this cost-less collar would allow the investor to continue to receive the DRD. However, under the proposed change to the holding period rules, the investor would not be entitled to the DRD. The proposed legislation would discourage this investor from entering into legitimate market-driven hedging strategies by penalizing the investor through a disallowance of all or a portion of the DRD.
Example 3: A corporate investor purchases shares of Corporation Y stock for $42 on March 15, 1997. For the purposes of obtaining an enhanced return, the investor immediately sells a June 1997 $40 call on the Y stock for 4 1/8 (a qualified covered call) to make an expected gross profit of 2 1/8 because the investor believes there is a limited risk below $40. On June 19, 1997, two days prior to the expiration of the June contract, when the stock price of the Y stock is $46, the corporate investor continues to believe that the Y stock price has limited risk below $40. Therefore, the investor ''rolls'' its June call position into a December call position by buying back the June 1997 call at $6 and selling the December 1997 call for 8 1/4 for a net credit of 2 1/4. Under current law, all dividends received would be entitled to the DRD. Under the proposed change to the DRD holding period rules, the corporate investor would not be entitled to the DRD with respect to dividends received during the period it is hedged with the December call, subjecting dividends received by a corporate investor to three levels of taxation. Consequently, the proposed legislation would discourage corporate investors from engaging in enhanced return strategies.
Page 303 PREV PAGE TOP OF DOC Segment 2 Of 2
Example 4: Similar to Example 3, a corporate investor buys Z stock at $53 with a 3.5% dividend yield in January 1995. For purposes of obtaining an enhanced return, the investor sells a January 1997 $50 call on the Z stock (having an implied volatility of 22) for 8 1/2 because the investor believes there is limited price risk below $50. Prior to expiration, the Z stock is trading at $56. The investor continues to believe there is limited price risk below $50 and rolls its existing call position by buying back the January 1996 call at $6 and selling the January 1999 $50 call (which also has an implied volatility of 22) for 10 5/8, for a net credit of 4 5/8. Because of recent increased volatility in the stock market, the implied volatility of the January $50 call has increased from 22 to 30, although the Z stock is still trading in the $56 range. On a marked-to-market basis, with the price of the stock virtually unchanged, the January $50 1999 call has increased from 10 5/8 to 12 3/4. The taxpayer purchased the Z stock and wrote the calls with the expectation of receiving the DRD and an enhanced return from premium. The proposed change to the holding period rules would dramatically impact the expected return. More importantly, unwinding the position at this time would result in a projected loss of 2 1/8 per share. This example demonstrates that, if Congress were to enact the proposed change to the DRD holding period rules, it would be inequitable not to grandfather existing positions.
Corporate investors will be discouraged from entering into hedging transactions through the use of options such as those described above because of the possibility of losing the DRD. This decrease in corporate investor participation in the options markets would result in wider spreads and greater volatility in options pricing. Ultimately, this will lead to less liquidity in the options markets, including the stock market whose trading volume is greatly influenced by the trading volume of the option markets.
This change to the DRD holding period rules would also increase the cost of capital for many corporate issuers of stock, especially issuers of preferred stock. The proposed holding period changes will create uncertainty as to the availability of the DRD for many preferred stock investors. Preferred stock issuers likely will have to increase the dividend yield to compensate for this uncertainty. The increased cost of capital will have particular impact on certain industries, such as utilities, in which preferred stock comprises a significant component of the capital structure.
Page 304 PREV PAGE TOP OF DOC Segment 2 Of 2
The current 46-day and 91-day holding period requirements and other related provisions ensure that the benefit of the DRD is available only for economic investments (as opposed to tax-motivated) in which the investor bears risk of loss for a meaningful period. First, no DRD is allowed with respect to any dividend on any share of stock which is held by the taxpayer for 45 days (90 days in the case of preferred stock) or less. In determining whether the taxpayer has held the stock for more than 45 days, the taxpayer s holding period is reduced for periods where the taxpayer s risk of loss is diminished. The regulations interpreting when the taxpayer has diminished its risk of loss are extremely broad and in essence treat the taxpayer as having diminished its risk of loss when the taxpayer enters into a broad range of hedging transactions (other than qualified covered calls). Thus, under current law, a corporate taxpayer must incur significant economic risk of loss during the 45 day holding period to be comfortable that it is entitled to the DRD.
Second, no DRD is allowed to the extent that the taxpayer is under an obligation (whether pursuant to a short sale or otherwise) to make related payments with respect to positions in substantially similar or related property. This rule is applicable to all dividend payments received by the corporate taxpayer and will prevent the taxpayer from obtaining a DRD even if the taxpayer has satisfied the holding period rules described above.
Third, no DRD is allowed to the extent that the taxpayer finances the purchase of its stock investment with indebtedness. This rule denies the DRD to a taxpayer that has satisfied with holding period rules and related payment rules described above.
The Administration proposes to make the provision effective for dividends paid or accrued 30 days after the date of enactment. The Administration s proposal has retroactive impact since corporate investors have entered into a variety of transactions whose economics were based upon the expectation of receiving the DRD. If Congress does choose to enact a modification to the DRD holding period rules, the provision, at a minimum, should have a prospective effect. The effective date of any legislation in this area should be for ''positions entered into'' after the date of enactment.
Page 305 PREV PAGE TOP OF DOC Segment 2 Of 2
The proposed modification to the DRD holding period rules will place corporate investors in the position of having to choose between entering into a bona fide hedge to reduce risk or losing the DRD. Congress should not pass legislation which either discourages hedging or increases triple taxation of corporate earnings.
—————
Statement of the Business Roundtable
The Business Roundtable appreciates the opportunity to respond to the Chairman's request for comments to the Committee on Ways and Means on the ''revenue-raising'' provisions included in President Clinton's fiscal 1998 budget plan.
The Business Roundtable is an association of more than 200 chief sa
executives of leading U.S. corporations, employing more than 10 million people. We strongly share with members of the committee and Congress the important objective of reducing the federal budget deficit. We also firmly believe that America's tax system should be a driving force for job creation and economic growth and not an obstacle to our country's competitiveness in the new global economy. In order to achieve these goals, the Business Roundtable recommends that America's tax policy strive to:
• Set and keep tax rates as low as possible,
• Encourage capital formation,
• Allow full deductions for business expenses,
• Simplify rules, particularly on international business,
• Assure that the minimum tax does not penalize business investment, and
Page 306 PREV PAGE TOP OF DOC Segment 2 Of 2
• Promote competitiveness of U.S. companies operating in foreign markets.
The Administration, in its fiscal 1998 budget, has proposed more than three dozen tax increase provisions, most targeting U.S. corporations. Taken together, these proposals would move U.S. corporate tax policy in the wrong direction and yield only short-term revenue gains. But of even greater concern, the Administration's tax increase proposals would put American jobs at risk and seriously undermine the ability of American businesses to compete at home and in the world marketplace.
The Administration's Tax Increase Proposals
The following are examples of some of the Administration's tax increase proposals that the Business Roundtable believes run contrary to sound tax and economic policy principles:
Taxation of Export Income
The United States generally requires its businesses operating overseas to allocate certain expenses—such as research and development—to foreign source income, resulting in lower U.S. tax deductions and higher taxes. Other countries generally do not have a similar requirement. Separately, the present law U.S. ''export source'' rule operates to balance, to some extent, these trade-inhibiting rules. What's more, the benefits of the export source rule are available only to U.S. companies that export.
The export source rule has served as an incentive for U.S. companies to increase their exports, which in turn create and support quality jobs within the United States. According to the U.S. Commerce Department, U.S.-based jobs in export industries pay 13–18 percent more and provide 11 percent higher benefits than jobs in non-exporting industries.
Page 307 PREV PAGE TOP OF DOC Segment 2 Of 2
Unfortunately, the President's Fiscal 1998 budget proposes to eliminate the export source rule and replaces it with a new and complex rule that would open the door to double taxation for U.S. exporters that utilize foreign tax credits. The Treasury explanation suggests that tax treaties provide relief. The U.S. treaty network covers only about 50 countries and does little to protect U.S. industry as regards exports; thus, the Treasury explanation is not in tune with business realities.
The Business Roundtable shares the views expressed by Chairman Archer and other members of Congress that any plan to replace the export source rule is counterproductive and unwise. Exports are fundamental to our economic health and our future standards of living. Congress should make every attempt to ensure that American export-oriented jobs continue to grow and that U.S. exporters are provided a level playing field on which to compete.
Corporate Dividends Received Deduction
Most U.S. trading partners have adopted a single level of corporate taxation as a goal and provide some relief from multiple taxation of corporate income through ''corporate integration'' rules. As part of these systems, our major trading partners generally exclude from tax the dividends received by corporations.
Unwisely, the Administration has proposed to increase multiple layers of taxation on corporate income by reducing the availability of the corporate deduction for dividends received from other corporations. Adopting provisions that increase multiple levels of taxation, rather than ameliorating this problem, would harm the international competitiveness of U.S.-based corporations. Instead, Congress should consider ways to reduce or eliminate the multiple taxation of corporate income.
Page 308 PREV PAGE TOP OF DOC Segment 2 Of 2
Foreign Source Income Proposals-Impact on Oil and Gas Industry
The use of foreign tax credits—which offset taxes paid to foreign governments against U.S. taxes—enables American companies to avoid double taxation. Deferral rules, meanwhile, provide that active business income from overseas operations generally will be taxed only when repatriated to the United States in the form of dividends. Foreign tax credits and deferral are two long-standing U.S. tax principles.
The Administration has proposed to change these rules for one industry—oil and gas companies. These proposals are targeted in such a way as to enhance competitiveness of the foreign competitors of the U.S. oil industry by increasing U.S. companies costs by as much as one-third. For this industry, and any U.S.-based industry, attempting to compete in the international arena, this proposal represents bad economic and tax policy.
Corporate Reorganizations
Business reorganizations enable companies to maximize management efficiencies, address antitrust concerns or regulatory restrictions, and protect customer bases. U.S. tax law has long held that corporations generally are not taxed when a subsidiary is ''spun off.'' Sufficient safeguards exist to protect against transactions that do not have a valid business purpose or are simply devices entered into to distribute earnings and profits tax-free.
The Administration has proposed to tax certain corporate reorganizations—known as ''Morris Trust'' transactions—in which a corporation merges with another corporation after spinning off a subsidiary. This proposal would interfere with such transactions by imposing new taxes on common market-driven business reorganizations. In some cases, this proposal would make it impossible for companies to shed unwanted subsidiaries or divisions while attempting to combine complementary elements in a more efficient and productive enterprise. The unfortunate result would be a tax system at odds with the real needs of the economy.
Page 309 PREV PAGE TOP OF DOC Segment 2 Of 2
We believe that if Congress finds loopholes in, or abuses of, the present law rules for such transactions, any reform measures should be narrowly focused and not impede transactions for which there is a legitimate business purpose.
Average Cost Basis
Savings and investment are two of the key building blocks of our economy. We believe that Congress should make every effort to stimulate savings and investment, including employee ownership of company stock.
The Administration, however, has proposed to move us in the opposite direction, proposing to modify the rules by which taxpayers compute capital gains on sales of corporate stock, bonds, and other securities. The President's proposal would require taxpayers to account for sales of ''substantially identical'' securities—e.g., shares of stock in Corporation X purchased at different times and for different amounts—using an ''average cost basis.'' This proposal would introduce significant new complexity into the tax system and, at the same time, penalize savings and investment and discourage employee stock ownership.
In sum, the Administration's corporate tax increase proposals would impose burdensome taxes and rules on U.S. exporters, increase taxation of corporate investment, curb necessary business reorganizations, and diminish the ability of U.S. companies to compete in the international area. In the process, these proposals would dampen investment and jeopardize domestic job creation. We urge the Ways and Means Committee to reject these proposals.
The Business Roundtable's Legislative Priorities
The Business Roundtable firmly believes that the United States should have a corporate tax system that encourages innovation, job-creation, and growth while providing fairness, simplicity, and stability. The following are a few legislative proposals that we believe would yield enormous benefits to our economy.
Page 310 PREV PAGE TOP OF DOC Segment 2 Of 2
Simplify International Tax Provisions
Global competition clearly is the order of the day, as goods, technological knowledge, and capital flow freely across borders. U.S. companies increasingly are adopting global investment and marketing strategies to survive and prosper. The U.S. corporate tax system, however, was designed for another era. The Business Roundtable has long advocated a simplified U.S. corporate tax system, one that recognizes the global character of today's marketplace and promotes the competitiveness of American businesses.
Many countries recognize that their self-interest lies in eliminating trade barriers and tax obstacles to the cross-border flow of investment. As the global economy has changed, our trading partners have changed their tax systems to conform to the new economic realities. Unfortunately, the U.S. tax system is obsolete and unready to meet the demands of the 21st century. For example, the United States is one of the few developed countries that taxes certain active foreign source income whether or not it has been repatriated.
The Business Roundtable strongly believes that simplifying international tax provisions of the U.S. tax system should be a paramount goal. The U.S. system for taxing foreign source income should be more compatible with the new economic environment. Failure to address the complex and anti-competitive aspects of U.S. international tax policy will handicap American companies competing in global markets and threaten American jobs.
Extend the Research and Development Tax Credit
The research and development (R&D) tax credit is a vital incentive for promoting business innovation and investment. Salaries and wages account for the bulk of R&D spending eligible for the R&D credit. Looked at another way, the R&D credit rewards companies that hire and retain high-skilled workers in the United States. The credit, however, will expire May 31, 1997. The Administration has proposed a one-year extension of the credit, through May 31, 1998.
Page 311 PREV PAGE TOP OF DOC Segment 2 Of 2
We believe that the R&D credit should be renewed for a longer period. Because of budgetary constraints, the R&D credit historically has been renewed for only short periods, usually year-to-year. But because businesses have far longer time horizons for R&D, the uncertain future of the credit has added uncertainty to critical business decisions. This uncertainty was exacerbated by Congress' failure to extend the credit for the period 7/1/95 to 6/30/96. Recent economic studies have shown that the responsiveness of R&D activities to R&D tax incentives is greatest when the incentives are provided on a permanent basis.
Reform the Corporate Alternative Minimum Tax
As part of any effort to simplify the corporate tax system, Congress should consider restructuring the anti-competitive aspects of the corporate alternative minimum tax (AMT). The Business Roundtable believes that the AMT, as it currently operates, is a special tax on depreciation, and thus discourages investment in new plant and equipment. The AMT also operates at cross-purposes, imposing higher taxes on companies during downturns in the economic cycle and lower taxes during good economic times. We support proposals to ameliorate the corporate AMT that were included in 1995 budget legislation passed by Congress but vetoed by President Clinton.
Provide Capital Gains Tax Relief
Reducing capital gains taxes would provide one of the surest ways to encourage savings and investment in our economy. We believe that Congress, as part of its efforts to provide needed capital gains tax relief for individuals, also should extend capital gains tax relief to corporations.
Page 312 PREV PAGE TOP OF DOC Segment 2 Of 2
The Administration has proposed targeted capital gains tax relief for residential home sales. High capital gains taxes stymie investment and bottle up enormous amounts of capital that could be reinvested and create new businesses and jobs. Targeted capital gains relief will yield only modest benefits for our economy. Broad-based capital gains relief, however, will give our country an unprecedented economic boost.
In Conclusion
American companies are the engine that drives job creation and economic growth. Congress can help keep that engine running and make it more powerful by providing a tax system that encourages growth and investment while ensuring that tax rules are fair and reflect economic reality. We applaud the Ways and Means Committee for considering tax proposals to spur economic growth, and urge the committee to continue its efforts to simplify the tax system and preserve tax incentives that clearly benefit the American economy.
By rejecting tax proposals that would undermine American companies' international competitiveness and hinder innovation and job creation, the Ways and Means Committee will continue to send a strong and clear message that the business of America is business.
—————
Statement of Caterpillar, Inc.
It is vitally important to U.S. based manufacturers with significant export sales to retain the Export Source Rule in its present form. The replacement of the 50/50 rule with an activity-based rule will have serious detrimental effects on the level of export sales and ultimately on the level of jobs that are dependent on those sales.
Page 313 PREV PAGE TOP OF DOC Segment 2 Of 2
In his remarks at the Treasury Conference on Formula Apportionment on December 12, 1996, Deputy Secretary of the Treasury Lawrence H. Summers cited the following five goals of the international tax system: neutrality of location, maintenance of competitiveness, administrability, protection of the revenue base, and compatibility with international norms. He further stated that ''Any proposed change should be viewed in the context of these goals and must bear the burden of proof that it will improve, not merely match the performance of the current system.'' Caterpillar believes the current Export Source Rule is an effective tool for meeting those goals and that its replacement with an activity-based rule does not achieve the goals cited by Deputy Secretary Summers.
For decades the 50/50 Export Source Rule has played a significant role in allowing U.S. multinational companies like Caterpillar Inc., to remain globally competitive in spite of the fact that the U.S. tax rules make it increasingly difficult for these companies to avoid double taxation of their income. The U.S. tax system has continually expanded the base of worldwide income subject to current U.S. tax and, to make matters worse, this expansion has been accompanied by introduction of numerous rules restricting a U.S.-based multinational corporation's ability to credit foreign tax.
The resulting double taxation many U.S. companies incur is not compatible with international norms and places these companies at a competitive disadvantage in the global marketplace. An activity-based source rule will further restrict utilization of foreign tax credits by reducing foreign source income based on the fact that a company chose to locate plant operations—and hence a major part of its activity—in the U.S. This ''penalty'' for U.S. activity is a definite deterrent in achieving the goal of location neutrality and could in fact encourage firms to locate operations outside the U.S.
It is generally accepted that current U.S. tax law, as it relates to international matters, is extremely complex. The provisions relating to the allocation and apportionment of income and expense required for the determination of foreign tax credit limitations are perfect examples of an onerous and expensive system. The compliance costs associated with data collection activities required to support this calculation are staggering.
Page 314 PREV PAGE TOP OF DOC Segment 2 Of 2
An activity-based source rule will add yet another level of complexity to this calculation as companies are forced to gather and analyze data required to support allocation of income to foreign and U.S. sources on the basis of activity. The Export Source Rule has evolved into one of the few WTO-consistent export incentives remaining in U.S. 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.
Finally, the Administration has cited increased tax revenues resulting from implementation of the activity-based source rule as a means of enhancing the current revenue base that may be diminished by tax cuts in other areas. Attempts to replenish the tax revenue base with the introduction of the activity-based source rule must be thoroughly examined. It is not appropriate to simply examine tax revenues associated with the current level of export sales since this sales base will inevitably be eroded as companies are encouraged to shift more of their manufacturing activities outside the U.S.
The 50/50 Export Source Rule encourages multinational companies like Caterpillar to produce goods in the U.S. and export. The relief that the rule provides with regard to the ability to generate foreign source income and thereby avoid double taxation allows companies that manufacture primarily from a U.S. base to remain globally competitive while providing high levels of employment in the U.S. The jobs that support export sales should not be jeopardized in the interest of raising tax revenues. Therefore, we would encourage the Committee to retain the Export Source Rule in its current form and reject proposals to replace it with an activity-based rule.
—————
Statement of Claude P. Boudrias, Chemical Manufacturers Association
Page 315 PREV PAGE TOP OF DOC Segment 2 Of 2
The Chemical Manufacturers Association (''CMA'') appreciates this opportunity to present its views on the revenue raising provisions in the Administration's Fiscal Year 1998 Budget Proposal.
CMA is a non-profit trade association whose member companies represent more than 90 percent of America's productive capacity for basic industrial chemicals. Since 1991, the U.S. chemical industry has been the nation's leading exporter with gross exports in 1996 of $61.8 billion which produced a net trade surplus of $16.9 billion. The chemical industry now provides over one million high-wage, high-tech jobs for American workers. The chemical industry also ranks first in company-funded research and development spending among all U.S. manufacturing sectors with an estimated $18.3 billion in 1996.
Although CMA has concerns about the adverse impact of several of the Administration's revenue-raising proposals, we will limit our comments to the two proposals that would have immediate impact on the international competitiveness of products manufactured in the United States and on the security of the jobs of the American workers who produce them. These are the Administration's proposals to (1) replace the Export Source Rule and (2) revise the tax treatment of foreign oil and gas income.
In our statement submitted to the Committee on Ways and Means in connection with its hearings on tax reform last year, CMA stressed the single, most important issue in tax reform is its impact on the international competitiveness of U.S. manufacturers and on the American jobs they provide. In recent years, the U.S. chemical industry has grown from producing basic commodity chemicals to producing commodity and specialty chemicals, and has greatly expanded its overseas operations and markets. Nonetheless, the chemical industry continues to provide over one million quality jobs for American workers. Today a substantial portion of those American jobs is directly dependent on the expanded market that growing U.S. chemical exports provide.
Page 316 PREV PAGE TOP OF DOC Segment 2 Of 2
The present Export Source Rule is a strong, recognized incentive for the export of U.S.-manufactured products. For over 70 years the regulations under the Internal Revenue Code have allowed U.S. manufacturers to generate a combination of manufacturing and sales income with respect to exports of products manufactured in the United States. In general, these taxpayers are permitted to treat half of this combined income as U.S. manufacturing income and to treat the other half as foreign source income. The amount of foreign source income is crucial to the use of the foreign tax credit. Thus, U.S. manufacturers that pay rates of foreign tax in excess of U.S. rates can reduce or eliminate U.S. tax on their export sales or other foreign income.
Expanding foreign trade is central to increasing the market for U.S.-manufactured products and to providing greater job security for American workers. Reducing the incentive now provided by the Export Source Rule as proposed in the Administration's budget would clearly make U.S. chemical exports less competitive in world markets. Last year we urged you to reject the proposed changes to the Export Source Rule and we do so again this year.
The review and reform of U.S. taxation of foreign income is greatly needed. The United States remains one of few countries that now tax companies on their world-wide income. Even those other countries that tax world-wide income find means to allow their companies to compete without tax handicaps in world markets. Congress should not modify the present Export Source Rule until it is willing to undertake comprehensive reform of the taxation of foreign income.
The ability to compete internationally is a complex problem. In addition, overall U.S. tax policy frequently may discourage U.S.-based firms from making investments abroad that result in expanded U.S. exports and American jobs. In this respect, CMA has strongly opposed proposals to tax U.S. corporations currently on the income of their foreign subsidiaries, such as S–1597, ''the American Jobs Act of 1996,'' introduced by Senator Dorgan (D–ND) in the last Congress. The Administration's proposal to tax foreign oil and gas income is little more than an attempt to end deferral. On principle, this proposal is very bad tax policy and we strongly urge the Committee on Ways and Means to reject it.
Page 317 PREV PAGE TOP OF DOC Segment 2 Of 2
The overseas operations of U.S. chemical companies have proven to be strong customers for U.S.-produced products. In 1990 U.S. chemical exports were $39.5 billion—then equal to the nation's total agricultural exports and significantly larger than U.S. aircraft exports of $30.1 billion in that same year. In 1990, we also enjoyed a healthy net U.S. trade surplus in chemicals of $16.8 billion. Six years later, U.S. chemical exports accounted for $61.8 billion with a net U.S. chemical trade surplus of $16. 9 billion in 1996. More importantly, the chemical industry today continues to provide over one million high-quality, high-paying jobs in the United States, while implementing major technological innovations and efficiencies.
Conclusion
We again urge the Committee on Ways and Means to consider the adverse impact on international competitiveness of the Administration's proposals to replace the Export Source Rule and to tax foreign oil and gas income and to reject those proposals accordingly.
—————
Statement of Coalition on Credit Card Interest
This statement is respectfully submitted on behalf of the Coalition on Credit Card Interest in response to the Committee's request for comments on revenue raising provisions included in the President's fiscal year 1998 budget. The Coalition appreciates the Committee's interest in public comments on the Administration's revenue proposals and welcomes the opportunity to express its strong opposition to one of these proposals in particular—the proposal to require a prepayment assumption in computing the accrual of grace period interest on credit card receivables outstanding at the end of a taxable year. The proposal is detrimental to credit card businesses located throughout the United States, including the credit card operations of commercial banking and thrift institutions, non-bank financial institutions and retailers.
Page 318 PREV PAGE TOP OF DOC Segment 2 Of 2
Background
Credit card issuers frequently provide an interest free ''grace period'' before customers are liable for any interest charges on purchases. In a typical arrangement, interest is not charged on a customer's credit card balance (other than the portion of the balance reflecting the principal amount of cash advances) during the grace period. The grace period typically begins on the date a customer's purchase is posted to his or her account and ends a specified number of days after close of the monthly billing cycle during which the purchase is posted.
For example, assume a customer purchases goods on November 15 using a credit card with a billing cycle ending the 12th of each month and a 25-day grace period. The purchase would likely be posted to the customer's account on November 15 or 16 and would be included on the customer's bill dated December 12. Under this arrangement, the customer would not incur a finance charge on the November 15 purchase if the December 12 balance, which includes the November 15 purchase, is paid on or before January 6. If, on the other hand, the customer fails to pay the balance by January 6, interest will generally be computed based on the average outstanding balance which was increased on the date the purchase was posted to the customer's account.
Under present law, a credit card issuer is not required to include grace period interest in taxable income until the grace period has expired. As the Committee knows, a provision in President Clinton's fiscal year 1998 budget would require a ''reasonable payment assumption'' for interest accruals on certain debt instruments.(see footnote 84) These debt instruments would include pools of credit card receivables. The proposal would require credit card issuers to use an assumption about payment patterns to accrue interest income when the receivables are outstanding over the end of a taxable year. Simply stated, the proposal would require credit card issuers to accrue an estimate of the total amount of interest income expected to be earned at the end of the grace period. 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.
Page 319 PREV PAGE TOP OF DOC Segment 2 Of 2
The Administration is proposing that this provision be effective for taxable years beginning after the date of enactment.
Problems With the Administration's Proposal
As discussed below, the Coalition believes that the Administration's proposal is an inappropriate departure from historic tax accrual standards. Additionally, the Coalition believes that this proposal is not an ''unwarranted tax benefit'' as the accrual method of accounting can hardly be viewed as ''unwarranted'' or contributing to ''corporate welfare.'' On the contrary, adopting the proposal in question can only be viewed as a tax increase on credit card issuers and an arbitrary departure from well-established tax policy. The Coalition strongly urges the Committee not to adopt the Administration's proposal in any form at any time.
1. The Proposal Is an Inappropriate Departure From Tax Accrual Standards
Accrual method taxpayers are generally governed by the ''all events test'' which dates back to 1926 Supreme Court case of United States v. Anderson.(see footnote 85) In deciding the appropriate time for an accrual method taxpayer to accrue a deduction for a munitions tax liability, the Court stated: ''in advance of the assessment of a tax, all the events may occur which fix the amount of the tax and determine the liability of the taxpayer to pay it.''(see footnote 86) The all events test subsequently became the consistent standard for accruing both income and expenses. The Treasury Regulations provide:
Under an accrual method of accounting, income is includible in gross income when all the events have occurred which fix the right to receive such income and the amount thereof can be determined with reasonable accuracy. Under such a method, a liability is incurred, and generally is taken into account for Federal income tax purposes, in the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability.(see footnote 87)
Page 320 PREV PAGE TOP OF DOC Segment 2 Of 2
The importance of accruing income and expense items based on a consistent standard cannot be overstated. In order to prevent a distortion of taxable income, the use of estimates should not be required for accruing income if estimates are not permitted in accruing expenses. As you are aware, estimates are not permitted in accruing expenses. For example, taxpayers are not permitted to accrue an estimate of the liability for self-insured medical costs even though the amount of the liability to be incurred can be accurately predicted by the taxpayer.(see footnote 88) In addition, all other types of reserves, including bad debt reserves, are not permitted as a deduction against taxable income.
As stated above, the right to receive credit card interest does not become fixed, and therefore is not includible in taxable income, until the end of the grace period. While the extent to which a credit card customer will pay the outstanding balance before the end of the grace period could be estimated, predictions of uncertain future events have long been rejected as a basis for tax accounting on both the income and the expense side. A return to the use of estimates solely on the income side represents a one-sided departure from long established accrual principals and will significantly distort taxable income solely for the sake of a one time revenue raiser.
2. The Administration Erroneously Equates Stated Interest on Credit Card Receivables With Original Issue Discount on REMIC Regular Interests and Qualified Mortgages
The Treasury Department's General Explanations of the Administration's Revenue Proposals suggests that the rationale for this proposed change is to treat interest on credit card receivables in a manner similar to the current law treatment of real estate mortgage conduit (REMIC) regular interests and REMIC qualified mortgages. Treasury's explanation, however, fails to state that the prepayment catch-up method applied under current law to REMIC regular interests and REMIC qualified mortgages is used solely to amortize fixed amounts of original issue discount, market discount or bond premium. Thus, under current law, the prepayment catch up method merely effects the timing of the recognition of a fixed amount of income.
Page 321 PREV PAGE TOP OF DOC Segment 2 Of 2
The prepayment catch-up method is not applied to the accrual of qualified stated interest. As a result, qualified stated interests on both REMIC regular interests and REMIC qualified mortgages is accrued under the all-events test of Internal Revenue Code section 451. Moreover, the prepayment catch up method is not applied under present law to accrue any amount of income that is not fixed.
Therefore, the fact that the prepayment catch up method applies under current law to REMIC regular interests and REMIC qualified mortgages does not provide any justification as a matter of tax policy for applying prepayment assumptions to the accrual of grace period interest on credit card receivables. As stated above, grace period interest is not fixed until the end of the grace period. In addition, once it becomes fixed, it is qualified stated interest rather than an amount of discount or premium. Unlike with REMICs, applying prepayment assumptions to grace period interest effectively results in a tax on income that has not been, and may never be, earned.
Recommendations
For the reasons set forth above, the Coalition strongly urges the Committee not to include the Administration's proposal to require the use of estimates for interest accruals on credit cards providing for a grace period, this year or in the future. The Coalition recognizes the need for modernization in the financial products area but believes this provision inappropriately attempts to treat contingent interest in the same manner as a fixed amount of original issue discount. Effectively, this proposal represents a tax increase on credit card issuers, not the elimination of an unwarranted tax benefit.
The Coalition appreciates the Committee's interest in its views on this significant issue.
Page 322 PREV PAGE TOP OF DOC Segment 2 Of 2
The Administration is proposing that this provision be effective for taxable years beginning after the date of enactment.
—————
| Coopers & Lybrand |
| March 26, 1997 |
The Honorable Bill Archer
Chairman, Ways and Means Committee
United States House of Representatives
1102 Rayburn House Office Building
Washington, DC 20515
Dear Mr. Chairman:
As you examine the revenue provisions contained in the President's Fiscal Year 1998 Budget proposal, Coopers & Lybrand and our affected clients appreciate your commitment to closely consider the unintended adverse effects of these provisions. In particular, we would emphasize the negative results produced by the proposal to effectively eliminate short against the box transactions, as well as many other security hedges, on both the market and the individual investor. This proposal, as included in the President's package, would severely restrict legitimate hedging transactions and force individual investors who remain in the market to face increased risk. The retroactive effective date would be particularly harmful, imposing a surprise tax on transactions that taxpayers might not have engaged in had a retroactive change in the law been considered a realistic possibility.
Page 323 PREV PAGE TOP OF DOC Segment 2 Of 2
The tax code has permitted the current law treatment of short against the box transactions for over fifty years. In a short against the box transaction, the taxpayer owns stock and enters into a short sale using borrowed shares of the same stock. This transaction allows individual investors to take a more active role in the securities market by managing the risk. When a security enters a period of fluctuation, or events outside the market indicate that the security's value may drop, owners of that security can eliminate the risk of any short-term loss on the stock. A taxpayer who believes in the long-term holding of a stock investment can maintain the investment. The short against the box transaction enables that taxpayer to protect a long-term investment gain and still retain the original shares without affecting the holding period or basis, while ''sitting out'' certain risky periods in the ownership of the security.
Recognizing such short against the box transactions as constructive sales forces the investor to utilize other, more costly transactions to protect gain. In some cases, the Administration proposal would tax transactions when the taxpayer is legally prohibited from selling the underlying stock. The Administration proposal is one more step toward a mark-to-market system of securities taxation, which is not in the best interest of strong markets in the United States. If the proposal is adopted, some taxpayers will elect to leave the market and seek alternative investment strategies.
If the Committee determines that, in tax and budget negotiations with the Administration, it must support some aspects of the President's proposal to eliminate short against the box transactions, then we encourage you to maintain your commitment to ensure that taxpayers who entered into these transactions in good faith reliance on the March 29, 1996 joint press release issued by Senate Finance Committee Chairman William Roth and yourself will not be harmed by effective dates that reach back to snare transactions engaged in prior to the date of Congressional action. The press release stated that ''so as not to disrupt normal market activities and business transactions ... the effective date of any of these legislative proposals that may be adopted by either of the tax-writing committees will be no earlier than the date of appropriate Congressional action.''
Page 324 PREV PAGE TOP OF DOC Segment 2 Of 2
Secure in the Congressional assurance provided by the March 12 press release, the investment and business community continued to operate normally for the last year. The Administration's January 12, 1996 effective date for this provision—which would require that all transactions entered into after that date be treated as constructive sales if not closed within thirty days after enactment of legislation—breaches investors' trust in their government. We ask that the Committee appropriately address this discrepancy.
Even more harmful, in some respects, is the Administration's proposal that the gain on short against the box transactions be treated as income in respect of a decedent (IRD) upon the death of a decedent who is holding such a position. This would retroactively apply to transactions entered into many years ago and could impose a combined income and estate tax burden of up to 67 percent. Although married individuals that die leaving their estate to a surviving spouse would incur no estate tax liability, the resulting income tax liability could operate to deplete the assets of the surviving spouse and upset financial solvency of many existing estate plans.
Attached are 1996 comments prepared by the New York State Society of Certified Public Accountants that provide an excellent technical explanation of the short against the box issues.
We are sending a similar comments to all Members of the tax writing Committees as well as to Treasury Secretary Rubin. We would be pleased to provide you any further information on this matter that you may feel is helpful. Please contact Pamela Pecarich, Director, Tax Policy (202–822–4239), John Harman, Manager, Tax Policy (202–822–4406), or Janice Johnson, Director, C&L New York (212–259–1114).
Sincerely,
Page 325 PREV PAGE TOP OF DOC Segment 2 Of 2
Attachment
INSERT OFFSET FOLIOS 1 TO 11 HERE
[The official Committee record contains additional material here.]
—————
Statement of Asael T. Sorensen, Jr., on Behalf of Covol Technologies, Inc.
Covol Technologies Inc., headquartered in Lehi, Utah, has developed technology to convert waste coal fines into a solid synthetic fuel. The technology has also been applied to recover high grade iron from the iron-rich waste streams of the steel industry and to recover other non-ferrous minerals from granular materials. Covol's strategic plan is to implement its technology in the remediation of waste materials to produce energy resources, metals and minerals, both domestically and internationally.
The Technology
Approximately ten to twenty percent of all coal mined in the United States ends up as ''coal fines,'' small particles ( 1/4 inch and smaller), which are land filled because they are too difficult to handle and move. Coal fines once broken up and exposed to the air will deteriorate over time and can cause ground water contamination. When blown into the air during the mining process or in landfills, the fines increase particulate levels and have been associated with black lung disease. To prevent fines from being blown into the air, some states require that coal fines be kept under water. Other states classify coal fines as industrial waste and require expensive reclamation projects which merely bury the fines and reclaim the surface. This does not address water contamination issues.
Page 326 PREV PAGE TOP OF DOC Segment 2 Of 2
For decades, people have tried various methods to recover these waste fines, but with little or no success. In 1992, Covol developed a technology that reacts with the carbon molecules in the coal so that they bind together in a covalent bond. The Covol process greatly reduces the expense of reclamation while at the same time producing a valuable product. The process is economically viable, but needs a large capital investment to implement it. Although the Section 29 tax credits are scheduled to expire at the end of 2007, the process of converting coal fines into solid synthetic fuel will continue indefinitely, thus remediating the environmental problems created by our past.
Problem Created by Changing Section 29
• In September 1995 Covol received a Private Letter Ruling from the IRS indicating the synthetic coal product qualifies for the IRC Section 29 tax credit.
• In August 1996 the President signed the Small Business Jobs Protection Act of 1996 which, among other things, modified IRC Section 29 by changing two effective dates for qualifying facilities; IRC Section 29 would apply to synthetic fuel produced by a facility constructed under a binding contract entered into by December 31, 1996 and placed in service by June 30, 1998.
• On or before December 31, 1996, Covol and other licensees of Covol technology (including PacifiCorp and Savage Industries) entered into binding contracts for the construction of qualifying facilities in states which have significant challenges with land filled waste coal fines. The contracts contemplated an 18-month construction horizon.
• On February 6, 1997, the President submitted his Fiscal Year 1998 Budget to Congress. The Administration's proposal reverses Congress' decision regarding the placed in service date for contracts entered into by December 31, 1996 to June 30, 1997 (rather than June 30, 1998). This change does not allow Covol and the licensees of its technology sufficient time to construct facilities and place them in service. Thus the proposal is RETROACTIVE in its effect because it interferes with the viability of contracts entered into prior to December 31, 1996.
Page 327 PREV PAGE TOP OF DOC Segment 2 Of 2
• If the plants are not constructed Covol and its licensees will be subject to multi-million dollar penalties for not constructing the facilities as called for in the binding contracts.
• Even if the proposed change does not pass, it has already placed in serious jeopardy the completion of these facilities; critical financing will not be available and construction will not commence until there is certainty that the proposal will not pass.
Cutting off the Section 29 projects at this point hurts more than just the companies who have developed the synthetic fuel technologies. To name just a few:
1. Lending Institutions
Institutions have provided millions of dollars in loans to fund the past six months worth of work since Section 29 was extended in July 1996. If the projects fail because they cannot be placed in service by July 1, 1997, the lending institutions may not be able to recoup their funds.
2. Individual Investors
Individual investors, some of whom are small players, have purchased equity interests in specific projects as well as in the companies that are providing the technology. They will obviously be hurt if the projects do not succeed.
3. Major Equipment Suppliers
Page 328 PREV PAGE TOP OF DOC Segment 2 Of 2
Millions of dollars worth of major, long lead time, specialty equipment has been ordered and is in the process of manufacture. Being special order equipment, there will be no other market for it and it will be a total loss.
4. Individual Taxpayers/Employees
Many of the Section 29 projects are in economically depressed areas. Individuals who have moved their families in order to obtain valuable employment will suffer significant relocation difficulties.
Proposed Solution
• Retain language of Section 29 as modified by Small Business Jobs Protection Act of 1996, with one exception:
• Extend the placed in service date to June 30, 1999 to compensate for the time lost in financing and construction as a result of the Administration's proposal.
• This proposed solution addresses the Administration's concern for the growth of the credit while treating equitably those who have in good faith entered into contracts under the current statute.
—————
Statement of Edison Electric Institute
Page 329 PREV PAGE TOP OF DOC Segment 2 Of 2
I. Introduction
The Edison Electric Institute (''EEI'') respectfully submits the following statement for inclusion in the record of the March 12, 1997 hearing before the Committee on Ways and Means, relating to revenue provisions appearing in the Administration's fiscal year 1998 budget proposals.
EEI is the association of the United States investor-owned electric utilities and industry affiliates worldwide. Its U.S. members serve 99 percent of all customers served by the investor-owned segment of the industry. They generate approximately 78 percent of all the electricity generated by electric utilities in the country and serve 76 percent of all ultimate customers in the nation.
While a number of the Administration's tax proposals are of interest to EEI and its members, this statement addresses only the proposal to amend section 355 of the Internal Revenue Code ''to require gain recognition on certain distributions of controlled corporation stock'' also known as the ''Morris Trust proposal.''(see footnote 89) This proposal contradicts longstanding case law and IRS ruling positions, as well as existing and proposed Treasury regulations. If enacted into law, it would have an especially severe impact on the critical restructuring efforts of electric utilities in response to the emerging climate of deregulation, competition and related industry restructuring and consolidation.
II. History of Morris Trust Transactions
More than 30 years ago, in Commissioner v. Morris Trust,(see footnote 90) the U.S. Court of Appeals for the Fourth Circuit held that a banking corporation's spin-off of an unwanted insurance department, followed by a merger into another bank, each qualified for tax-free treatment. The court concluded that the asserted business reason for the spin-off, i.e., to pave the way for the subsequent merger, was an acceptable ''corporate business purpose'' under section 355; and that the other statutory and regulatory requirements of that provision were not violated by reason of the planned merger.
Page 330 PREV PAGE TOP OF DOC Segment 2 Of 2
The basic elements of the typical Morris Trust transaction are as follows:
• Company D operates two or more businesses. Company P wants to acquire only one of the businesses. D and P are usually each publicly traded corporations. To facilitate the acquisition, D transfers to its shareholders the stock of a subsidiary (''C'') which contains the ''unwanted'' business(es).
• The distribution or ''spin-off'' of the C stock is designed to qualify for tax-free treatment under section 355. D (which now owns only the ''wanted'' business) is then combined with P in a ''reorganization'' which is designed to qualify for tax-free treatment under section 368.
• The reorganization typically involves either D merging into P (with D going out of existence), or D becoming a P subsidiary. In either case, the D shareholders exchange all their D stock for shares of P stock.(see footnote 91)
While the former D shareholders in the Morris Trust case received 54% of P's stock in the merger, the more usual result is that a much smaller percentage of the P case stock ends up in the hands of the acquired corporation's shareholders. The IRS has consistently affirmed tax-free treatment in these ''whale swallows minnow'' scenarios as well.
Under current law, the specific federal income tax consequences of the typical Morris Trust transaction are as follows:
• The former D shareholders have no taxable income on their receipt of the C shares in the spin-off, or on their receipt of P shares in the subsequent reorganization. However, their total tax basis in the C and P shares will be the same as their tax basis in the formerly-owned D shares. As a result, when either the C or P shares are sold, any appreciation in the value of such shares, including the appreciation incurred as of the time of the spin-off and the reorganization, will be triggered as taxable gain to the selling shareholder.
Page 331 PREV PAGE TOP OF DOC Segment 2 Of 2
• D generally will not have any taxable gain upon the spin-off, even though the value of the distributed C stock typically exceeds D's tax basis in such stock.
• D will not have taxable gain as a result of the reorganization. However, the tax basis of the D assets transferred in the reorganization will be the same in P's hands as they were in D's hands. As a result, when such assets are sold by P (or by D, if D becomes a P subsidiary), any appreciation in value that may have existed in such assets at the time of the reorganization will be taxed to the selling corporation as well as any post acquisition appreciation in value.
III. Importance of Morris Trust Technique to Electric Utilities
Historically, investor-owned electric utilities have furnished most of the electric power consumed in this country. Such utilities are subject to extensive federal, state and local regulation and have traditionally operated on a sole provider basis in defined customer service areas. Their operations typically embody generation, transmission and distribution functions, with the ultimate price to customers being determined through public ratemaking agencies on a ''cost of service'' basis.
Now, however, the electric utility industry is well into the initial phase of a major deregulation process. The principal elements of this process are (i) the emergence of competition in both wholesale and retail power markets, and (ii) substantial industry-wide restructuring and consolidation with a promise of significantly more of this activity. The elimination of cost of service regulation will most likely be implemented in the generation segment, with the transmission and distribution segments continuing to be subject to various types of regulatory regimes.
Most states are currently studying electric industry competition and deregulation issues. California, Rhode Island, Pennsylvania, and New Hampshire have already enacted specific legislation in this area, and further legislative and/or administrative action by many other state jurisdictions is inevitable over the next few years. Many electric utilities, moreover, are now implementing or seriously considering corporate restructuring plans for separating their generation, transmission and distribution functions in order best to meet the new competitive environment.
Page 332 PREV PAGE TOP OF DOC Segment 2 Of 2
One concern that regulators have as the industry restructures into a competitive environment is that of market power.(see footnote 92) Mergers and other restructuring may be approved only if measures are taken to reduce market power. In some cases, the merging parties may propose spinoffs while in other cases federal and state regulatory bodies may condition the mergers on a spinoff. The Federal Energy Regulatory Commission has recently promulgated a merger policy which addresses market power issues.
The important point to emphasize is that as the approximate 100 current companies at the common stock level become involved in restructuring to meet the competitive challenge, opportunities to enhance competition should not be foreclosed or made prohibitively expensive. One obvious restructuring alternative is to transfer one or more energy or non-energy-related business segments to shareholders via a qualifying tax-free spin-off under section 355. Some of these spin-off transactions likely will entail forced divestiture under state law; while others will be voluntary, though strongly encouraged as a matter of state legislative or administrative policy.
In addition, given the growing trend towards utility company mergers and other consolidation transactions (including those between electric utilities and natural gas companies), many of these spin-offs may be coupled with tax-free reorganizations using the Morris Trust format. The availability of this familiar, combined spin-off/acquisition technique is very important to electric utilities as they decide how best to deal with the major, industry-wide changes that are now underway.
IV. The Administration's Proposal
For reasons that are not at all clear, the Administration proposes to essentially eliminate the Morris Trust technique. This would be done via an amendment to existing section 355(d), a provision which was added in 1990 and generally imposes corporate-level tax on certain spin-off transactions in which a 50% or more stock ownership shift in D or C occurs during the 5-year period preceding the spin-off. More specifically, application of the Administration's proposal would yield the following consequences:
Page 333 PREV PAGE TOP OF DOC Segment 2 Of 2
• D would be taxed on any gain inherent in the C stock at the time of the spin-off, if the D shareholders fail to retain at least 50% control of both D and C during the 2-year period following the spin-off. The requisite control must exist in terms of both voting power and value. A breach of the 50% control requirement during the 2-year period preceding the spin-off would also trigger the corporate-level tax.
• In the typical Morris Trust transaction, the reorganization occurs on the same day or shortly after the spin-off; and neither transaction occurs without the other. The so-called ''unrelated transaction'' exception in the proposal would therefore be unavailable.(see footnote 93) A Morris Trust transaction could otherwise survive the proposal only in the unusual case where D is larger than P and the former D shareholders end up with more than 50% of the P stock.
• The D shareholders would still have tax-free treatment on their receipt of C shares in the spin-off. Nor would the proposal affect the tax-free qualification of the reorganization with P. In most cases, however, imposition of a corporate-level tax on D would be sufficiently onerous to derail the transaction. As a result, it is doubtful that any significant amount of revenue would be raised by enactment of the proposal. Indeed, the ultimate revenue impact could be negative, because the hoped-for increase in taxable earnings that successful Morris Trust type combinations are designed to produce would never enter the tax base if such transactions are discontinued.
V. Shortcomings of the Proposal
The Morris Trust proposal should be rejected for a number of reasons, including the following:
Page 334 PREV PAGE TOP OF DOC Segment 2 Of 2
• Morris Trust transactions have long been blessed by the IRS in published and private rulings and are explicitly recognized as an acceptable spin-off format in recently issued advance ruling guidelines.(see footnote 94)
• The so-called ''device'' restriction of section 355 is designed principally to preclude tax-free qualification of a spin-off where the D shareholders dispose of a substantial portion of their D or C stock relatively soon after the spin-off—i.e., the very type of event that triggers application of the proposal. The Treasury regulations, however, expressly exempt from the device rules dispositions of D or C stock pursuant to a tax-free reorganization, provided that any taxable ''boot'' received in the reorganization is insubstantial in amount.(see footnote 95) The reorganizations in Morris Trust transactions usually involve purely stock consideration, i.e., no boot.
• The proposal also contradicts longstanding Treasury regulations which permit indirect ''continuity of shareholder interest'' in connection with both tax-free spin-offs and tax-free reorganizations.(see footnote 96) Again, it is that very circumstance which seems to be at the heart of the proposal because the tax is triggered only if the former D shareholders end up with less than a 50% interest in P. Continuity of interest has never been considered lacking in ''whale swallows minnow'' reorganizations, simply because the shareholders of the acquired company collectively end up with a small percentage stock interest in the acquiring corporation. Indeed, given that the continuity of interest requirement would be greatly relaxed under recently proposed Treasury regulations, it is hard to understand why the Administration would put forth a legislative change that moves in precisely the opposite direction.(see footnote 97)
Page 335 PREV PAGE TOP OF DOC Segment 2 Of 2
• Morris Trust transactions do not violate either the letter or the spirit of the 1986 Act repeal of the so-called ''General Utilities doctrine.'' The thrust of General Utilities repeal is that appreciated assets cannot be moved out of corporate solution without a corporate-level tax, if the recipient of the assets takes them with a tax basis that reflects their then fair market value.(see footnote 98) In a Morris Trust transaction, all of the pre-spin-off D and C assets remain in corporate solution with their historic basis; the basis of the D shareholders in their D stock transfers to their C and P stock; and there is no ''cash-out'' by any of the shareholders. Thus, neither the spin-off nor the reorganization is an appropriate event for triggering taxable income. Nor do they foreclose future taxation of full historic gains when the stock or assets are eventually sold.
In short, the Morris Trust proposal is at odds with longstanding case law, IRS ruling positions, existing and proposed Treasury regulations, the rationale behind General Utilities repeal, and tax simplification.(see footnote 99) The tax-free spin-off and reorganization provisions of the Internal Revenue Code provide important flexibility for corporations to rearrange and modify their business structures in order to meet new priorities and changing economic and competitive environments. Morris Trust transactions should not be inhibited by the tax system because they are a legitimate vehicle for accomplishing such business objectives. As aptly put by the appeals court in Morris Trust, such transactions involve ''no empty formalism, no utilization of empty corporate structure, no attempt to recast a taxable transaction in nontaxable form and no withdrawal of liquid assets.'' The preservation of Morris Trust transactions thus is entirely consistent with the underlying rationale of the relevant Code provisions, and reflects sound tax policy.
Page 336 PREV PAGE TOP OF DOC Segment 2 Of 2
VI. Other Section 355 Concerns
EEI is well aware of the so-called ''debt-shifting'' and ''cash-out'' concerns that have surfaced in connection with certain isolated, but well-publicized, spin-off transactions.(see footnote 100) These transactions involved formats and other circumstances far different from those present in ''plain vanilla'' Morris Trust transactions. To the extent that these and similar transactions are in fact abusive from a tax standpoint, at least three vehicles exist for dealing with the perceived problems administratively namely: section 337(d) regulations;(see footnote 101) published rulings; and/or the denial of favorable private letter rulings. If the Congress believes that such concerns should instead be addressed via legislation, any resulting amendment of section 355 should be narrowly targeted and permit continued tax-free treatment of the basic Morris Trust formats.
EEI appreciates the opportunity to submit this statement and would be pleased to meet with the Committee staff or to provide further information.
INSERT OFFSET FOLIOS 14 TO 15 HERE
[The official Committee record contains additional material here.]
—————
Statement of ENSERCH Corp., Dallas, Texas
Introduction
Page 337 PREV PAGE TOP OF DOC Segment 2 Of 2
ENSERCH Corporation submits these comments on the Administration's Fiscal Year 1998 Budget Proposal because it stands to be directly and adversely impacted by the proposal to amend section 355 of the Internal Revenue Code to require gain recognition on certain distributions of controlled corporation stock. These comments are limited to that single provision of the Administration's overall proposal.
ENSERCH is a Dallas-based integrated natural gas company. ENSERCH's major business segments include natural gas distribution, natural gas and oil exploration and production, natural gas gathering, processing and marketing, and independent power generation.
Lone Star Gas Company, a division of ENSERCH Corporation, is a regulated public utility, owning and operating some 550 local gas utility distribution systems in the State of Texas. Lone Star serves more than 1.3 million residential and commercial customers.
Among ENSERCH's other subsidiaries is a group headed by Enserch Exploration, Inc. (''EEX''). EEX is engaged in the exploration for, and production of, natural gas and oil. EEX's onshore activities are concentrated in the State of Texas, its offshore activities in the Gulf of Mexico.
Reason for Submission
On April 13, 1996, ENSERCH Corporation and Texas Utilities Company (''TUC'') entered into a merger agreement which was announced publicly two days later. TUC is a Dallas-based holding company for two electric utility systems serving 372 cities in Texas, including some 2.4 million customers also served by Lone Star. On completion of the merger, TU's total service area will cover more than half of the state.
Among the preconditions to the merger is that ENSERCH spin off its EEX group. TUC made it clear from the outset of discussions between the two companies that it would not acquire EEX. Accordingly, on June 12, 1996, ENSERCH submitted to the Service its request for a ruling that the planned distribution of the stock of EEX would be tax-free under Code section 355. On February 26, 1997, the Service issued the requested ruling.
Page 338 PREV PAGE TOP OF DOC Segment 2 Of 2
Various other requisite public filings and actions were taken by ENSERCH and TUC. On November 6, 1996, TUC filed its Form U–1 under the Public Utility Holding Company Act of 1935. On September 23, 1996, TUC and ENSERCH filed, and shortly thereafter mailed, a Joint Proxy Statement pursuant to which special shareholder meetings were held on November 11, 1996. The merger resolutions passed overwhelmingly.
As of the date of this submission, the only remaining condition to the spin-off of EEX and the closing of the merger by TUC and ENSERCH is final SEC approval.
Impact of Administration Proposal
In order to eliminate nonrecognition treatment for transactions ''that are effectively dispositions of a business,'' the Administration proposes to create a four-year ''control'' requirement. If applicable here, ENSERCH shareholders, as identified two years prior to the spin-off, would have to own at least 50 percent of the total outstanding voting power and value of ENSERCH as continuing indirect shareholders—that is, as TUC shareholders—as determined on a ''snap-shot'' basis two years after the spin-off.
The planned spin-off of EEX and merger with TUC, taken together, amount to a classic Morris Trust transaction but for the relative size of the merging companies. In Morris Trust, the former target/distributing shareholders received 54.385 percent of the acquiring corporation's stock. By contrast, the shareholders of ENSERCH are expected to receive only about 6 percent of the issued and outstanding stock of TUC.
If the Administration's proposal were applicable, the spin-off of EEX would not take place. As a result, the ENSERCH–TUC merger would not take place, despite the binding merger agreement, the public announcements, the special shareholder meetings, the issuance of the private ruling, and other regulatory filings and preparatory actions.
Page 339 PREV PAGE TOP OF DOC Segment 2 Of 2
Need for Prospective Effective Date or Adequate Transitional Rules
The announcements by key lawmakers that the amendment of section 355 would not be retroactive are appreciated but not dispositive. These expressions of intent could fall victim to the imperatives of revenue targets, or to compromises forced notwithstanding the leadership's wishes.
Legislation, when introduced, should include a prospective effective date that gives reasonable and adequate notice to taxpayers contemplating Morris Trust transactions. Because acquisitions so often involve the need to ''tailor'' a target to eliminate unwanted assets, it is a fair inference that ongoing planning, discussion and negotiations for such reorganizations are commonplace at any time. Note that it has been almost a full year since the ENSERCH–TUC merger was announced.
Short of a prospective effective date, legislation should include transitional relief carving out safe harbors for (1) transactions subject to binding contracts, (2) transactions that have been publicly announced, (3) transactions with respect to which requests for private letter rulings have been filed, and (4) transactions with respect to which SEC or other public filings have been made. Without relief for ''in the pipeline'' circumstances, legislation and public policy would be at cross purposes.
Administration Proposal Unsound Regardless of Effective Date
The notion that some (but not all) Morris Trust transactions should generate taxable results is troubling. There is no readily apparent reason why thirty years of case law, formal Internal Revenue Service acquiescence and tacit Congressional approval suddenly merit a wholesale legislative about-face. In any event, the Administration's proposal draws lines in the sand that are arbitrary and inadequately thought out. Finally, the scoring of the proposal for its positive effect on tax receipts is suspect.
Page 340 PREV PAGE TOP OF DOC Segment 2 Of 2
Numerous commentators have already reminded the Committee that Morris Trust is of venerable old age by case law standards. Almost as long-standing, the Service's 1968 acquiescence did not prescribe any particular percentage of target shareholders' continuing indirect interest, merely that ''the control requirement . . . implies no limitation upon a reorganization of [distributing] after the distribution of stock of [controlled]. . . . ''
In fact, the Service's favorable attitude toward combined spin-off and acquisitive reorganizations has never flagged. Revenue Rulings 72–530 and 78–251 are examples of favorable Morris Trust pronouncements. As late as just one year ago the Service issued updated guidelines for ruling requests under Code section 355 that implicitly approved Morris Trust again. Revenue Procedure 96–30, 1996–19 I.R.B., Appendix A, section 2.07 (''Facilitating an acquisition of Distributing.'').
The call to reverse such established precedent and practice suggests some clear and overarching imperative. But none is found in the publicized instances of extraordinary circumstances, for example, the incurring of substantial debt coupled with a pre-spin-off cash distribution. Such cases may justify selective fine-tuning, but there is no reason to penalize the great majority of cases, those based on legitimate business exigencies.
It is worth noting that Morris Trust apparently would still be tax-free under the Administration's proposal, but just barely. Had the 4.385 (or any less) percent swing been below rather than above 50 percent, however, the same transaction would be taxable. This legislative hair-splitting needs clear and compelling logic, though none has been offered and none is evident.
When historic shareholders are not being ''cashed out,'' the tax results associated with a tailored merger should not turn on the relative sizes of the acquiring and target corporations. The Administration's proposal effectively forces the common equity of merging companies to be equal. The implication is that something is suspect whenever a larger company acquires a smaller, tailored target. This obviously would taint a great many beneficial business combinations.
Page 341 PREV PAGE TOP OF DOC Segment 2 Of 2
The ''not pursuant to a common plan'' exception actually illustrates the proposal's essential arbitrariness. Numerically identical transactions would have opposite results because one was contemplated, the other unforeseen. Elevating hostile tender offers to a more favored status than ''friendly'' combinations is without any conceivable justification.
Finally, the scoring of this proposal as a revenue raiser is problematic. The Joint Committee's 1998–2002 aggregate revenue estimate of $349 million suggests $1 billion of built-in gain in stock to be spun off over five years. How this number could have been arrived at without specific information concerning taxpayers' adjusted bases in stock distributed during a presumed test period is unknown. It seems a fairer inference that the Administration's proposal would simply block any distribution of materially appreciated stock. Accordingly, meaningful tax revenues are unlikely.
Conclusion and Recommendations
The Administration's Morris Trust proposal is unsound, overly broad, and a problematic revenue raiser. Congress should confront perceived abuses of current law with precise, carefully considered amendments, not by making the relative size of the acquiror and target the touchstone of tax legitimacy for tailored mergers. Even assuming that a broad change of law was desirable, a prospective effective date, or reasonable transition rules, are amply justified.
—————
Statement of the Financial Executives Institute
Introduction
Page 342 PREV PAGE TOP OF DOC Segment 2 Of 2
Mr. Chairman and Members of the Committee:
The FEI Committee on Taxation is pleased to present its views on the Administration's Budget proposals and their impact on the international competitiveness of U.S. businesses and workers. FEI is a professional association comprising 14,000 senior financial executives from over 8,000 major companies throughout the United States. The Tax Committee represents the views of the senior tax officers from over 30 of the nation's largest corporations.
The FEI thanks the House Ways & Means Committee for scheduling these hearings on the Administration s budget proposals. We support a few of the proposals, for example, the extension of the tax credit for research. This provision should help improve the competitive position of U.S. companies. However, in many of the other tax proposals, the Administration replaced sound tax policy with some unwise revenue raisers. These latter proposals do nothing to achieve the objective of retaining U.S. jobs and making the U.S. economy stronger. For example, provisions are found in the Budget to restrict the carryback rules for foreign tax credits and net operating losses, extend Superfund taxes with no concomitant improvement of the cleanup programs, arbitrarily change the sourcing of income rules on export sales by U.S. based manufacturers, eliminate ''deferral'' for multinationals engaged in critical petroleum exploration and production overseas, and restrict the ability of ''dual capacity taxpayers'' to take credit for certain taxes paid to foreign countries.
Targeting publicly held U.S. multinationals doing business overseas for budget revenue raisers is unwise and the FEI urges that such proposals not be adopted by Congress. Businesses establish foreign operations to serve local overseas markets so they are able to compete more efficiently with foreign based competition. In addition to assisting with the growth of exports and consequently job creation in the U.S., investments abroad help the U.S. balance of payments. The long-standing creditability of foreign income taxes is intended to alleviate the double taxation of foreign income. Replacing such credits with less valuable deductions will result in double taxation and greatly increase the costs of doing business overseas, which will place U.S. multinationals at a competitive disadvantage versus foreign based companies.
Page 343 PREV PAGE TOP OF DOC Segment 2 Of 2
U.S. jobs and the economy overall would be best served by Congress working with the Administration to do all it can to make the U.S. tax code more friendly; a position already afforded our international competitors by their home country governments. The budget should be written with the goal of reintegrating sound tax policy into decisions about the revenue needs of the government. Provisions that merely increase business taxes by eliminating legitimate business deductions should be avoided. Ordinary and necessary business expenses are integral to our current income based system, and needless elimination of them will only distort that system. Higher business taxes impact all Americans, directly or indirectly. It should be kept in mind that millions of ordinary Americans are shareholders, through their retirement plans, of corporate America and that proposals that decrease the competitiveness of U.S. business harm those persons both as shareholders and employees.
Sound and justifiable tax policy should be paramount when deciding on taxation of business—not mere revenue needs.
Provisions That Should Not Be Adopted
The FEI offers the following comments on certain specific tax increase proposals set forth in the Administration's budget:
Foreign Oil and Gas Income
The President's budget proposal dealing with foreign oil and gas income moves in the direction of limiting use of the foreign tax credit and repealing deferral of U.S. tax on foreign oil and gas income. This selective attack on a single industry's utilization of the foreign tax credit and deferral is not justified. U.S. based oil companies are already at a competitive disadvantage under current law since most of their foreign based competition pay little or no home country tax on foreign oil and gas income. Perversely, this proposal cedes an advantage to overseas competitors by subjecting foreign oil and gas income to U.S. double taxation which will severely hinder U.S. oil companies in the global oil and gas exploration, production, refining and marketing arena.
Page 344 PREV PAGE TOP OF DOC Segment 2 Of 2
Change in Carryover/Carryback Periods
Two of the Administration's proposals would decrease the time period for carrying back foreign tax credits (''FTCs'') from 2 years to 1 year, and decrease the net operating loss (''NOL'') carryback period from 3 years to 1 year. At the same time, the FTC carryforward period would be extended from 5 to 7 years while the NOL carryforward period would be increased from 15 to 20 years. Although these changes were arguably made to simplify tax administration, they are clearly mere revenue raisers that will actually cause highly inequitable results.
Net Operating Loss
The federal income tax is based on an arbitrary annual accounting concept. Business income may, however, fluctuate over a somewhat longer period. The most obvious example is a business affected by the business cycle, the duration of which may be several years. The net operating loss carryback prevents the income tax from being charged before the taxpayer has earned any net income. For example, if a company earns income of 10 in year 1, has no income or loss in year 2, and experiences a loss of 10 in year 3, it has earned no net income. A net operating loss carryback operates to eliminate the tax imposed in year 1 under the annual accounting concept. The Administrations proposal would eliminate the offset in this example and result in the payment of tax when the taxpayer has not, in fact, earned any income.
To be conceptually correct, the net operating loss carryback ought to have no limitation. Therefore, any limitation on the carryback represents an arbitrary concession to the annual accounting system. The Administration s proposal makes the present situation worse and represents a tax increase on affected taxpayers. It is no answer to extend the net operating loss carryforward. Again, any limitation on the carryforward is arbitrary and unjustified, and the recovery of a prepaid tax in 15 or 20 yeas is obviously worth far less than a current refund of overpayment of taxes made within the last three years.
Page 345 PREV PAGE TOP OF DOC Segment 2 Of 2
Finally, the Administration s claim that is proposal reduces administrative burdens and complexity is hollow. Any burden borne by the taxpayer is voluntary because existing law permits taxpayers to relinquish the carryback.
No further limitation should be imposed on the existing 3-year net operating loss carryback.
Foreign Tax Credit
When companies invest overseas, they often receive very favorable local tax treatment from foreign governments, at least in the early years of operation. For example, companies are often granted rapid depreciation write-offs, and low or even zero tax rates, for a period of years until the new venture is up and running. This results in a very low effective tax rate in those foreign countries for those early years of operation. For U.S. tax purposes, however, those foreign operations must utilize much slower capital recovery methods and rates, and are still subject to residual U.S. tax at 35 percent. Thus, even though those foreign operations may show very little profit from a local standpoint, they may owe high incremental taxes to the U.S. government on repatriations or deemed distributions to the U.S. parent. However, once such operations are ongoing for some length of time, this tax disparity often turns around, with local tax obligations exceeding residual U.S. taxes. At that point, the foreign operations generate excess FTCs but without an adequate carryback period, those excess FTCs will just linger and expire. Extending the carryforward period will not alleviate the problem since the operation will likely continue to generate excess FTCs in comparison with the U.S. residual tax situation, resulting in additional FTCs for eventual expiration.
The U.S. tax system is based on the premise that FTCs help alleviate double taxation of foreign source income. By granting taxpayers a credit against their U.S. liability for taxes paid to local foreign governments, the U.S. government allows its taxpayers to compete more fairly and effectively in the international arena. However, by imposing limits on carrying back excess FTCs to earlier years, the value of these FTCs diminish considerably (if not entirely in many situations). Thus, the threat of double taxation of foreign earnings becomes much more likely.
Page 346 PREV PAGE TOP OF DOC Segment 2 Of 2
Require Gain Recognition on Certain Distributions of Controlled Corporation Stock
The Administration has proposed additional restrictions under section 355 on distributions of stock that precede the tax-free acquisition of one or more of the businesses of the distributing corporation. This proposal imposes a capital gain tax on a company engaged in a Morris Trust transaction. According to the Administration, section 355 should not apply to distributions that are effectively dispositions of a business.
A post-spinoff acquisition of a business in a so-called Morris Trust transaction no more constitutes the disposition of a business than does any other form of tax-free business combination. The stockholders of the acquired business in a Morris Trust transaction or any tax-free merger continue to hold a proprietary interest in their business through their ownership of stock of the acquiring company, which holds the combined businesses. The assets of the acquired business remain in corporate solution, and there is no increase in the basis of these assets. Such a reorganization of businesses within corporate solution is not an appropriate occasion to impose tax. The Internal Revenue Service has for many years permitted Morris Trust transactions to proceed on a tax-free basis, and it has not viewed a straightforward transaction to be abusive.
Elimination of the Morris Trust transaction would severely restrict the ability of corporations to restructure businesses into more economically efficient forms. Products and markets are constantly changing, and business combinations that make economic sense one day may no longer make sense the next. It is therefore important that corporations be given the flexibility to reorganize and recombine businesses within corporate solution on a tax-free basis.
The Administration's section 355 proposal should not be adopted.
Page 347 PREV PAGE TOP OF DOC Segment 2 Of 2
Repeal of Section 863 (b)
When products manufactured in the U.S. are sold abroad, § 863(b) enables the U.S. manufacturer to treat half of the income derived from those sales as foreign source income, as long as title passes outside the U.S. Since title on export sales to unrelated parties often passes at the point of origin, this provision is more often applied to export sales to foreign affiliates.
The Administration proposes to repeal Sec. 863(b) because it allegedly gives multinational corporations a competitive advantage over U.S. exporters that conduct all of their business activities in the U.S. It also believes that replacing § 863(b) with an allocation based on actual economic activity will raise $7.5 billion over five years. This proposal is nonsensical.
First, to compete effectively in overseas markets, most U.S. manufacturers find that they must have operations in those foreign markets to sell and service their products. Many find it necessary to manufacture products specially designed for a foreign market in the country of sale, importing vital components of that product from the U.S. wherever feasible. Thus, the supposed competitive advantage over a U.S. exporter with no foreign assets or employees is a myth. There are many situations in which a U.S. manufacturer with no foreign activities simply cannot compete effectively in foreign markets.
Second, except in the very short term, this proposal could reduce the Treasury's revenues rather than increase them. This is because the multinational corporations, against which this proposal is directed, may have a choice. Instead of exporting their products from the U.S., they may be able to manufacture them abroad to the extent of excess capacity in foreign plants. If even a small percentage of U.S. exporters are in a position to make such a switch, the proposal will fail to achieve the desired result and taxes on manufacturing profits and manufacturing wages will go to foreign treasuries, instead of to the U.S. Amazingly, the Administration seems to encourage this result by calling for an allocation based on ''actual economic activity'' which would incent a behavioral response to increase economic activity in foreign jurisdictions which could result in more foreign jobs, investment, and profits.
Page 348 PREV PAGE TOP OF DOC Segment 2 Of 2
At present, the U.S. has too few tax incentives for exporters, especially compared to foreign countries with VAT regimes. The U.S. should be stimulating the expansion of exports. Given our continuing trade deficit, it would be unwise to remove a tax incentive for multinational corporations to continue making GATT legal export sales from the United States. Ironically, this proposal could result in multinationals using existing foreign manufacturing operations instead of U.S. based operations to produce export products. We encourage Congress not to adopt it.
Average Stock Basis
The Administration proposes to eliminate the long-standing ''identification rule'' under which a taxpayer who buys shares of the same stock at different times and later sells less than all of the shares may identify which shares are being sold (usually the shares with the highest basis). Instead, the taxpayer would be treated as having sold shares with an ''average basis.
The FEI is opposed to this proposal for three reasons. First, we believe it runs directly counter to the broader federal income tax treatment of sales of stock and securities, and therefore leads to anomalous results. If a taxpayer purchases shares of stock A on day one and stock B on day two, the taxpayer should be entitled to choose to sell the shares of stock B, which have a higher basis, rather than the shares of stock A, which have a lower basis. There is no good tax policy rational for changing the rule merely because stock A and stock B are substantially identical. Although this proposal may have something to do with the Administration's concern about short-against-the-box transactions, the Administration has already addressed this concern with a more direct proposal.
Second, the FEI believes the provision would lead to greater complexity in the record-keeping and reporting of purchases and sales of stock. Taxpayers (and their agents) would have to maintain and consult with historical records for all of the taxpayer's transactions relating to a given stock each time a taxpayer undertook to sell a few shares. Each sale , as well as each purchase, would change the basis of the shares held (presumably under detailed regulations which would explain precisely how the average basis rule works), so that the basis calculations for subsequent sales would depend in part on the mechanics of previous sales. We do not think this approach would be well-suited to routine equity transactions, given their sheer volume and the number of individuals they affect. Furthermore, the proposal would significantly hinder the effectiveness of employee stock purchase plans by raising the costs of administering such plans as regards tracking of acquisition costs.
Page 349 PREV PAGE TOP OF DOC Segment 2 Of 2
Third, if 100 shares of stock A were held long term, while another 100 shares of stock A were held short term, and 50 shares were sold, we are not sure what the rule would be regarding the holding period of the sold shares, i.e., whether all 50 would be treated as long term, all 50 as short term, or averaged. Tax fairness and policy is best served by a direct matching of the actual basis of the item being sold with the proceeds of the sale, so that neither phantom gain nor loss is deemed to be realized on the transaction, and there is no question of the appropriate holding period for the sale.
Lowering the Dividend Received Deduction
The Administration proposed to both lower the corporate dividends received deduction (DRD) from 70% to 50% for dividends received by corporations that own less than 20 percent of other corporations, and to have taxpayers establish a separate and distinct 46 day holding period in a stock in order for each dividend to qualify for the DRD. We believe that both of these proposals will be making changes to the law that are not in the best interests of public policy. Currently, the U.S. is the only major western industrialized nation that subjects corporate income to multiple levels of taxation. Over the years, the DRD has been decreased from 100% for dividends received by corporations that own over 80 percent of other corporations, to the current 70% for less than 20 percent owned corporations. As a result, corporate earnings have become subject to multiple levels of taxation, thus driving up the cost of doing business in the U.S. To further decrease the DRD would be another move in the wrong direction.
Since the DRD is intended to avoid multiple levels of taxation, the imposition of any holding period in the stock cannot be justified. Again, over time, the requisite holding period requirement has risen from 16 to 46 days. The reason for the adoption of this rule was to stop taxpayers from purchasing the stock just prior to a dividend record date and selling the stock shortly thereafter, resulting in both a tax-preference dividend and a capital loss. However, imposing a separate holding period requirement for each dividend does not enhance the rule and, in fact, just adds further needless complexity.
Page 350 PREV PAGE TOP OF DOC Segment 2 Of 2
Superfund Taxes
The three taxes that fund Superfund (corporate environmental tax, petroleum excise tax, and chemical feed stock tax) all expired on December 31, 1995. The President's budget would reinstate the two excise taxes at their previous levels for the period after the date of enactment through September 30, 2007. The corporate environmental tax would be reinstated at its previous level for taxable years beginning after December 31, 1996 and before January 1, 2008.
These taxes, which were previously dedicated to Superfund, would instead be used to generate revenue to balance the budget. This use of taxes historically dedicated to funding specific programs for deficit reduction purposes should be rejected. The decision whether to re-impose these taxes dedicated to financing Superfund should instead be made as part of a comprehensive examination of reforming the entire Superfund program.
Modification of the Substantial Understatement Penalty
The Administration proposed to make any tax deficiency greater than $10 million ''substantial'' for purpose of the penalty, rather than applying the existing test that such tax deficiency must exceed 10% of the taxpayer's liability for the year. While to the individual taxpayer or even a privately-held company, $10 million may be a substantial amount of money—to a publicly-held multinational company, in fact, it may not be ''substantial.'' Furthermore, a 90% accurate return, given the agreed-upon complexities and ambiguities contained in our existing Internal Revenue Code, should be deemed substantial compliance, with only additional taxes and interest due and owing. There is no policy justification to apply a penalty to publicly-held multinational companies which are required to deal with much greater complexities than are all other taxpayers.
Page 351 PREV PAGE TOP OF DOC Segment 2 Of 2
The difficulty in this area is illustrated by the fact that the Secretary of the Treasury has yet to comply with Section 6662(d)(2)(D) of the IRC, which requires the Secretary to publish a list of positions being taken for which the Secretary believes there is not substantial authority and which would affect a significant number of taxpayers. The list is to be revised not less frequently than annually. Taxpayers still await the Secretary s FIRST list.
Applying Assumptions to Credit Card Receivables
The Administration proposed to apply a prepayment assumption to credit card receivables. Such a change would impose a tax on grace period interest even where no financial benefit has been received or accrued. This proposal ignores the accrual rules and goes beyond even the doctrine of constructive receipt. For accrual method taxpayers, the recognition of income depends on when the taxpayer's right to receive the income becomes fixed and determinable. In the case of ''grace period interest,'' however, unless and until payment of a credit card balance is delayed beyond the grace period, even the doctrine of constructive receipt would not apply (because no income is available).
The Administration's stated goal of ''equalizing'' the treatment of REMIC interests and credit card receivables is misplaced. The REMIC prepayment rule applies solely for purposes of determining the inclusion of OID, amounts that the payee is entitled to receive. The proposal ignores the fact that the federal income tax is calculated on an annual basis so that income is determined and reported at fixed intervals of a year and the accrual method requires taxpayers to determine income under the ''all events'' test at year-end. There is no precedent for departing from the annual accounting period where income has not been constructively received.
Pro Rata Disallowance
Page 352 PREV PAGE TOP OF DOC Segment 2 Of 2
The FEI strongly opposes the Administration s proposal to extend the pro rata disallowance of tax-exempt interest expense to all corporations. By reducing corporate demand for tax-exempts, this proposal only serves to increase the financing costs of state and local governments. The application of the pro rata rule on an affiliated company basis penalizes companies that hold tax-exempt bonds to satisfy state consumer protection statutes, such as state money transmitter laws, but happen to be affiliated with other businesses that have interest expense totally unrelated to the holding of the tax-exempt bonds. These corporate investors, holding principally long-term bonds, are critical to the stable financing of America s cities and states. Treasury currently has the authority to prevent any abuse in this area by showing that borrowed funds were used to carry tax-exempt securities; this more targeted approach provides appropriate protection without disrupting the public securities market.
Secondly, corporations often invest some operating funds in tax-exempt bonds for cash management reasons. No evidence exists that these corporations are engaged in improper interest-rate arbitrage. Not only are there no tax-motivated abuses in this area which merit increasing the borrowing costs of state and local governments, these investors help support an active and liquid short-term municipal bond market vital to states and localities. Again, the result of the Administration s proposal would be to reduce demand for tax-exempt bonds and drive up costs for state and local governments. This is something that Congress should not do when it is looking to these very same state and local governments to do more.
Increased Penalties for Failure to File Returns
The Administration also proposed to increase penalties for failure to file information returns, including all standard 1099 forms. IRS statistics bear out the fact that compliance levels for such returns are already extremely high. Any failures to file on a timely basis generally are due to the late reporting of year-end information or to other unavoidable problems. Under these circumstances, an increase in the penalty for failure to timely file returns would be unfair and would fail to recognize the substantial compliance efforts already made by American business.
Page 353 PREV PAGE TOP OF DOC Segment 2 Of 2
Effective Dates
The FEI believes that it is bad tax policy to add significant tax burdens on business in a retroactive manner. Businesses should be able to rely on the tax rules in place when making economic decisions, and expect that those rules will not change while their investments are still ongoing. It seems plainly unfair to encourage businesses to make economic decisions based on a certain set of rules, but then change those rules midstream after the taxpayer has made significant investments in reliance thereon. Thus, whenever possible, we call on Congress to assure that significant tax changes do not have retroactive application. To do otherwise can have a chilling effect on business investments which could be adversely impacted by rumored tax changes.
Components of Cost (COC) inventory Accounting Method
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. The Administration would repeal the COC method for LIFO inventory accounting. 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.
Page 354 PREV PAGE TOP OF DOC Segment 2 Of 2
We urge you to oppose repeal of COC.
Positive Tax Proposal
As stated above, certain of the Administration s tax proposals will have a positive impact on the economy. For example:
Extension of Research Tax Credit
The proposal to extend the research tax credit is to be applauded. The credit, which applies to amounts of qualified research in excess of a company's base amount, has served to promote research that otherwise may never have occurred. The buildup of ''knowledge capital'' is absolutely essential to enhance the competitive position of the U.S. in international markets—especially in what some refer to as the Information Age. Encouraging private sector research work through a tax credit has the decided advantage of keeping the government out of the business of picking specific winners or losers in providing direct research incentives. The FEI recommends that Congress work together with the Administration to extend the research tax credit on a permanent basis.
Conclusion
The FEI urges Congress not to adopt the revenue raising provisions identified above when formulating its own budget proposals. They are based on unsound tax policy. Congress, in considering the Administration's budget, should elevate sound and justifiable tax policy over mere revenue needs. Revenue can be generated consistent with sound tax policy, and that is the approach that should be followed as the budget process moves forward.
Page 355 PREV PAGE TOP OF DOC Segment 2 Of 2
The Administration s proposals would add complexity in direct contrast to the Administration s stated need to simplify the tax law in order to assist the Internal Revenue Service in more effectively filling its role as the nation's tax collector.
—————
Statement of the Financial Services Council
The President's Fiscal Year 1998 Budget Revenue Proposal To Treat Certain Preferred Stock Received in a Nonrecognition Transaction As ''Boot''
Mr. Chairman and Members of the Committee, the Financial Services Council, a diverse trade association representing companies from every sector of the financial services industry, appreciates the opportunity to submit testimony on the Administration's proposal treating certain preferred stock received in otherwise tax-free transactions as ''other property'' (or boot).
We would urge that the Committee not adopt the proposal. We believe that change as significant as this proposal, at a minimum, requires more careful consideration. The characterization of a financial instrument as debt or equity should take into account numerous factors, including the proper treatment to both the holder and the issuer of the financial instrument. Unfortunately, the proposal sets forth only a few factors under which the determination is to be made whether a financial instrument used in a nonrecognition transaction constitutes debt-like preferred stock. Additionally, Treasury's regulatory authority with respect to this issue should be carefully delineated so as to ensure that any regulations issued in connection with a statutory change do not affect transactions not intended to be covered by the proposal.
Page 356 PREV PAGE TOP OF DOC Segment 2 Of 2
The use of preferred stock has been critical to numerous business transactions in the past. The preferred stock market has provided a ''safety net'' for companies in need of equity capital. For example, during the equity crisis of the early 1990's, when banks were unable to raise additional equity capital in the common stock market, they were able to satisfy their capital needs by using traditional preferred stock. Our country has the only well-developed preferred stock market in the world. Accordingly, before adopting the Administration's proposal, an assessment should be made of the reasons for and the efficiency of utilizing preferred stock in business transactions and the related consequences of adopting the proposed treatment of preferred stock as ''taxable boot.''
Of particular concern to us is the absence of transition relief offered by the proposal. The precedent set by the omission of such relief may have a chilling effect on business and investment decisions on Wall Street and other business environments. It is difficult for companies to begin or continue transactions when the tax ramifications associated with the transactions remain uncertain. If changes to our tax laws may be made that impact open transactions without transition relief, then business entities will be hesitant to engage in future transactions.
Further, to the extent that companies have already relied on current tax laws in structuring transactions that have yet to be consummated, a sudden change in tax treatment impacting those transactions is unfair and may be costly to the parties involved. Not only are there opportunity costs at issue when the economics of contemplated transactions are suddenly altered by new legislation, but there are very real costs associated with the planning and financing of transactions that are potentially rendered worthless as well.
Should Congress determine that a legislative change is necessary, transition relief in the form of realistic adjustment periods during which companies could complete their open affected transactions would ease the business community into a new taxation system that treats certain preferred stock as debt in the context of nonrecognition transactions. Moreover, establishing or continuing a pattern of providing transition relief whenever there is a change to corporate tax law will provide companies with the assurance that they safely can plan, structure and finance their current business transactions without the risk that the government will modify critical assumptions to the economics of the transactions.
Page 357 PREV PAGE TOP OF DOC Segment 2 Of 2
Thank you for this opportunity to present the Financial Services Council's views on this important matter.
—————
Statement of David McKittrick, Chief Financial Officer, Gateway 2000
As the Chief Financial Officer for Gateway 2000, I would like to express our serious concerns regarding the provision in the President's Budget Proposals for the Financial Year 1998 to repeal the Lower of Cost or Market (''LCM'') method of valuing inventory in accounting.
I would concur with the testimony given by the National Retail Federation (''NRF'') on March 12, 1997 explaining that LCM has been the ''best accounting practice'' for tax purposes for many years. LCM is a long standing practice that is well understood by entrepreneurs, managers and their accountants. It meets the basic requirement that all accounts should give a true and accurate depiction of the financial situation in that it reflects changes in value that occur to inventory while it is held by the manufacturer or retailer but before it is sold. LCM is used for internal management reporting purposes and in reporting to shareholders at Gateway 2000 and is the preferred method that industry understands.
The NRF testified that taxes on retailers would increase if LCM were to be repealed as proposed. Gateway 2000 has estimated that the tax cost of this provision on Gateway 2000 alone would be $4.2 million in 1998. Since the company operates in a very competitive industry with low net income as a percentage of sales, Gateway 2000 would inevitably attempt to pass all of this tax increase on to its customers in the form of higher prices. This makes the company less competitive in a global economy and impacts decisions on expansion and hiring.
Page 358 PREV PAGE TOP OF DOC Segment 2 Of 2
Secondly, if this proposal becomes law, Gateway 2000 and all the other companies affected would be forced to maintain two sets of computations, one for accounting purposes and another for tax purposes. In addition to the obvious confusion this would cause, it would cost the company an enormous amount in additional working time, resources, and paperwork to create and maintain dual sets of inventory records for no visible benefit. The costs related to additional inventory systems could be significant and take years to design and implement, placing Gateway 2000 and other American companies at a competitive disadvantage to their foreign counterparts.
Thirdly, LCM is the most realistic method to use for businesses involved with high technology. The United States has seen phenomenal growth in this sector of the economy over the last few years and this is important to off-set the loss of revenue and jobs due to the decline of traditional industries. The existing rules of taxation were designed to accommodate the needs of heavy industry, such as the long period for depreciation. Such rules fail to recognize the realities of current technological advances where things become obsolete very quickly. The LCM rule operates fairly in this regard to reflect the rapid changes in value to the inventory of high technology companies such as Gateway 2000.
Conclusion
The rule that taxpayers should use the lower of cost or market value in establishing the value of inventory is not a ''corporate loophole'' that needs to be closed, but rather a long established method of accounting that is understood by everyone involved in business and is acknowledged to be a fair method. Furthermore, since this method is preferred by corporations and mandated by generally accepted accounting principles, it would involve enormous expenditure to create and maintain the second set of computations that these tax proposals would require. It would also create unnecessary confusion and uncertainty in companies who, instead, need the support and encouragement of the government to stay competitive in a global economy.
Page 359 PREV PAGE TOP OF DOC Segment 2 Of 2
—————
Statement of General Motors Corp.
General Motors is a member of the American Automobile Manufacturers Association (AAMA), which submitted both written and oral statements at the Ways and Means Committee hearing on March 12, 1997. General Motors fully endorses these AAMA positions which, in brief, express strong opposition to the Administration's proposals to:
• Repeal components of cost (COC) inventory accounting method;
• Modify the net operating loss (NOL) carryback and carryforward rules; and
• Replace the export source rule with an activity-based rule.
In addition, General Motors would like to register its concern and strong opposition to the Administration's proposed modifications to the so-called ''Morris Trust'' provisions of section 355 of the Internal Revenue Code, and especially to the Administration's proposed effective date for these modifications. If enacted and with the effective date as proposed by the Administration, these modifications would adversely impact a major pending transaction which General Motors has publicly announced, i.e., the spin-off of its defense electronics subsidiary Hughes Aircraft Company, followed by Hughes Aircraft's merger with the Raytheon Company.
The specific Administration provision of concern is the proposal to modify Code Section 355 which currently permits certain corporate spin-offs without taxation, to require a continuing minimum 50% level of both voting and equity shareholder interests for two years before and after a spin-off in order for tax-free treatment to apply. Of particular concern, the provision would be effective for distributions after the date of first committee action in Congress.
Page 360 PREV PAGE TOP OF DOC Segment 2 Of 2
Background
On January 16, 1997, General Motors announced a series of transactions designed to address strategic challenges and to unlock shareholder value in its defense electronics, automotive electronics, and telecommunications and space business sectors. As a part of this, Hughes Aircraft, the defense electronics subsidiary of GM's Hughes Electronics Corporation, will be spun-off and immediately thereafter merged with Raytheon Company. This merger is considered by General Motors and Hughes management as essential for the Hughes defense business to be competitive in the defense industry, which is in the latter stages of a major consolidation that began several years ago and recently accelerated. The industry consolidation has been encouraged by the U.S. Department of Defense.
After the spin-off and merger with Raytheon, Hughes shareholders would have a continuing 80.1% voting interest and a continuing 30% equity interest. These transactions are covered by a legally binding contract, but their completion is contingent upon customary transaction conditions, including:
• Receipt of favorable tax rulings from the IRS (now pending);
• Receipt of anti-trust clearances; and
• Receipt of shareholder approvals.
Based on the above, the pending Hughes/Raytheon transactions would satisfy the continuing 50% voting requirement, but not the 50% equity requirement. Also the current effective date proposed by the Administration would not exclude these pending transactions from the new requirements since Congressional committee action will likely occur before the necessary approvals are secured and the transactions are completed. Thus, the Administration's proposal to change Code section 355 combined with the proposed effective date would almost certainly cause the pending Hughes/Raytheon transaction to become a taxable event to General Motors, and thereby effectively preclude General Motors and Raytheon from proceeding with the transaction.
Page 361 PREV PAGE TOP OF DOC Segment 2 Of 2
Discussion
General Motors believes the proposed changes to Code section 355 should not be adopted in their present form. Under current law, a Morris Trust transaction is the only way for one corporation to combine tax-free with less than all of another corporation. This flexibility is particularly important when one would-be merger partner does not want to or cannot combine with the other would-be merger partner if such corporation continued to hold the business being spun-off. For example, the first merger partner may not be qualified to manage certain businesses, or may be prohibited because of regulatory or other reasons from owning such businesses.
Over thirty years of settled tax and business practice with respect to Morris Trust transactions has demonstrated that such transactions are in no sense abusive, but rather are an efficient means of rearranging and recombining corporate assets. The proposed legislation would make it significantly more costly for businesses to rearrange their component parts in an efficient manner. In increasingly competitive global markets and with the need to reduce government spending through less costly operations of defense contractors, the efficiency of domestic businesses should be encouraged, not discouraged.
The tax imposed by the proposed legislation would be unwarranted as a policy matter. The shareholders would continue to own a share of what they previously owned without any increase in tax basis; thus, no one would escape any shareholder-level tax. Moreover, all assets that were previously held in corporate solution continue to be held in corporate solution without any increase in tax basis. No owners of these businesses have received income that has escaped tax, and no corporation has escaped any corporate-level tax. As a result, the Administration's proposal to deny tax-free treatment to a Morris Trust spin-off would cause the assets underlying the spun-off corporation effectively to be subject to three levels of tax, i.e., tax would be imposed on (i) the distributing corporation, (ii) the spun-off corporation when such corporation sells its assets, and (iii) the spun-off corporation's shareholders when such shareholders sell their shares of the spun-off corporation. Taxation without a corresponding basis adjustment violates the basic tenet of tax symmetry, and the resulting imposition of three levels of tax on the same economic income is not a sound policy goal.
Page 362 PREV PAGE TOP OF DOC Segment 2 Of 2
As to the effective date, the Administration's same proposal in last year's Budget to modify Section 355 would have excluded transactions that were publicly announced, under a binding contract, or pending the receipt of tax clearances at the proposed effective date. Similarly, fair tax policy this year should exclude transactions pending as of the effective date, e.g., date of first committee action, from any change to section 355. This is necessary so as not to disrupt current market activities and normal business transactions, such as the pending Hughes/Raytheon merger that is part of the ongoing consolidation of the defense industry.
In summary, General Motors believes the Administration's proposed changes to Code section 355, as currently offered, should not be adopted. However, if Section 355 is modified, General Motors strongly urges that the changes be made prospective in application so as not to affect pending transactions which have relied on long-standing, settled tax law and business practice.
—————
Written Statement of Government Finance Officers Association (GFOA), on Behalf of the Airports Council International—North America (ACI–NA), American Association of Port Authorities (AAPA), American Public Power Association (APPA), American Public Works Association (APWA), Association of Local Housing Finance Agencies (ALHFA), Association of Metropolitan Sewerage Agencies (AMSA), Association of Metropolitan Water Agencies (AMWA), Council of Development Finance Agencies (CDFA), Council of Infrastructure Financing Authorities (CIFA), Education Finance Council (EFC), Municipal Treasurers' Association (MTA), National Association of Counties (NACo), National Association of Higher Educational Facilities Authorities (NAHEFA), National Association of State Auditors, Comptrollers and Treasurers (NASACT), National Association of State Treasurers (NAST), National Conference of State Legislatures (NCSL), National Council of Health Facilities Finance Authorities (NCHFFA), National Council of State Housing Agencies (NCSHA), National League of Cities (NLC), National School Boards Association (NSBA), and United States Conference of Mayors (USCM)
Page 363 PREV PAGE TOP OF DOC Segment 2 Of 2
This statement is submitted on behalf of 22 state and local government organizations. We are writing in strong opposition to a tax provision in President Clinton's recent budget proposal that would extend the pro rata disallowance of tax-exempt interest expense to all corporations. Our members are elected and appointed state and local government officials who oppose this provision because it would drive up state and local borrowing and lease financing costs for equipment, infrastructure, and other capital facilities and result in tax and fee increases or budget cuts. Last year, Congress rejected a similar proposal in response to concerns raised by state and local governments.
Financing costs would increase because, under current law, nonfinancial corporations are permitted to take a deduction for interest expenses if they can demonstrate that they did not finance their purchases of tax-exempt securities. This tax treatment is advantageous because corporations are not required to reduce their interest deductions on a pro rata basis, which is determined by calculating what percentage of their total assets are tax-exempt securities. Furthermore, the Internal Revenue Service (IRS) has established tests to assist taxpayers in complying with current law. The so-called two percent de minimis rule simplifies compliance by providing that if an investor's holdings of municipal securities constitutes less than two percent of its total assets, then the IRS generally will not inquire whether any of the borrowings of the investor were incurred for the purpose of purchasing or carrying tax-exempt securities. Current law permits nonfinancial corporations to accept a lower interest rate on the municipal bonds they purchase and the lease purchase or conditional sales agreements they negotiate.
Different types of corporations, which would be affected by the proposal, participate in the municipal market in different ways, as described below. With the proposed change, these corporations would be expected to change their investment strategies.
Page 364 PREV PAGE TOP OF DOC Segment 2 Of 2
• Traveler's Check and Money Order Companies. These firms invest their reserves in long-term tax-exempt securities. For example, traveler's check and money order companies are required by state money transmitter laws that control their investment options to invest in U. S. Treasuries, municipal bonds and other highly rated securities.
• Freddie Mac, Fannie Mae and Sallie Mae. Federally sponsored corporations such as the Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal National Mortgage Association (Fannie Mae) have been active in the market for state and local housing bonds, in part, because they are required by federal law to engage in activities relating to mortgages on housing for low- and moderate-income families. The Student Loan Marketing Association (Sallie Mae) purchases tax-exempt student loan bonds.
• Affiliated Companies. The proposal will result in unfair tax treatment for affiliated companies that under current law invest in municipal securities, but are not subject to the pro rata rule because they do not borrow to make securities purchases. The new provision that would extend the pro rata disallowance of interest on a combined basis to affiliated companies that file consolidated returns would eliminate companies' ability under current law to demonstrate that no borrowing occurred for the purpose of purchasing tax-exempt securities.
• Bank and Nonbank Leasing Companies. States and localities lease various types of equipment from bank and nonbank leasing companies, including portable classrooms, schools, school buses, software, telecommunications systems, correctional facilities, computers, medical equipment, courthouses and energy management systems. This form of financing is particularly useful to communities that cannot afford to borrow in the bond market, or don't have access to the bond market because of market inexperience or lack of a credit rating.
• Other Corporations. Many other corporations invest in short-term municipal securities or securities that behave like short-term securities for their own cash management purposes. Their participation in the market is responsible for the stability and low level of short-term rates.
Page 365 PREV PAGE TOP OF DOC Segment 2 Of 2
To understand the impact of the President's proposal, we provide information about a leasing transaction. Under current law, a private lessor's cost of funds is 6.2 percent, the lessor's tax rate is 35 percent and the interest rate charged to a government lessee is 5.33 percent. Without the benefit of the two percent de minimis rule, a lessor will have to increase the interest rate by 2.17 percentage points (increasing the interest rate charged to the government to 7.5 percent) to earn the same profit on the transaction. This increase represents a 41 percent increase in a government lessee's borrowing rate.
From a technical standpoint, we believe the Administration has provided information about its proposal that downplays its impact. It provides that the rule would not apply to certain nonsaleable tax-exempt bonds acquired by a corporation in the ordinary course of business in payment for goods or services sold to state and local governments. However, what the Administration fails to take into account is that tax-exempt leases are frequently sold to third-party finance companies. Thus, any relief intended by this exception may be meaningless. Additionally, Treasury Secretary Rubin has said that the change in the disallowance rule will not materially affect the cost of borrowing for state and local governments because nonfinancial corporations hold only about five percent of the outstanding tax-exempt securities. This analysis is somewhat misleading because the impact of the proposal is highly concentrated in certain sectors, such as the short-term market and in leasing. Furthermore, as we have shown above, for an individual government, the impact may be devastating.
During the past 11 years, demand for state and local government debt has undergone a dramatic shift in the composition of borrowers. Tax law changes have resulted in large reductions in corporate holdings and increased reliance on individual purchasers. These changes include the application of alternative minimum tax to tax-exempt interest, the denial of the bank interest deduction for most municipal bonds, and a reduction of deductible loss reserves for property and casualty firms that purchase municipal securities. This development causes us concern because it has introduced more volatility into the market. While demand from individuals may be strong now, a shortfall could occur in the future.
Page 366 PREV PAGE TOP OF DOC Segment 2 Of 2
The Administration takes the narrow view that this proposal will eliminate inappropriate corporate interest expense deductions. In fact, however, the proposal raises the cost of tax-exempt municipal financing and affects the ability of state and local governments to finance infrastructure, affordable housing, economic development, other facilities and equipment. Accordingly, we are opposed to this effort by the federal government to shift tax burdens to state and local governments.
For more information about the impact of the extension of the pro rata disallowance rule or the names and phone numbers of the contact persons for the organizations supporting this statement, please call Catherine L. Spain, Director—Federal Liaison Center, Government Finance Officers Association, 1750 K St., NW, Suite 650, Washington, DC 20006, (202) 429–2750.
—————
| The Hartford Steam Boiler |
| Inspection and Insurance Co. |
| March 5, 1997 |
The Honorable Bill Archer, Chairman
House Committee on Ways and Means
1135 Longworth House Office Building
Washington, DC 20515
Dear Mr. Archer,
As Chief Investment Officer of The Hartford Steam Boiler Inspection and Insurance Company, I strongly urge that you not adopt the tax proposals relating to (I) the Reduction and Elimination of the Dividends-Received Deduction (DRD) and (II) the Extension of the Pro Rata Disallowance of Tax-Exempt Interest—Elimination of the ''2% De Minimis Rule.'' For the reasons cited below, the proposals exact a punitive added tax on corporations which obviously redounds to the detriment of the economy as a whole as well as America's global competitiveness. Viewed more parochially, these proposals would negatively affect our corporation's financial performance and returns. We are a significant investor in and ongoing purchaser of the securities potentially impacted. The negative consequences for the company's financial results also attach to its employees and its shareholders, as well as the greater Hartford community.
Page 367 PREV PAGE TOP OF DOC Segment 2 Of 2
The Affects
Both proposals can be characterized as anti-investment, anti-business and harmful to capital formation. If enacted in their current form, the proposals will have a negative impact on equity investments, job growth, non-federal government services, municipal financing and global competitiveness.
I. DRD Change
1. Increases Equity Costs and Corporate Leverage
The change in the DRD will cause an increase in the cost of all equity financing and favor debt financing alternatives that have an interest deduction. This will increase the leverage of corporate America and crowd the debt markets, thus increasing interest costs for all borrowers. The elimination of the DRD on future issuance of certain preferred stocks will force issuers into the debt markets in order to grow and provide new and continuing sources of jobs. The migration to debt financing, and associated interest deduction, increases corporate leverage and will not increase revenue to the federal government.
2. Stifles Investment
The proposals not only negatively affect preferred stock dividends but also change the economics of receiving common stock dividends for corporations. This will dampen corporate investment in venture capital, minority shareholder participations, and strategic equity partnerships between corporations. The result will stifle investment and cause a decline in economic and job growth.
Page 368 PREV PAGE TOP OF DOC Segment 2 Of 2
3. Creates Real Economic Loss
The decrease in the DRD from 70% to 50% will increase issuer costs by 8.5% due to the adjustment in yields required to fully compensate corporate equity investors. As we all know, increases in yields result in decreases in price. Real losses will be incurred by all types of preferred and common stock holders, including individual investors, as corporate investors adjust to the proposed changes.
4. Decreases Global Competitiveness
The proposals place the U.S. capital markets at a disadvantage in relation to many European and Asian equity capital markets where dividend income is 100% tax free. The DRD proposal will decrease capital formation and financial flexibility by eliminating future issuance of floating rate preferred stock and sinking fund preferred stock.
5. Causes Double Taxation
Dividends are after-tax distributions, meaning they have already been taxed. Reducing the DRD or denying the DRD on future issuance of floating rate preferred stock amounts to double and in some cases triple taxation of the same dollar as it flows through the corporate economic system. The financial flexibility to issue equity capital should not be determined by the nature of a dividend reset process as long as those dividends have already been taxed.
Page 369 PREV PAGE TOP OF DOC Segment 2 Of 2
II. Eliminating the ''2% De Minimis Rule''
1. Creates Investment Losses
Corporate purchases of tax-exempt securities are primarily concentrated in the ''short end'' of the tax-exempt yield curve. There are roughly $300 billion of tax-exempt securities outstanding in what can be characterized as ''money market type'' or ''money market alternative'' securities. It is estimated that up to $100 billion of these securities are owned by corporations. If corporations were forced out of the short-term tax-exempt market, then the remaining participants, primarily individual investors through their ownership of money market funds, would be forced to buy those securities, or issuers will be forced to redeem those same securities. It is unrealistic to expect the market to absorb the amount of securities put up for sale by exiting corporations at current prices. Again, any changes in yield affect price, thus, an upward change in yields will cause a decrease in prices for all participants in the tax-exempt markets. The primary losers in this scenario are the individual investors who will bear the brunt of losses as corporations exit the tax-exempt markets.
2. Raises Interest Costs
Access to any market is determined by demand. The elimination of corporate demand for short-term tax-exempt securities will cause state and local governments as well as various authorities such as industrial development authorities, higher education authorities, water and sewer authorities, and other public purpose authorities, either to pay higher short-term interest expenses or to use longer fixed rate financing alternatives at an inherently higher cost.
Page 370 PREV PAGE TOP OF DOC Segment 2 Of 2
3. Decreases Investment in InfraStructure and Local Services; Raises Local Taxes
Elimination of the ''2% de minimis rule'' will limit access to the tax-exempt markets for many different types of government and quasi-government bodies. Limiting financial flexibility prohibits municipal borrowers from financing efficiently and causes municipalities to limit financing, infrastructure development, and the local services they provide. Additionally, if market access is limited, it is possible that taxes at the local level would have to be raised in order to maintain essential services.
4. Increases Cumbersome Record Keeping and Tax Complexity
Currently, the Internal Revenue Service allows corporations to invest up to 2% of their assets in tax-exempt securities without the cumbersome record keeping necessary for tracing funds sources. The purpose of the ''2% de minimis rule'' is tax simplification. If enacted, the disallowance would require undue paperwork in order to avoid inadvertently violating onerous regulatory requirements.
Sincerely,
| James C. Rowan, Jr. |
| Vice President |
—————
Statement of the International Mass Retail Association, Robert J. Verdisco, President
On behalf of the members of the International Mass Retail Association (IMRA), I am hereby submitting for the record comments on two of the Administration's revenue raising provisions included in the fiscal year 1998 budget proposal. We strongly oppose both the changes in the Federal Unemployment Tax Act (FUTA) and the repeal of the Lower of Cost or Market Inventory Accounting Method (LCM).
Page 371 PREV PAGE TOP OF DOC Segment 2 Of 2
By way of background, IMRA represents the largest and fastest growing segment of the retail industry. Its membership includes discount department stores, home centers, category dominant or specialty discounters, catalogue showrooms, dollar stores, warehouse clubs, deep discount drugstores, and off-price stores, as well as industry suppliers. Collectively, IMRA retail members operate more than 75,000 stores in the U.S. and abroad and employ millions of Americans. IMRA retail members cumulatively represent over $346 billion in annual sales. As high volume, low margin retailers, IMRA members are leaders in bringing value to the consumer. (Attached is a list of our membership.)
First, the provision to require monthly, rather than quarterly, deposits of FUTA taxes, and the proposal to extend the current 0.2 percent surcharge through the year 2006 will both have significant cost implications for our companies. It results in a direct tax on labor which impacts job creation.
The proposal to change to monthly collection of federal FUTA taxes rather than quarterly, would create significant new paperwork burdens and administrative costs, even though it does not actually result in a real revenue gain for the government. Indeed, it is nothing more than an accounting trick.
In addition, extending the 0.2 percent surcharge would, in our view, violate a promise made to employers in 1976 that this tax would be temporary. The surcharge was put in place in 1976 to retire a loan from general revenues used to finance supplemental benefit extensions. That deficit was retired in 1987. Continuing the surcharge would simply be unfair. In addition, it will result in the accumulation of funds in the Unemployment Trust Fund that is not needed to fund benefits. We strongly oppose using the surcharge as a means to reduce the federal deficit.
Congress should not move precipitously on these proposals at a time when consideration and debate is just beginning on much needed reform of the unemployment compensation system.
Page 372 PREV PAGE TOP OF DOC Segment 2 Of 2
Second, repeal of LCM unfairly penalizes retailers on the use of their inventory accounting method. Essentially, the proposal would impact retailers not currently using the last-in first-out (LIFO) method to determine the cost of their ending inventories. Therefore, the one billion dollars this provision is expected to raise falls disproportionately on only those retailers currently using this method of accounting.
Taxpayers using LCM are able to ''write down'' (for tax purposes) the value of their inventory when it decreases in value over time due to damage, imperfection, becomes out-dated, or other causes. This method of accounting has been an accepted tax accounting method since 1917 and conforms with Generally Accepted Accounting Principles (GAAP). The LCM has never been treated as a tax preference or loophole, and its use is required for the determination of both earnings and profits and the alternative minimum tax calculations.
A repeal of the LCM method would result in an exorbitantly high increase in federal tax dollars as well as an enormous compliance burden for those affected retailers. Also, if repealed, many retailers may be forced to expend considerable resources to request approval from the Internal Revenue Service for a change in their accounting method in order to establish a more acceptable way to calculate inventory costs.
As we mentioned earlier in our statement, our member companies are leaders in bringing value to the consumer. By operating on low margins and in high volume, changes that increase taxes, payroll or administrative burdens, threaten this efficiency and impact job growth. Nor can our member companies pass such costs along to the consumer since it is their philosophy to offer the lowest prices possible. In short, it is the consumer that ultimately pays the price for any new tax increases.
For these reasons, we urge you to reject these proposals. Thank you for your consideration of this issue and please feel free to call on us if we can be of assistance to you.
Page 373 PREV PAGE TOP OF DOC Segment 2 Of 2
Attachment: List of members of the International Mass Retail Association
INSERT OFFSET FOLIOS 16 TO 19 HERE
[The official Committee record contains additional material here.]
—————
Statement for the Record by the Interstate Natural Gas Association of America
I. The Interstate Natural Gas Association of America and the Foreign Pipeline Projects of Its Members
The Interstate Natural Gas Association of America (''INGAA'') is a non-profit national trade association that represents virtually all of the major interstate natural gas transmission companies operating in the United States. These companies handle over 90 percent of all natural gas transported and sold in interstate commerce. INGAA's United States members are regulated by the Federal Energy Regulatory Commission pursuant to the Natural Gas Act, 15 U.S.C. § § –717–717w, and the Natural Gas Policy Act of 1978, 15 U.S.C. § § –3301–3432.
In recent years a number of INGAA's members have become engaged in the design, construction, engineering, ownership and operation of major pipeline and power plant projects outside the United States. Investments are made in these foreign projects generally by foreign subsidiaries of the U.S. companies. These projects, which are highly capital-intensive, often involve construction of a natural gas pipeline and related facilities to transport gas from its point of extraction within one or more foreign countries to an electric generating facility for use as fuel in the generation of power or for local distribution. The project may include the generating plant, and in some cases may also include an interest in the gas wells which provide the gas supply. The gas being transported in the pipeline may or may not be owned by the pipeline owner. Most of these projects are being undertaken in Latin America, Asia, India and in less developed countries in other parts of the world.
Page 374 PREV PAGE TOP OF DOC Segment 2 Of 2
Most of these large energy projects are awarded through a bidding process. The bidding is highly competitive, and the economics of such projects are tax sensitive. In many cases there is substantial income tax payable to the local country where the project is based. U.S. bidders are currently at a disadvantage vis-a-vis their foreign competitors, including particularly those based in Canada, Australia, or Europe, because of the manner in which U.S. tax law currently applies to such projects, as is explained below.
The Administration's proposal to revise the tax treatment of foreign oil and gas income (the ''Proposal'') would, if enacted, have a substantial adverse effect on the ability of INGAA members to compete for these projects, and would drastically affect the economics of projects already undertaken, resulting in losses and adverse financial statement effects to INGAA members. Chairman Archer has stated that the purpose of the Hearing is to determine which of the Administration's proposals are ''firmly grounded in tax policy'' and which are ''simply tax increases.'' As this testimony will demonstrate, the Proposal is not grounded in sound tax policy but is simply a tax increase that would seriously affect INGAA members with foreign pipeline operations. INGAA recommends that Congress reject the Proposal. Moreover, INGAA recommends that the taxation of foreign oil and gas income be reformed by Congress to eliminate certain clear inequities of current law as applicable to foreign pipeline projects.
II. The Administration's Proposal
On February 6, 1997 the Administration put forth the Proposal, which would result in a substantial change in the taxation of foreign oil and gas income. Briefly, the Proposal would treat all foreign income earned by a controlled foreign corporation (''CFC'') relating to oil and gas activities, including income from the transportation of gas through a pipeline, as being subject to current U.S. taxation pursuant to Subpart F, even though not repatriated to the U.S. shareholders of the CFC. Moreover, the foreign income taxes paid with respect to that income would be subject to a separate foreign tax credit limitation instead of being included as part of the ''general basket'' of active income.
Page 375 PREV PAGE TOP OF DOC Segment 2 Of 2
In the General Explanation of the Proposal the Treasury Department does not articulate any reason for taxing all foreign oil and gas income currently under Subpart F, or for creating a separate basket for foreign oil and gas income under the foreign tax credit limitation. Treasury's ''Reasons for Change'' addresses only the issue of whether or not a foreign tax should be creditable. The absence of a stated Treasury tax policy rationale for the Proposal should raise a question as to whether any such rationale exists.
In its Description and Analysis of Certain Revenue- Raising Provisions Contained in the President's Fiscal Year 1998 Budget Proposal, issued March 12, 1997, the Staff of the Joint Committee on Taxation identified ''simplification'' as a possible rationale for both the Subpart F and the foreign tax credit features of the Proposal.(see footnote 102) However, the Joint Committee Staff identified a powerful counter-argument to the Subpart F proposal:
[O]thers argue that the proposed expansion of the subpart F rules is inconsistent with the tax policy underlying such provisions. The subpart F rules historically have been aimed at requiring current inclusion of income of a CFC that is either passive or easily movable. The categories of foreign oil and gas income that would be added to subpart F income under the proposal (i.e., foreign oil and gas extraction income and certain same-country foreign oil related income) do not constitute income that is either passive or manipulable as to location.(see footnote 103)
INGAA concurs with this analysis. There is no policy justification for treating active income earned by a CFC from transporting locally extracted natural gas through a pipeline, whose location cannot be manipulated, as Subpart F income. Nor is there any tax policy reason to separate foreign oil and gas transportation income from other active income for purposes of the foreign tax credit limitation.
Page 376 PREV PAGE TOP OF DOC Segment 2 Of 2
In this testimony INGAA will describe current law, illustrate the inequity of current law to INGAA members, and then further illustrate how the Proposal would greatly exacerbate this inequity.
III. U.S. Taxation of Foreign Pipelines Under Current Law
A. Subpart F
1. Description of Current Law
Under the Subpart F rules, U.S. 10 percent shareholders of a CFC are subject to U.S. tax currently on their proportionate shares of ''Subpart F income'' earned by the CFC, whether or not it is distributed to the U.S. shareholders. Included among the categories of Subpart F income is ''foreign base company oil related income.'' See section 954(g). Foreign base company oil related income is income derived outside the United States from the processing of minerals extracted from oil or gas wells into their primary products; the transportation (including by pipeline), distribution or sale of such mineral or primary products; the disposition of assets used in a trade or business involving the foregoing; or the performance of any related services.
There are two significant exceptions to this classification of income.
a. The extraction exception: income, including income from operating a pipeline, derived from a source within a foreign country in connection with oil or gas which was extracted by any person from a well located in such foreign country is not foreign base company oil related income.
b. The consumption exception: income, including income from operating a pipeline, derived from a source within a foreign country in connection with oil or gas (or a primary product thereof) which is sold by the CFC or a related person for use or consumption within the foreign country is not foreign base company oil related income.
Page 377 PREV PAGE TOP OF DOC Segment 2 Of 2
There is a general exception to this Subpart F provision for CFCs which do not produce 1,000 barrels per day of foreign crude oil and natural gas; this exception is often not available because for this purpose all related persons are aggregated, and many significant investors in natural gas pipelines and power projects around the world own foreign production which exceeds 1,000 barrels per day.
c. Unavailability of high tax exception: All types of foreign base company income except foreign oil related income may be excluded from current taxation under Subpart F if the income is subject to an effective rate of local income tax greater than 90 percent of the U.S. corporate rate. Section 954(b)(4). No reason is given in the legislative history as to why this high tax exception is not applicable to foreign oil related income. Because Congress chose not to allow this exception, highly taxed income from the operation of foreign pipelines by a CFC may be subject to current U.S. tax under Subpart F, with a likelihood that credit will not be available for the foreign income tax paid and international double taxation will occur.
2. Tax Policy Rationale of Current Law
The Subpart F taxation of foreign oil related income was enacted in the Tax Equity and Fiscal Responsibility Act of 1982 (''TEFRA''), P.L. 97–248, September 3, 1982. The legislative history explaining the tax policy rationale for the Subpart F treatment of foreign oil and gas income is as follows:
because of the fungible nature of oil and because of the complex structures involved, oil income is particularly suited to tax haven type operations.
S. Rep. No. 494, 97th Cong., 2d Sess. 150 (1982).
Page 378 PREV PAGE TOP OF DOC Segment 2 Of 2
The only other reference made in the legislative history of TEFRA to any reason for including foreign oil related income in Subpart F is the general statement of the Finance Committee that ''the petroleum companies have paid little or no U.S. tax on their foreign subsidiaries' operations despite their extremely high revenue.'' Id. Accordingly, Subpart F taxation was imposed on all foreign oil related income without analysis of whether such income fit the criteria of Subpart F, i.e., was passive in nature or moveable. Income from the ownership and operation of foreign gas pipelines is neither passive or moveable. Moreover, it is unlikely that such income could have been a target of TEFRA since there was little foreign pipeline investment by U.S. companies at that time.
B. Foreign Tax Credit
U.S. persons are subject to U.S. income tax on their worldwide income. To eliminate international double taxation, i.e., the taxation of the same income by more than one tax authority, the United States allows a credit against the U.S. tax on foreign source income for foreign income taxes paid. The amount of credits that a taxpayer may claim for foreign taxes paid is subject to a limitation intended to prevent taxpayers from using foreign tax credits to offset U.S. tax on U.S. source income. The foreign tax credit limitation is calculated separately for specific categories of income. Generally speaking, the foreign income activities conducted by INGAA members, such as operating pipelines to transport natural gas in foreign countries, produce ''active basket'' (sometimes referred to as ''general basket'') foreign source income. Income from the extraction of oil and gas is also generally ''active basket'' income, although foreign oil and gas extraction income taxes are creditable only to the extent that they do not exceed 35 percent of the extraction income.
The ''separate basket'' approach of current law was instituted in the Tax Reform Act of 1986. In 1986 Congress expressed a concern that the overall foreign tax credit limitation permitted a ''cross crediting'' or averaging of taxes so that high foreign taxes on one stream of income could be offset against U.S. tax otherwise due on only lightly taxed foreign income. Nevertheless, in 1986 Congress endorsed the overall limitation as being ''consistent with the integrated nature of U.S. multi-national operations abroad,'' and therefore concluded that averaging credits for taxes paid on active income earned anywhere in the world should generally be allowed to continue. General Explanation of the Tax Reform Act of 1986, 99th Cong., 2d Sess. 862 (1986) (''1986 Blue Book''). Congress limited the cross crediting of foreign taxes when it would ''distort the purpose of the foreign tax credit limitation.'' Id. For example, one identified concern was the use of portfolio investments in stock in publicly-traded companies, which could quickly and easily be made in foreign countries rather than in the United States. In order to limit opportunities for cross-crediting, Congress added additional baskets for income that frequently either bore little foreign tax or abnormally high foreign tax, or was readily manipulable as to source. The baskets enacted in 1986 included passive income, financial services income, shipping income, high withholding tax interest, and dividends from non-controlled section 902 corporations. H.R. Conf. Rep. No. 841, 99th Cong., 2d Sess. 564–66 (1986).
Page 379 PREV PAGE TOP OF DOC Segment 2 Of 2
IV. Current Law Is Unfair to INGAA Members Which Participate in Pipeline Projects Abroad
A. Subpart F
As described above, CFCs owned by INGAA members participate in large foreign projects which typically involve the construction and operation of gas pipelines and related facilities, sometimes include the participation in power plants, and occasionally also include investment in gas wells. These are all active business activities which have occurred only in recent years. As illustrated by the legislative history of TEFRA, Congress expressed no policy reason why this type of income should be currently taxed to U.S. shareholders of a CFC under Subpart F. This foreign income of CFCs owned by INGAA members is no more ''particularly suited to tax haven operations'' (as the Senate Finance Committee Report states) than is any foreign manufacturing or processing activities conducted by a CFC, such as the manufacture of consumer or industrial goods. Surely it is not possible to ''manipulate'' income earned by a CFC from operating a gas pipeline permanently installed in a particular foreign country.
Most U.S. bidders have generally only won projects where either the ''extraction'' or ''consumption'' exceptions applied. If a pipeline project does not qualify for one of these exceptions to Subpart F it is unlikely that a U.S. bidder could successfully win a bid for that project against foreign competitors. Such a U.S. bidder is at a competitive disadvantage even for projects with local income taxes higher than the U.S. corporate rate because the Subpart F exception for high-tax income does not apply.
Moreover, the exceptions to Subpart F for foreign oil related income apply irrationally. Consider the example where gas is extracted and processed by persons unrelated to the CFC in country A. The CFC constructs a pipeline from country A through country B and into country C where the gas is delivered to a power plant. Assume that the CFC receives $100 for transportation of the gas in each of countries A, B, and C, and that each country imposes tax on the CFC of $35. The U.S. taxation of the $300 of income is as follows:
Page 380 PREV PAGE TOP OF DOC Segment 2 Of 2
• Country A—the $100 is not subpart F income because the extraction exception applies—the income is derived from country A where the gas was extracted.
• Country B—the $100 is Subpart F income, currently taxed in United States because the income is not earned either in a country where the gas was extracted (Country A) or consumed (Country C).
• Country C—the $100 is Subpart F income if the CFC does not own the gas but instead charges a tariff for transportation—however, if the CFC takes title to the gas and sells it in country C, the consumption exception applies and the $100 is not Subpart F income.
As a matter of tax policy, different tax treatment of each separate $100 of income cannot be justified. It is submitted that none of this $300 of income should be Subpart F income because it is not passive or moveable. At the very least, the consumption exception should apply to the income earned in Country C irrespective of whether the CFC owns the gas, since the gas is consumed in Country C. (Such application would make the consumption exception operate in the same manner as the extraction exception, where ownership of the gas by the CFC is irrelevant). In addition, under current law the high-tax exception does not apply to exempt the income earned in Countries B and C from Subpart F—this is also incorrect as a tax policy matter.
Note that if the CFC also participates in ownership of the power plant, income from that activity is not Subpart F income.
B. Foreign Tax Credit
Under current law, all income from the transportation of natural gas through a foreign pipeline is active basket income. This is clearly the correct result. INGAA members, however, are frequently in an excess foreign tax credit position because of the substantial interest expense on debt incurred to finance domestic capital expenditures which is apportioned to foreign source income, reducing the numerator of the foreign tax credit limitation which in turn reduces the amount of the foreign tax credit. Thus, as a practical matter it is difficult for a U.S. pipeline company to obtain foreign tax credits with respect to the income earned from its foreign operations. In the example described above, although the $200 of income from Countries B and C would be subject to U.S. tax under Subpart F, it is unlikely that the $70 of foreign income taxes paid to Countries B and C would be available as a foreign tax credit. Thus international double taxation would result.
Page 381 PREV PAGE TOP OF DOC Segment 2 Of 2
V. The Proposal Would Greatly Exacerbate the Unfairness of Subpart F for Pipelines, Would Be a Substantial Tax Increase With Respect to Existing Projects, Would Materially Harm U.S. Businesses and Their Employees, and Would Not Achieve Simplification
Under the Proposal all income of a CFC from the extraction, processing and transportation of gas in any foreign country would be subject to U.S. tax irrespective of whether any of the income is distributed to U.S. shareholders (and irrespective of whether it is subject to a high local income tax). In the example discussed above, $300 would be subjected to U.S. tax, and the $105 of foreign taxes paid with respect to the $300 (to countries A, B and C) would be subject to a separate foreign tax credit limitation. Income derived from the power plant would not be subject to current tax under Subpart F under the Proposal because it is not foreign oil and gas income. When the income from operating the power plant is distributed, however, it would be included in the general basket for purposes of the foreign tax credit limitation, not the new foreign oil and gas income basket which includes the pipeline income. Thus, the income from an integrated project would be divided into two baskets, a foreign oil and gas income basket for income from activities up to the delivery of the gas to the power plant, and a general basket for income from the operation of the power plant. It would be difficult and complex to separate out how much of a project's income is foreign oil and gas income, which would be currently taxed under Subpart F and subject to a separate foreign tax credit basket, and other income, which would not be Subpart F income and would be general basket income when it is eventually subject to U.S. tax. Certainly the Proposal cannot be justified as simplification; the result for INGAA members would be the antithesis of simplicity.
As articulated above, there is no tax policy basis for the current Subpart F taxation of income from the operation of foreign pipelines. The one sentence policy rationale in the legislative history of TEFRA certainly does not apply to foreign income from gas pipelines, as no ''fungible'' gas is involved, nor is a ''complex structure'' being used. Moreover, the Treasury Department did not even attempt to set forth a policy rationale for the Proposal in its General Explanation. The Joint Committee's Analysis could only identify ''simplification'' as a possible policy rationale for the Proposal. This rationale clearly does not apply to pipelines. Moreover, separation of foreign oil and gas income into a separate foreign tax credit limitation basket would be contrary to the basic general Congressional determination in 1986 that all active income from anywhere in the world should be included in one foreign tax credit limitation basket.(see footnote 104)
Page 382 PREV PAGE TOP OF DOC Segment 2 Of 2
The Proposal would materially harm U.S. businesses, affecting U.S. jobs and U.S. competitiveness in the global economy. The effect of the Proposal would be to preclude most U.S. investors from successfully bidding for the capital-intensive foreign pipeline projects. The current U.S. taxation of a project's income before its distribution, with little chance of obtaining a credit for foreign taxes paid on income from the project, would substantially impair the economics for a U.S. bidder. Thus, the Proposal would probably disqualify most U.S. companies from participating in foreign pipeline projects. This would have the effect of destroying a thriving business currently available to INGAA members. This business creates a demand for U.S. jobs, particularly engineering and support services, which is highly desirable in an industry where not many new pipeline projects are being undertaken in the United States. Moreover, auxiliary industries in the United States, such as the exportation of pipe and related materials and services, are benefitted by the participation by U.S. companies in these foreign projects. Elimination of most U.S. pipeline companies from participating in foreign pipeline projects seems to INGAA to be wholly counterproductive and misguided tax policy which would cost U.S. jobs.
In addition, the Proposal would apply to projects already completed and in operation. U.S. investors would therefore realize returns greatly different from their economic projections, with large losses likely and materially adverse financial statement impacts. Indeed, because of the likely significant losses, U.S. investors would most probably be required to sell to their foreign competitors those projects which the Proposal would make uneconomic. In short, enactment of the Proposal would create profound economic harm for INGAA members with foreign pipeline activities.
VI. Recommendations
Page 383 PREV PAGE TOP OF DOC Segment 2 Of 2
A. Reject the Proposal
The Proposal must be rejected because it fails the test articulated by Chairman Archer: it is not ''firmly grounded in tax policy''; moreover, it would result in a catastrophic ''tax increase'' for INGAA members which own foreign gas pipelines.
B. Reform the Subpart F Taxation of Foreign Oil Related Income As It Applies to Gas Pipelines
Current law includes all foreign oil related income as Subpart F income. It is INGAA's position that ownership and operation of gas pipelines and other immovable assets in foreign countries as described herein should never result in Subpart F income, whether or not the activities occur in a country where the gas was extracted or consumed, and whether or not the CFC takes title to the gas being transported, because these activities do not produce income which is passive or manipulable. At a minimum, as noted above the consumption exception should be amended to apply in the same manner as the extraction exception, i.e., its application should not be dependent upon whether the CFC takes title to the gas it is transporting. Moreover, the high-tax exception to foreign base company income should be amended so that it applies to foreign base company oil related income as it does to all other foreign base company income.
INGAA appreciates the opportunity to provide this testimony and would be pleased to furnish any information requested by the Committee.
—————
Statement of the Investment Company Institute
Page 384 PREV PAGE TOP OF DOC Segment 2 Of 2
The Investment Company Institute (the ''Institute'')(see footnote 105) submits for the Committee's consideration the following comments regarding proposals to (1) require sellers of securities to calculate gains and losses using an average cost basis, (2) increase the penalties under section 6721 for failure to file correct information returns, and (3) modify section 1374 of the Internal Revenue Code(see footnote 106) to require current gain recognition on the conversion of a large C corporation to an S corporation.
I. Average Cost Basis for Securities
Background
Taxpayers who sell stocks or other securities generally calculate gain or loss on disposition by either specifically identifying the securities sold (the ''specific identification'' method) or treating the shares held longest as sold first (the ''first-in-first-out'' or ''FIFO'' method). Dispositions of shares in a regulated investment company (''RIC'') also may be accounted for using either the single-category or double-category average cost basis method. Under the single-category average cost method, the basis of shares sold is calculated by adding together the amounts paid for all of the shareholder's investments in the RIC (total cost basis), subtracting the amount of basis attributable to prior redemptions and dividing the remainder by the total number of shares owned by the shareholder immediately prior to the redemption.(see footnote 107)
Page 385 PREV PAGE TOP OF DOC Segment 2 Of 2
Proposal
The President's Fiscal Year 1998 budget includes a proposal which would require taxpayers to calculate gains and losses on dispositions of substantially identical securities, including shares of a RIC, using the single-category average cost basis method. The proposal would apply to securities sold more than 30 days after enactment of the proposal.
Recommendation
The Institute strongly opposes the average cost basis proposal. The proposal would increase taxes on securities investors, reduce incentives to save, discourage capital investment and complicate tax calculations.
By eliminating the present law option to specifically identify the securities sold, the proposal would increase taxes on securities investors. Millions of middle-income investors saving for retirement and other long-term objectives (such as college tuition for their children) would be disadvantaged by this proposal. By increasing taxes on investors, the proposal would reduce incentives to save and discourage capital investment. Moreover, the proposal would discourage reinvestment in successful companies, but would have no effect on those who purchase a particular type of security only once.
Requiring use of the average cost basis method also would complicate, rather than simplify, tax calculations. For example, if a RIC investor purchased shares and reinvested quarterly dividends for ten years, the investor's cost basis for a single share would not be the price paid for that share, but would instead be an average of 41 different purchases occurring over a ten year period. Holding RIC shares for longer time periods and/or purchasing shares more frequently, such as through a monthly periodic purchase plan or participation in a monthly dividend reinvestment plan, would increase significantly the complexity of these calculations.(see footnote 108)
Page 386 PREV PAGE TOP OF DOC Segment 2 Of 2
Complexity also would arise from the attribution rules that would be needed to prevent avoidance of the average cost basis requirement through the use of related persons and controlled entities. For example, attribution rules would be required to prevent avoidance by (1) having securities held by the taxpayer's children or other relatives, (2) holding securities in joint accounts, and (3) establishing separate partnerships, trusts and other entities to hold securities.
The proposal's effective date, applying to all securities sales more than 30 days after date of enactment, would retroactively affect in an adverse manner every investor who purchased securities when the specific identification method of determining cost basis was permissible. By applying to securities already held as well as shares purchased in the future, millions of RIC shareholders would be required to perform these detailed and cumbersome calculations. While many RICs now provide average cost basis information to their shareholders, they typically do so only for accounts opened after (or shortly before) the implementation of a system for providing average cost basis information. The provision of average cost basis information to new accounts reflects the fact that RICs, as a practical matter, cannot accurately determine the average cost basis with respect to old accounts (1) from which shares were redeemed prior to the establishment of the system to calculate average cost basis(see footnote 109) or (2) for which less than all of the cost data is stored in machine-readable format.(see footnote 110) In addition, in many cases a RIC would not be able to provide average cost basis calculations to investors who acquire shares by gift or inheritance, or to investors who otherwise did not purchase the securities from the RIC seeking to provide the average cost basis calculations. Thus, it is erroneous to assume that the necessary average cost basis calculations will be provided to all RIC investors. Those many investors who do not receive average cost information will be burdened with new, time consuming mathematical computations.
Page 387 PREV PAGE TOP OF DOC Segment 2 Of 2
II. Increased Penalties for Failure To File Correct Information Returns
Background
Current law imposes penalties on payers, including RICs, that fail to file with the Internal Revenue Service (''IRS'') correct information returns showing, among other things, payments of dividends and gross proceeds to shareholders. Specifically, section 6721 imposes on each payer a penalty of $50 for each return with respect to which a failure occurs, with a maximum penalty of $250,000.(see footnote 111) The $50 penalty is reduced to $15 per return for any failure that is corrected within 30 days of the required filing date and to $30 per return for any failure corrected by August 1 of the calendar year in which the required filing date occurs.
Proposal
The President's Fiscal Year 1998 budget contains a proposal which would increase the $50-per-return penalty for failure to file correct information returns to the greater of $50 per return or five percent of the aggregate amount required to be reported correctly but not so reported. The increased penalty would not apply if the total amount reported for the calendar year was at least 97 percent of the amount required to be reported.
Recommendation
The Institute opposes the proposal to increase the penalty for failure to file correct information returns. Information reporting compliance is a matter of serious concern to RICs. Significant effort is devoted to providing the IRS and RIC shareholders with timely, accurate information returns and statements. As a result, a high level of information reporting compliance is maintained within the industry.
Page 388 PREV PAGE TOP OF DOC Segment 2 Of 2
The Internal Revenue Code's information reporting penalty structure was comprehensively revised by Congress in 1989 to encourage voluntary compliance. Information reporting penalties are not designed to raise revenues.(see footnote 112) The current penalty structure provides adequate, indeed very powerful, incentives for RICs to promptly correct any errors made.
III. Conversions of Large C Corporations to S Corporations
Background
Section 1374 generally provides that when a C corporation converts to an S corporation, the S corporation will be subject to corporate level taxation on the net built-in gain on any asset that is held at the time of the conversion and sold within 10 years. In Notice 88–19, 1988–1 C.B. 486, the IRS announced that regulations implementing repeal of the so-called General Utilities doctrine would be promulgated under section 337(d) to provide that section 1374 principles, including section 1374's ''10-year rule'' for the recognition of built-in gains, would be applied to C corporations that convert to RIC or real estate investment trust (''REIT'') status.
Notice 88–19 was supplemented by Notice 88–96, 1988–2 C.B. 420, which states that the regulations to be promulgated under section 337(d) will provide a safe harbor from the recognition of built-in gain in situations in which a RIC fails to qualify under Subchapter M for one taxable year and subsequently requalifies as a RIC. Specifically, Notice 88–96 provides a safe harbor for a corporation that (1) immediately prior to qualifying as a RIC was taxed as a C corporation for not more than one taxable year, and (2) immediately prior to being taxed as a C corporation was taxed as a RIC for at least one taxable year. The safe harbor does not apply to assets acquired by a corporation during the C corporation year in a transaction that results in its basis in the assets being determined by reference to a corporate transferor's basis.
Page 389 PREV PAGE TOP OF DOC Segment 2 Of 2
Proposal
The President's Fiscal Year 1998 budget proposes to repeal section 1374 for large corporations. For this purpose, a corporation is a large corporation if its stock is valued at more than five million dollars at the time of the conversion to an S corporation. Thus, a conversion of a large C corporation to an S corporation would result in gain recognition both to the converting corporation and its shareholders. The proposal further provides that Notice 88–19 would be revised to provide that the conversion of a large C corporation to a RIC or REIT would result in the immediate recognition of the corporation's net built-in gain. Thus, the Notice, if revised as proposed, would no longer permit a large corporation that converts to a RIC or REIT to elect to apply rules similar to the 10-year built-in gain recognition rules of section 1374.
Recommendation
Because the safe harbor set forth in Notice 88–96 is not based upon the 10-year built-in gain rules of section 1374, the repeal of section 1374 for a large C corporation should have no effect on Notice 88–96. The safe harbor is based on the recognition that the imposition of a significant tax burden on a RIC that requalifies under Subchapter M after failing to qualify for a single year would be inappropriate. Moreover, the imposition of tax in such a case would fall directly on the RIC's shareholders, who are typically middle-class investors.
The Institute understands from discussions with the Treasury Department that the proposed revision to section 1374 and the related change to Notice 88–19 are not intended to impact the safe harbor provided by Notice 88–96.
Page 390 PREV PAGE TOP OF DOC Segment 2 Of 2
Should the Congress adopt this proposal, the Institute recommends that the legislative history include a statement, such as the following, making it clear that the proposed revision to section 1374 and the related change to Notice 88–19 would not impact the safe harbor set forth in Notice 88–96 for RICs that fail to qualify for one taxable year:
This provision is not intended to affect Notice 88–96, 1988–2 C.B. 420, which provides that regulations to be promulgated under section 337(d) will provide a safe harbor from the built-in gain recognition rules announced in Notice 88–19, 1988–1 C.B. 486, for situations in which a RIC temporarily fails to qualify under Subchapter M. Thus, it is intended that the regulations to be promulgated under section 337(d) will contain the safe harbor described in Notice 88–96.
INSERT OFFSET FOLIO 12 HERE
[The official Committee record contains additional material here.]
—————
Statement of Merrill Lynch & Co., Inc.
Merrill Lynch is pleased to provide this written statement for the record of the March 12, 1997 hearing of the Committee on Ways & Means on ''Revenue Raising Provisions in the Administration's Fiscal Year 1998 Budget Proposal.''(see footnote 113)
I. Introduction
Merrill Lynch believes that a strong, healthy economy will provide for increases in the standard of living that will benefit all Americans as we enter the challenges of the 21st Century. Investments in our nations future through capital formation will increase productivity enabling the economy to grow at a healthy rate. Merrill Lynch is, therefore, extremely supportive of fiscal policies that raise the United States savings and investment rates. For this reason, Merrill Lynch has been a strong and vocal advocate of policies aimed to balance the federal budget. Merrill Lynch applauds the continuing efforts of this Congress to do so.
Page 391 PREV PAGE TOP OF DOC Segment 2 Of 2
While Merrill Lynch applauds the ongoing efforts to balance the federal budget, it is unfortunate that many of the tax changes proposed by the Administration in its FY 1998 Budget would raise the costs of capital and discourage capital investment policies contradictory to the objective of a balanced budget. The Administration's FY 1998 Budget contains a number of revenue-raising proposals that would raise the cost of financing new investments in plant, equipment, research, and other job-creating assets. This will have an adverse effect on the economy.
Merrill Lynch agrees with the comments related by Chairman Bill Archer to President Clinton when many of these same proposals were being considered for inclusion in the Administration's FY 1997 Budget. On a broad basis, Chairman Archer stated that he is ''deeply troubled and believe(s) that the impact of your plan is fundamentally anti-business, anti-growth and . . . further concerned that the manner in which you have arrived at these proposals appears to be based on how much revenue you can raise from tax increases rather than how to improve the current tax code based on sound policy changes.'' See, Letter from Chairman Bill Archer to President Clinton (dated December 11, 1995). Chairman Archer also stated that: ''you have proposed numerous new tax increases on business which reflect anti-business bias that I fear will diminish capital formation, economic growth, and job creation. For example, I don't understand why you would want to exacerbate the current problem of multiple taxation of corporate income by reducing the intercorporate dividends received deduction and denying legitimate business interest deductions. ... it will not only be America's businesses that pay the tab; hard-working, middle income Americans whose nest-eggs are invested in the stock market will pay for these tax hikes.''
The U.S. enjoys the world's broadest and most dynamic capital markets. These markets allow businesses to access the capital needed for growth, while providing investment vehicles individuals can rely on to secure their own futures. Our preeminent capital markets have long created a competitive advantage for the United States, helping our nation play its leading role in the global economy.
Page 392 PREV PAGE TOP OF DOC Segment 2 Of 2
Merrill Lynch is seriously concerned about the damage the Administration's proposals could cause to the capital-raising activities of American business and the investments these companies are making for future growth. Merrill Lynch believes these proposals are anti-investment and anti-capital formation. If enacted, they would increase the cost of capital for American companies, thereby harming investment activities and job growth.
Unfortunately, the Administration's proposals would serve to limit the financing alternatives available to businesses, harming both industry and the individuals who invest in these products. Merrill Lynch believes this move by the Administration to curtail the creation of new financial options runs directly counter to the long-run interests of our economy and our country.
While Merrill Lynch is opposed to all such proposals in the Administration's FY 1998 Budget,(see footnote 114) our comments in this written statement will be limited to the proposals that:
—Defer original issue discount deduction on convertible debt. This proposal would place additional restrictions on the use of hybrid preferred instruments and convertible original issue discount (''OID'') bonds and would defer the deduction for OID and interest on convertible debt until payment in cash (conversion into the stock of the issuer or a related party would not be treated as a ''payment'' of accrued OID);
—Deny interest deductions on certain debt instruments. Under this proposal, no deduction would be allowed for interest or OID on a corporate debt instrument that either (i) has a maturity of more than 40 years; (ii) has a maturity of more than 15 years and is not shown as indebtedness on the balance sheet of the issuer (including certain ''trust preferred'' instruments); or (iii) is payable in stock of the issuer or a related party, including an instrument that is mandatorily convertible or convertible at the issuer's option into stock.
Page 393 PREV PAGE TOP OF DOC Segment 2 Of 2
—Limit the dividends-received deduction (''DRD''). This proposal would reduce the DRD from 70% to 50% for corporations with limited corporate holdings; modify the holding period for the DRD deduction; and deny the DRD for preferred stock with certain non-stock characteristics.
Hereinafter these proposals will be referred to as the ''Administration's proposals.''
To be clear, these proposals are not ''loopholes'' or ''corporate welfare.'' They are fundamental changes in the tax law that will increase taxes on savings and investment. They do little more than penalize middle-class Americans who try to save through their retirement plans and mutual funds. Rather than being a hit to Wall Street, as some claim, these proposals are a tax on Main Street a tax on those who use capital to create jobs all across America and on millions of middle-class individual savers and investors.
It is unfortunate that the Treasury has chosen to characterize these proposals as ''unwarranted corporate tax subsidies'' and ''tax loopholes.'' The fact is, the existing tax debt/equity rules in issue here have been carefully reviewed some for decades by Treasury and Internal Revenue Service (''IRS'') officials, and have been deemed to be sound tax policy by the courts. Far from being ''unwarranted'' or ''tax loopholes,'' the transactions in issue are based on well established rules and are undertaken by a wide range of the most innovative, respected, and tax compliant manufacturing and service companies in the U.S. economy, who collectively employ millions of American workers.
Merrill Lynch urges Congress to get past misleading ''labels'' and weigh the proposals against long standing tax policy. Under such analysis, these proposals will be exposed for what they really are nothing more than tax increases on Americans.
Merrill Lynch believes that these proposals are ill-advised, for four primary reasons:
Page 394 PREV PAGE TOP OF DOC Segment 2 Of 2
• They Will Increase the Cost of Capital, Undermining Savings, Investments, and Economic Growth. While Treasury officials have stated their tax proposals will primarily affect the financial sector, this is simply not so. In reality, the burden will fall on issuers of, and investors in, these securities that is, American businesses and individuals. Without any persuasive policy justification, the Administration's proposals would force companies to abandon efficient and cost-effective means of financing now available and turn to higher-cost alternatives, and thus, limit productive investment. Efficient markets and productive investment are cornerstones to economic growth.
• They Violate Established Tax Policy Rules. These proposals are nothing more than ad hoc tax increases that violate established rules of tax policy. In some cases, the proposals discard tax symmetry and deny interest deductions on issuers of debt instruments, while forcing holders of such instruments to include the same interest in income. In other cases, the proposals look to regulatory or financial statement rules to characterize an instrument for tax purposes but only when it raises revenues. In addition, the Administration substitutes its unsubstantiated opinion of how an instrument is ''viewed,'' even though such opinion is contradictory to all available facts and circumstances. Disregarding well-established tax rules for the treatment of debt and equity only when there is a need to raise revenue is a dangerous and slippery slope that can lead to harmful tax policy consequences.
• They Will Disrupt Capital Markets. Arbitrary and capricious tax law changes have a chilling effect on business investment and capital formation. Indeed, the Administration's proposals have already caused significant disruption in capital-raising activities, as companies reevaluate their options.
• They Will Fail To Generate Promised Revenue. The Administration's proposals are unlikely to raise the promised revenue, and could even lose revenue. Treasury's revenue estimates appear to assume that the elimination of the tax advantage of certain forms of debt would cause companies to issue equity instead. To the contrary, most companies would likely move to other forms of debt issuance ones that carry higher coupons and therefore involve higher interest deductions for the issuer.
Page 395 PREV PAGE TOP OF DOC Segment 2 Of 2
At a time when the private sector and the federal government should join to pursue ways to strength the U.S. economy, the Administration has proposed tax law changes that would weaken the economy by disrupting capital-raising activities across the country. Merrill Lynch strongly urges the Administration and Congress to set aside these proposals. Looking forward, Merrill Lynch would be delighted to participate in full and open discussions on the Administration's proposals, so that their ramifications can be explored in depth.
The following are detailed responses and reaction to three of the Administration's proposals that would directly affect capital-raising and investment activities in the U.S.
II. Proposal To Defer OID Deduction on Convertible Debt
The Administration's FY 1998 Budget contains proposals that would defer the deduction for original issue discount (''OID'') until payment and deny an interest deduction if the instrument is converted to the stock of the issuer or a related party. These proposed changes to fundamental tax policy rules relating to debt and equity come under two separate (but related) proposals.
One proposal, among other things, defers OID on convertible debt. The only stated ''Reasons for Change'' relating specifically to this proposal is contained in the Treasury Department's ''General Explanations of the Administration's Revenue Proposals'' (February 1997): ''In many cases, the issuance of convertible debt with OID is viewed by market participants as a de facto purchase of equity.''
A related Administration proposal to deny interest deductions on certain debt instruments is discussed in more detail in Section III, below. The ''Reasons of Change'' cited with respect to this proposal are as follows: ''The line between debt and equity is uncertain, and it has proved difficult to formulate general rules to classify an instrument as debt or equity for all purposes or to bifurcate an instrument into its debt and equity components. While the IRS has taken the position that some purportedly debt instruments with substantial equity features should be treated as equity, other instruments have not been specifically addressed. Taxpayers have exploited this lack of guidance by, among other things, issuing instruments that have substantial equity features (including many non-tax benefits of equity), but as to which they claim interest deductions. In many cases, these instruments have been issued in exchange for outstanding preferred stock.''
Page 396 PREV PAGE TOP OF DOC Segment 2 Of 2
The Treasury Department goes on to say that the proposal would ''not affect typical convertible debt'' apparently suggesting that typical convertible debt is viewed somehow as more like debt than other convertible instruments (e.g., instruments with OID).
Merrill Lynch strongly opposes the Administration's proposal to defer or eliminate deductions for OID on Original Issue Discount Convertible Debentures (''OIDCDs'') for a number of reasons more fully described below. To summarize:
—The Treasury's conclusion that the marketplace treats OIDCD as de facto equity is demonstrably false and inconsistent with clearly observable facts;
—In an attempt to draw a distinction between OIDCDs and traditional convertible debt, Treasury misstates current law with regard to the deduction of accrued but unpaid interest on traditional convertible debentures;
—The proposal ignores established authority that treats OIDCDs as debt, including guidance from the IRS in the form of a private letter ruling;
—The proposed elimination of deductions for OID paid in stock is at odds with the tax law's general treatment of expenses paid in stock;
—The proposal would destroy the symmetry between issuers and holders of debt with OID. This symmetry has been the pillar of tax policy regarding OID. The Administration offers no rationale for repealing this principle;
—The proposal disregards regulations adopted after nearly a decade of careful study by the Treasury and the Internal Revenue Service. Consequently, the Administration's proposal would hastily reverse the results of years of careful study; and
—While billed as a revenue raiser, it is clear that adoption of the Administration's proposal would in fact reduce tax revenue.
A. Treasury's Conclusion That the Market Treats OIDCD As De Facto Equity Is Demonstrably False and Inconsistent With Clearly Observable Facts
Page 397 PREV PAGE TOP OF DOC Segment 2 Of 2
The proposal is based on demonstrably false assumptions about market behavior, which assumptions are also inconsistent with clearly observable facts. There is no uncertainty in the marketplace regarding the status of OIDCDs as debt. These securities are booked on the issuers' balance sheets as debt, are viewed as debt by the credit rating agencies, and are treated as debt for many other legal purposes, including priority in bankruptcies. In addition, zero coupon convertible debentures are typically sold to risk averse investors who seek the downside protection afforded by the debentures. Thus, both issuers and investors treat convertible bonds with OID as debt, not equity. Accordingly, it is clear that the market's ''view'' supports the treatment of OIDCD as true debt for tax purposes.
Treasury makes clear that its proposal would not affect ''typical'' convertible debt on the grounds that the ''typical'' convertible debentures are not certain to convert. Because OIDCDs have been available in the market place in substantial volume for over ten years, it is possible to compare the conversion experience of so-called ''typical'' convertible debentures with the conversion experience of OIDCDs, nearly all of which have been zero coupon convertible debt. The data shows that ''typical'' convertible debentures are much more likely to convert to equity, that is, to be paid off in stock, than zero coupon convertible debentures.
An analysis of all 90 zero coupon convertible debt securities sold in the public debt markets since 1985 shows that 48 of those issues have already been retired.(see footnote 115) Of those 48, only 13 were finally paid in stock. The other 35 were paid in cash. The remaining 42 of the 90 issues were still outstanding as of December 31, 1996. If those 42 securities were called today, only 12 of them would convert to stock and the other 30 would be paid in cash. In other words, the conversion features of only 12 of the 42 issues remaining outstanding were ''in the money.'' Overall, only 28% of the 90 public offerings of zero coupon convertible debt securities have been (or would be if called today) paid in stock. Thus, in only 28% of the OIDCD issuances has the conversion feature ultimately controlled.
Page 398 PREV PAGE TOP OF DOC Segment 2 Of 2
On the other hand, an analysis of 605 domestic issues of ''typical'' convertible debt retired since 1985 shows just the opposite result. Seventy-five percent (75%) of these offerings converted to the issuer's common stock. In light of the historical data, Treasury's statement that ''the proposal would not affect typical convertible debt'' because of the uncertainty of the conversion is completely at odds with the proposed treatment of OIDCDs.
The Treasury's proposal is clearly without demonstrable logic. It makes no sense to say that an instrument that has a 28% probability of converting into common stock is ''viewed by market participants as a de facto purchase of equity,'' and therefore, the deduction for OID on that instrument should be deferred (or denied), while an instrument that has a 75% probability of conversion should be treated for tax purposes as debt.(see footnote 116) In Treasury's defense, officials admit to not having this data when the original proposal was developed. We would be happy to provide this data, and any other relevant information, to the Administration and Congress.
B. Proposal Misstates Current Law
The Treasury's statement of ''Current Law'' contained in the ''General Explanation of the Administration's Revenue Proposals'' (February 1997) misstates the law regarding interest that is accrued but unpaid at the time of the conversion. The Treasury suggests that the law regarding ''typical'' convertible debt is different from the law for convertible debt with OID. This is clearly not the case. Both the Treasury's own regulations and case law require that stated interest on a convertible bond be treated the same as OID without regard to whether the bondholder converts.
When the Treasury finalized the general OID regulations in January, 1994 (T.D. 8517), the Treasury also finalized Treasury Regulations section 1.446–2 dealing with the method of accounting for the interest. The regulations state: ''Qualified stated interest (as defined in section 1.1273–1(c )) accrues ratably over the accrual period (or periods) to which it is attributable and accrues at the stated rate for the period (or periods). See, Treas. Reg. Section 1.446–2(b).
Page 399 PREV PAGE TOP OF DOC Segment 2 Of 2
All interest on a debt obligation that is not OID is ''qualified stated interest.'' Treasury regulations define ''qualified stated interest'' under Treas. Reg. Section 1.1273–1(c ) as follows:
(i) In general, qualified stated interest is stated interest that is unconditionally payable in cash or in property ... or that will be constructively received under section 451, at least annually at a single fixed rate ...
(ii) Unconditionally payable . . . For purposes of determining whether interest is unconditionally payable, the possibility of a nonpayment due to default, insolvency or similar circumstances, or due to the exercise of a conversion option described in section 1272–1(e) is ignored. This applies to debt instruments issued on or after August 13, 1996 (emphasis added).
Thus, according to the Treasury's own regulations, fixed interest on a convertible bond is deductible as it accrues without regard to the exercise of a conversion option. The Treasury's suggestion to the contrary in the description of the Administration's proposal contradicts the Treasury's own recently published regulations.
In addition, case law from the pre-daily accrual era established that whether interest or OID that is accrued but unpaid at the time an instrument converts is an allowable deduction depends on the wording of the indenture. In Bethlehem Steel Corporation v. United States, 434 F.2nd 1357 (Ct. Cl. 1971), the Court of Claims interpreted the indenture setting forth the terms of convertible bonds and ruled that the borrower did not owe interest if the bond converted between interest payment dates. The Court merely interpreted the indenture language and concluded that no deduction for accrued but unpaid interest was allowed because no interest was owing pursuant to the indenture. The Court stated that if the indenture had provided that interest was accrued and owing, and that part of the stock issued on conversion paid that accrued interest, a deduction would have been allowed. The indentures controlling all of the public issues of zero coupon convertible debt were written to comply with the Bethlehem Steel court's opinion and thus, the indentures for all of these offerings provide that if the debentures convert, part of the stock issued on conversion is issued in consideration for accrued but unpaid OID.
Page 400 PREV PAGE TOP OF DOC Segment 2 Of 2
Thus, there is no tax law principle that requires a difference between ''typical'' convertible bonds and zero coupon convertible deductions. The only difference is a matter of indenture provisions and that difference has been overridden by the Treasury's own regulations.
C. Proposal Ignores Established Authority That Treats OIDCDs As Debt, Including Guidance From the IRS in the Form of a Private Letter Ruling
Under current law, well-established authority treats OIDCDs as debt for tax purposes, including guidance from the IRS in the form of a private letter ruling. The IRS has formally reviewed all the issues concerning OIDCDs and issued a private letter ruling confirming that the issuer of such securities may deduct OID as it accrues. See, PLR 9211047 (December 18, 1991). Obviously rather than having not ''exploited [a] lack of guidance''(see footnote 117) from the IRS, issuers of OIDCDs have relied on official IRS guidance in the form of a private letter ruling. That the IRS issued a ruling on this topic confirms that OIDCDs do not exploit any ambiguity between debt and equity. If any such ambiguity existed the IRS would not have issued its ruling.
D. Proposal Is Inconsistent With the Fundamental Principle That Payment in Stock Is Equivalent to Payment in Cash
We would now like to focus not on the timing of the deduction but on the portion of the Administration's proposal that would deny the issuer a deduction for accrued OID if ultimately paid in stock. The proposal is inconsistent with the general policy of the tax law that treats a payment in stock the same as a payment in cash. A corporation that issues stock to purchase an asset gets a basis in that asset equal to the fair market value of the stock issued. There is no difference between stock and cash. A corporation that issues stock to pay rent, interest or any other deductible item may take a deduction for the item paid just as if it had paid in cash.
Page 401 PREV PAGE TOP OF DOC Segment 2 Of 2
More precisely on point, the 1982 Tax Act added section 108(e)(10)(see footnote 118) to repeal case law that allowed a corporate issuer to escape cancellation of indebtedness income if the issuer retired corporate debt with stock worth less than the principal amount of the corporate debt being retired. The policy of that change was to make a payment with stock equivalent to a payment with cash. Section 108(e)(10) clearly defines the tax result of retiring debt for stock. As long as the market value on the stock issued exceeds the amortized value of the debt retired, there is no cancellation of indebtedness income. The Administration's proposal to treat payment of accrued OID on convertible debt differently if the payment is made with stock rather than cash is inconsistent with the fundamental rule that payment with stock is the same as payment with cash. The Administration's proposal would create an inconsistency without any reasoned basis.
E. Treasury's Proposal Removes the Long Established Principle of Tax Symmetry Between Issuers and Holders of Debt With OID
As discussed above, the current law is clear that an issuer of a convertible debenture with OID is allowed to deduct that OID as it accrues. The Service's private letter ruling, cited above, confirms this result. It is important to note that the OID rules were originally enacted to ensure proper timing and symmetry between income recognition and tax deductions for tax purposes. Proposals that disrupt this symmetry violate this fundamental goal of tax law.
The Administration's proposal reverses the policy of symmetry between issuers and holders of OID obligations. Since 1969, when the tax law first addressed the treatment of OID, the fundamental policy of the tax law has been that holders should report OID income at the same time that the issuer takes a deduction. The Administration's proposal removes this symmetry for convertible debt with OID. Not only would the holders report taxable income before the issuer takes a deduction, but if the debt is converted, the holders would have already reported OID income and the issuer would never have an offsetting deduction. The Administration does not offer any justification for this unfairness.
Page 402 PREV PAGE TOP OF DOC Segment 2 Of 2
F. Treasury's Proposal Is an Arbitrary Attempt To Reverse Tax Policies That Were Adopted After Nearly a Decade of Careful Study
The manner in which this legislative proposal was offered is a significant reason to doubt the wisdom of enacting a rule to defer or deny deductions for OID on convertible debentures. When the Treasury issued proposed regulations interpreting 1982 and 1984 changes in the Internal Revenue Code regarding OID, the Treasury asked for comments from the public regarding whether special treatment was necessary for convertible debentures. See, 51 Federal Register 12022 (April 18, 1986).
This issue was studied by the Internal Revenue Service and the Treasury through the Reagan, Bush and Clinton Administrations. Comments from the public were studied and hearings were held by the current administration on February 16, 1993. When the current Treasury Department adopted final OID regulations in January of 1994, the final regulations did not exclude convertible debentures from the general OID rules. After nearly nine years of study under three Administrations and after opportunity for public comment, the Treasury decided that it was not appropriate to provide special treatment for OID relating to convertible debentures. Merrill Lynch suggests that it is not wise policy to reverse, in the heat of budget negotiations and without opportunity for hearings or study, a tax policy that Treasury had adopted after nearly a decade of study.
G. Proposal Regarding OID Convertible Debentures Would Reduce Tax Revenue
While billed as a ''revenue raiser,'' adoption of the Administration's proposal with respect to OIDCDs would in fact reduce tax revenue for the following reasons:
Page 403 PREV PAGE TOP OF DOC Segment 2 Of 2
• Issuers of OIDCDs view them as a debt security with an increasing strike price option imbedded to achieve a lower interest rate. This a priori view is supported by the historical analysis of OIDCDs indicating that over 70% have been, or if called would be, paid off in cash.
• If OIDCDs were no longer economically viable, issuers would issue straight debt.
• Straight debt rates are typically 200 to 300 basis points higher than comparable rates. Therefore, issuers' interest deductions would be significantly greater.
• According to the Federal Reserve Board data, at June 30, 1995 over 60% of straight corporate debt is held by tax deferred accounts versus less that 30% of OIDCDs held by such accounts.
Consequently, the empirical data suggests that if OIDCDs are not viable, issuers will issue straight debt with higher interest rates being deducted by issuers and paid to a significantly less taxed holder base. The Administration's proposal would therefore reduce tax revenue while at the same time interfering with the efficient operation of the capital markets.
Giving full consideration to the above data, Merrill Lynch believe rejection of the proposal with respect to OIDCDs is warranted and the reasons for doing so compelling.
III. Proposal To Deny Interest Deductions on Certain Debt Instruments
The Administration has proposed denying interest deductions on certain debt instruments that have a maturity of longer than 40 years, or a maturity of longer than 15 years where the instruments are not characterized as debt in an issuer's financial statements (including ''trust preferred'' instruments, TOPrS, etc.). The Administration's reasons for this proposal are cited in Section II, above.
Page 404 PREV PAGE TOP OF DOC Segment 2 Of 2
A. Debt With Maturity Over 40 Years
The Administration has proposed to deny interest deductibility on any debt obligation with a weighted average maturity of over 40 years. Merrill Lynch believes this is bad tax policy. With regard to any financial instrument, it is wrong to base the deductibility of interest on an arbitrary maturity limit. Indeed, the Administration's proposal represents a significant departure from existing IRS rules and practices regarding the classification of debt and equity. Currently, in distinguishing between the two, a facts and circumstances test should apply. In applying this test, the IRS considers the following factors:
• A reasonable maturity date;
• 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 in the event of a default;
• 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.
Page 405 PREV PAGE TOP OF DOC Segment 2 Of 2
On all but the first of these attributes, it is immediately obvious that debt obligations with maturities over 40 years enjoy exactly the same features as other debt instruments. On the remaining attribute a reasonable maturity date it has been well established that a debt obligation with a maturity over 40 years will be deemed to possess a ''reasonable maturity date'' if the issuer's business is expected to continue for the period the obligation remains outstanding. In addition, recent public offerings of debt obligations with maturities greater than 40 years were priced to provide investors with a debt return, not an equity return. The fact is that investors view these instruments as possessing the characteristics of debt including the attributes of a reasonable maturity date. Is there any reason whatsoever why a 41 year instrument with the same terms and conditions as a 39 year instrument should be afforded different treatment for tax purposes? What if the 39 year debt was issued by a credit risky start-up company and the 41 year debt was issued by a financially secure publicly traded company? Does focusing solely on the length of maturity make any sense?
Finally, if this proposal were adopted, Merrill Lynch believes most issuers would simply shift to long-term debt with a maturity under 40 years not to equity. This seems to be contrary to the assumptions underlying Treasury's ''scoring'' of this proposal. Given that issuers would respond to this proposal by continuing to issue debt and therefore deduct coupon payments Merrill Lynch believe it is unlikely that there will be an increase in revenue to the U.S. Treasury resulting from this proposal.
B. Deny Deductibility on Other Debt Obligations
The Administration has also proposed to deny interest deductibility on obligations with a maturity greater than 15 years, which are not shown as indebtedness on the issuer's balance sheet. This proposal appears to be aimed at eliminating the interest deductibility of innovative new financial instruments, such as Monthly Income Preferred Securities (MIPS) and Trust-Originated Preferred Securities (TOPrS).
Page 406 PREV PAGE TOP OF DOC Segment 2 Of 2
Merrill Lynch believes that a careful analysis of these instruments reveals that they possess all of the critical attributes of debt listed above. Indeed, the Administration's proposal does not rely on any of these attributes to curtail the interest deductibility of these instruments.
Application of a facts and circumstances test that applies the factors relied on by the IRS, as described above, establishes that these instruments possess all the critical attributes of debt. First, they have a definite term to maturity. In cautioning against unreasonably long maturities in Notice 94–47,(see footnote 119) 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, MIPS, TOPrS and other similar instruments are 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. If interest is deferred, investors must impute interest income as is the case with other debt instruments, but not with equity. Third, these instruments are priced to give investors a debt return, not an equity return. Lastly, although subordinated, these instruments are secured and senior to equity.
Rather then using the same facts and circumstances test that they have applied in the past, the Administration has focused on the fact that MIPS, TOPrS, and similar products are not typically shown as debt on a company's balance sheet. The reality is, financial accounting treatment of these instruments has never before been the overriding factor regarding their tax treatment. Nor should it be.
TOPrS are a case in point. A company utilizing these instruments issues debt obligations to a trust which, 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. Because these debt obligations are issued through a trust, TOPrS are not shown on the issuers' balance sheet as debt, although the status of the obligations as indebtedness is clearly disclosed in a footnote to the company's balance sheet. These obligations are, however, shown as a non-debt liability.
Page 407 PREV PAGE TOP OF DOC Segment 2 Of 2
The balance-sheet characterization of TOPrS or MIPS as a non-debt liability does not alter the conclusion that the underlying debt securities possess all the critical attributes of debt for tax purposes. 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 legal rights and economic benefits as if they had purchased the debt obligations directly from the issuer rather than certificates from the trust.
• 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.
Moreover, treatment for regulatory or financial accounting purposes should not be the sole source for determining treatment of an instrument for tax purposes. In fact, by so doing, tax policy would become subject to the whims of other agencies who establish rules for fundamentally different reasons. 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 (''FASB'') and the Securities Exchange Commission (''SEC'').
The concerns of credit agencies, FASB and the SEC are very different from the concerns that should drive the federal tax system. Rating agencies, FASB and the SEC are focused on determining the likelihood of the issuer defaulting; while the IRS normally concerns itself with distinguishing debt from equity based on whether the instrument has a return which represents a participation in the profits and risks of the business enterprise. Given the different objectives of the tax system, and other agencies, the labels attached by the latter should have no bearing on tax classification.
In fact, many times rating agencies disagree as to the proper label for an instrument. Importantly, the National Association of Insurance Commissioners (''NAIC'') has recently classified TOPrS, MIPS and other similar instruments as qualifying as bonds for statutory accounting by insurance companies. The NAIC expressed the view that there was ''no discernible difference'' between capital securities (including MIPS) and other types of debt.
Page 408 PREV PAGE TOP OF DOC Segment 2 Of 2
The Administration's budget itself is internally inconsistent and contradictory with respect to following non-tax regulatory and financial treatment. In this instance, the Administration's budget forces taxpayers to follow the treatment of regulators. Whereas, in other parts of the Administration's budget, taxpayers are specifically prohibited from following regulatory and financial accounting treatment for tax purposes (see, budget proposals relating to inventory method changes).
With regard to the Administration's proposals, it is also crucial to recognize that no other major industrialized country has adopted such restrictive and arbitrary limitations on interest deductibility. Our global competitors instead look to the rights of a holder of an instrument under corporate law to determine its categorization for tax purposes. If enacted, the proposal would restrict financial flexibility of U.S. corporations. Ironically, under this proposal, foreign issuers would be allowed to access the U.S. capital markets with instruments (such as long-dated or perpetual debt) far more desirable to both issuers and investors exploiting the vacuum created in part by this proposal.
Examples of the competitive disadvantage American companies face due to tax law restrictions on interest deductibility is increasing. Recently, Merrill Lynch completed a uniquely structured convertible offering for a foreign bank that involved tax deductible, perpetual debt securities that can be converted to noncumulative preferred stock by the foreign bank. This transaction was attractive to the foreign issuer but not widely available to U.S. issuers because of the current and proposed restrictions on interest deductibility. Enactment of additional tax restrictions will only further disadvantage U.S. companies seeking to raise capital in the global marketplace.
Contrary to Treasury's revenue projections, Merrill Lynch also believes this proposal will fail to raise revenue. Issuers that are impacted by the proposed legislation will either choose to issue MIPS- or TOPrS-like securities with a maturity of 15 years or less, or they will maintain the 15+ year maturity of the instruments and issue them directly to investors, rather than through a partnership or trust. Either way, the Administration's proposal will ultimately fail to reduce the amount of interest issuers deduct, and it will therefore, be unlikely to raise tax revenue.
Page 409 PREV PAGE TOP OF DOC Segment 2 Of 2
Merrill Lynch firmly believes that MIPS, TOPrS, and other similar instruments are debt obligations, not equity, and they should be taxed as such regardless of their treatment for regulatory and financial accounting purposes.
IV. Proposal To Reduce the DRD, Modify the DRD Holding Period, and Eliminate the DRD on Certain Limited Preferred Stock
The Administration has proposed to: (1) reduce the DRD from 70% to 50% for corporations owning less than a 20% interest in the stock of another corporation; (2) modify the holding period for the DRD; and (3) eliminate the DRD for dividends on certain limited-term preferred stock.
It has long been recognized that the ''double taxation'' of dividends under the U.S. tax system tends to limit savings, investment, and growth in our economy. The DRD was designed to mitigate this multiple taxation, by excluding some dividends from taxation at the corporate level.
Unfortunately, the Administration's proposal to reduce the DRD, modify the DRD holding period, and eliminate the DRD on certain stock would significantly undermine this policy. In the process, it would further increase the cost of equity capital and negatively affect capital formation. Indeed, the Administration's proposal would boost the effective tax rate on inter-corporate dividends by 67%. Ultimately, the burden of the resultant triple taxation will be borne by the individual investor at a maximum effective overall tax rate of 67.6%.
From an economic standpoint, Merrill Lynch believes that in addition to exacerbating multiple taxation of corporate income, the Administration's proposal are troubling for a number of reasons and would have a number of distinct negative impacts:
• Dampen Economic Growth. If the DRD reduction were enacted, issuers would react to the potentially higher cost of capital by: lowering capital expenditures, reducing working capital, moving capital raising and employment offshore, and otherwise slowing investments in future growth. In particular, American banks, which are dependent on the preferred stock market to raise regulatory core capital, would see a significant increase in their cost of capital and, hence, may slow their business-loan generation efforts.
Page 410 PREV PAGE TOP OF DOC Segment 2 Of 2
• Limit Competitiveness of U.S. Business. The reduction in the DRD would also further disadvantage U.S. corporations in raising equity vis-à-vis our foreign competitors, especially in the UK, France, and Germany. In these countries, governments have adopted a single level of corporate taxation as a goal, and inter-corporate dividends are largely or completely tax free. As long as American firms compete in the global economy under the weight of a double- or triple-taxation regime, they will remain at a distinct competitive disadvantage.
• Discriminate Against Particular Business Sectors and Structures. The Administration's proposal may have a disproportionate impact on taxpayers in certain industries, such as the financial and public utility industries, that must meet certain capital requirements. Certain types of business structures also stand to be particularly affected. Personal holding companies, for example, are required to distribute their income on an annual basis (or pay a substantial penalty tax) and thus do not have the option to retain income to lessen the impact of multiple levels of taxation.
• Companies Should Not Be Penalized for Minimizing Risk of Loss. As a result of the Administration's proposal, the prudent operation of corporate liability and risk management programs could result in disallowance of the DRD. Faced with loss of the DRD, companies may well choose to curtail these risk management programs.
• No Tax Abuse. In describing the DRD proposal, the Administration suggests that some taxpayers may be able to take advantage of the 70% deduction in a way that ''undermines the separate corporate income tax.'' To the extent Treasury can demonstrate that the deduction may be subject to misuse, targeted anti-avoidance rules can be provided. The indiscriminate approach of arbitrarily cutting back on the DRD goes beyond addressing inappropriate transactions and unnecessarily penalizes legitimate corporate investment activity.
Page 411 PREV PAGE TOP OF DOC Segment 2 Of 2
• The Justification for the DRD Proposal is Unconvincing. The Administration argues that the current 70% DRD ''is too generous.'' Since Congress already has addressed (in the ''Omnibus Reconciliation Act of 1987'') the argument that an 80% deduction was ''too generous,'' and responded by reducing the deduction to 70%, it is hard to see why only 10 years later the same deduction could again be considered ''too generous.''
The Administration's proposal to modify the DRD holding period is a change that Merrill Lynch believes would impair trading-market liquidity. Currently, investors have to be ''at risk'' (i.e., unhedged) for 46 days on their equity portfolio securities to qualify for the DRD. Given the volatility of the equity markets, the risk inherent in a 46-day holding period is already significant. The proposal to have a ''rolling'' holding period requirement with respect to every dividend payment date is unwarranted and will cause disruption for dealers attempting to provide liquidity in the equity markets.
While the overall revenue impact of the DRD proposal may be positive, Merrill Lynch believes the revenue gains, particularly with respect to the elimination of the DRD on certain limited-term preferred stock, will not be nearly as large as projected, due to anticipated changes in the behavior of preferred-stock issuers and investors.
• Issuers of Preferred Stock. Reducing the DRD will increase the cost of preferred-stock financing and cause U.S. corporations to issue debt instead of preferred stock because of interest deductibility. This overall increase in deductible interest would result in a net revenue loss to Treasury.
• Secondary Market for Preferred Stock. Currently, the market for outstanding preferred stock is divided into two segments:
A $15 billion to $20 billion variable-rate preferred stock market where dividends are set via Dutch auctions. The dividend rate on these securities will necessarily increase to adjust for the lower DRD, and may cause some of these issuers to call these preferred securities at par and replace them with debt. This will result in a revenue loss to Treasury.
Page 412 PREV PAGE TOP OF DOC Segment 2 Of 2
A $45 billion to $55 billion fixed-rate preferred stock market where the issuing corporations cannot immediately call the securities. Retail investors, who comprise 80% of this market cannot utilize the DRD and therefore pay full taxes on dividends. Hence, there will be no meaningful revenue gains to Treasury from this market segment.
This proposal may also create losses for individual investors. Institutions, which own approximately 20% of all fixed-rate preferred stock, may sell their holdings given the increased taxation. Individual investors will bear the brunt of any price decline, because they currently account for about 80% of the fixed-rate preferred market. These capital losses, when taken, will offset any capital gains and result in a revenue loss to Treasury.
At a time when U.S. tax policy should be moving toward fewer instances of ''double taxation,'' Merrill Lynch believes it would be a mistake to reduce the DRD, modify the DRD holding period, or eliminate the DRD on certain limited-term preferred stock. Any such action will make ''triple taxation'' even more pronounced in, and burdensome on, our economy.
V. Conclusion
Based on the discussion set forth above, Congress should reject the Administration's proposals out of hand. These proposals which include the denial or deferral of legitimate interest deductions and the reduction, modification, and elimination of the DRD are nothing more than tax increases which raise the cost of financing new investments, plant, equipment, research, and other job-creating assets. These tax increases hurt the ability of American companies to compete against foreign counterparts and are born by the millions of middle-class Americans who try to work and save through their retirement plans and mutual fund investments. These impediments to investment and savings would hurt America's economic growth and continued leadership in the global economy.
Page 413 PREV PAGE TOP OF DOC Segment 2 Of 2
Moreover, from a tax policy perspective, the Administration's proposals are ill-advised, arbitrary and capricious tax law changes that have a chilling effect on business investment and capital formation. Indeed, the Administration's proposals are nothing more than ad hoc tax increases that violate established rules of tax policy. In some cases, the proposals discard tax symmetry and deny interest deductions on issuers of certain debt instruments, while forcing holders of such instruments to include the same interest in income. In other cases, the proposals look to regulatory or financial statement rules to characterize an instrument for tax purposes but only when it raises revenues. In addition, the Administration substitutes its unsubstantiated opinion of how an instrument is ''viewed,'' even though such opinion is contradictory to all available facts and circumstances. Disregarding well-established tax rules for the treatment of debt and equity only when there is a need to raise revenue is a dangerous and slippery slope that can lead to harmful tax policy consequences.
The Administration's proposals also are unlikely to raise the promised revenue, and could even lose revenue. Treasury's revenue estimates appear to assume that the elimination of the tax advantage of certain forms of debt would cause companies to issue equity instead. To the contrary, most companies would likely move to other forms of debt issuance ones that carry higher coupons and therefore involve higher interest deductions for the issuer.
Far from being ''unwarranted'' or ''tax loopholes,'' the transactions in issue are based on well established rules and are undertaken by a wide range of the most innovative, respected, and tax compliant manufacturing and service companies in the U.S. economy, who collectively employ millions of American workers.
Merrill Lynch urges Congress to get past misleading ''labels'' and weigh the proposals against long standing tax policy. Under such analysis, these proposals will be exposed for what they really are nothing more than tax increases on Americans.
For all the reasons stated above, the Administration's proposals should be rejected in toto.
Page 414 PREV PAGE TOP OF DOC Segment 2 Of 2
—————
Statement of Monsanto, Co.
Monsanto, Co. is pleased to provide this written statement for the record of the March 12, 1997 hearing of the Committee on Ways & Means on ''Revenue Raising Provisions in the Administration's Fiscal Year 1998 Budget Proposal.''
I. Background
Monsanto, Co. (''Monsanto'') is a Delaware corporation engaged in a number of businesses that are principally involved in manufacturing and sales of four product lines crop and lawn protection, performance chemicals, fibers, and food ingredients. This is coupled with Monsanto's leadership position in the biotechnology arena. In addition, Monsanto is involved in the pharmaceutical industry through its wholly owned subsidiary, G.D. Searle, a manufacturer and seller of a variety of ethical drugs. Monsanto is a major exporter of ''U.S. made'' products. With about 40% of its sales occurring outside the United States, Monsanto is an important participant in the Global economy. Some of Monsanto's leading products are Roundup (an agricultural herbicide), NutraSweet (a sweetener), and Ambien (a pharmaceutical product).
In 1996, Monsanto decided to ''spin-off'' its chemical business (fibers and performance chemicals) and to focus on its ''Life Science'' business (agricultural, food ingredients and pharmaceuticals). The spin-off was approved by Monsanto's Board of Directors and publicly announced on December 6, 1996. Monsanto submitted a ruling request to the Internal Revenue Service (''IRS'') on December 20, 1996. Pending approval by the IRS, Monsanto expects to complete the ''spin-off'' sometime in the late summer of 1997. Substantial resources in the form of time and money have been and will continue to be expended to complete all necessary steps to accomplish the ''spin-off.''
Page 415 PREV PAGE TOP OF DOC Segment 2 Of 2
II. Current Law—IRC Section 355(see footnote 120) ''Spin-Offs''
Under section 355 of current law, a corporation which distributes stock in a controlled corporation to its shareholders is not required to recognize gain on the distribution (or ''spin-off''), provided certain requirements are met. To be tax-free, the distributing company must distribute stock representing at least an 80% interest in the controlled subsidiary; both the distributing company and the controlled subsidiary must be engaged in an active five-year old business following the stock distribution; and there must be a valid business purpose for the ''spin-off.''
The reason no gain is recognized is that all of the assets remain in ''corporate solution.'' The distribution or ''spin-off'' of the controlled corporation is simply a reorganization of the companies, and not a sale of stock.
A company is considered to have entered into a Morris Trust(see footnote 121) transaction, if following a ''spin-off,'' the company engages in a pre-arranged merger or reorganization of either the distributing company or the ''spun-off'' controlled subsidiary. A Morris Trust transaction simply combines two tax-free transactions (e.g., a tax-free ''spin-off'' followed by a tax-free merger or reorganization). For over 30 years, the courts and the IRS have upheld tax-free treatment for ''spin-offs'' which were followed by pre-arranged mergers or reorganizations of the distributing company, consistent with the theory that capital gains tax should not be imposed on assets that have not left ''corporate solution.''(see footnote 122)
Page 416 PREV PAGE TOP OF DOC Segment 2 Of 2
III. Summary of Administration's Morris Trust Proposal
One of the revenue raising provisions in the Administration's FY 1998 Budget proposal is a provision which would adopt additional restrictions on nonrecognition of gain on certain distributions of controlled corporation stock (the ''Morris Trust proposal'').
The Administration's FY 1998 proposal is effective for distributions after the date of ''first committee action.'' Importantly, this year's proposal does not provide ''transition relief'' for taxpayers who are complying with current law and who will not be able to complete their transaction by the date of ''first committee action.'' A similar Morris Trust proposal was contained in the FY 1997 Budget plan proposed by the Administration last year. However, last year's proposal did contain reasonable transition relief for transactions which were either: (1) made pursuant to a binding written contract, (2) described in an IRS ruling request, or (3) described in a public announcement or SEC filing.
The Administration's Morris Trust proposal would overturn 30 years of tax law and deny tax-free treatment on legitimate ''spin-offs,'' unless the shareholders of the distributing corporation hold stock representing at least 50 % of the vote and value of both the distributing corporation and the ''spun-off'' corporation for a 4 year period beginning 2 years prior to the ''spin-off'' (e.g., 2 years before and 2 years after the ''spin-off''). Accordingly, any change in stock ownership of 50% or more, even if as a result of a subsequent tax-free transaction (e.g., a merger or acquisition), could trigger a new tax.
An exception is provided if the change in stock ownership is not related to the ''spin-off,'' meaning not pursuant to a ''common plan or arrangement'' that includes the ''spin-off.'' The Administration proposal goes on to state that a subsequent friendly acquisition transaction ''will generally be considered related to the distribution (''spin-off'') if it is pursuant to an agreement negotiated (in whole or in part) prior to the distribution (''spin-off'').''
Page 417 PREV PAGE TOP OF DOC Segment 2 Of 2
The practical effect is that if there is a 50% or greater change in stock ownership (resulting from a tax-free merger or reorganization of either the distributing or controlled corporation) within a 4 year period surrounding the ''spin-off,'' the transaction will be subject to unwarranted IRS scrutiny as to whether a ''common plan or arrangement'' existed at the time the stock of the ''spun-off'' corporation was distributed to shareholders.
Moreover, if the subsequent tax-free transaction is a friendly acquisition, the subjective test to be administered by the IRS is whether or not the acquisition was ''pursuant to an agreement negotiated (in whole or in part)'' prior to the ''spin-off.'' The Administration's proposal does not clarify the scope of what is meant by ''negotiated (in whole or in part).'' Existing case law and administrative guidance also give no direction for interpreting this critical phrase.
The stated reason for this fundamental change in tax policy is contained in Treasury's ''General Explanations of the Administration's Revenue Proposals'' (February 1997) which states: ''Corporate nonrecognition under section 355 should not apply to distributions that are effectively dispositions of business.''
Acting Assistant Secretary Donald C. Lubick clarified to some extent the intended goal of the proposal as ''prevent[ing] tax-free disguised sales of businesses.''(see footnote 123)
IV. Economic and Tax Policy Concerns With Proposal
The Administration's Morris Trust proposal would reverse long-standing tax policy regarding treatment of tax-free reorganizations and impose another layer of capital gains tax on legitimate corporate restructuring transactions. Fundamentally, the proposal is anti-business and anti-growth.
Page 418 PREV PAGE TOP OF DOC Segment 2 Of 2
1. Inconsistent With Efforts To Lower Tax on Capital Gains and Tax Reform
At a time when Congress is considering a reduction in the capital gains tax, it would be inconsistent and counterproductive to adopt a proposal which adds yet another layer of tax to the current system. Further, imposing a ''double or triple'' level of tax on corporate earnings would be the antithesis of tax integration and fundamental tax reform.
One of the fundamental goals of tax reform is to integrate the corporate and individual tax systems so that income is not taxed twice (i.e., once when the corporation earns the money and again when those earnings are distributed to individual shareholders). Any proposal that increases the ''double'' taxation of corporate income cannot be considered sound tax policy.
2. The Proposal Is Misguided and Undermines U.S. Competitiveness
With a constantly changing regulatory and corporate environment, pressures exist for many corporations to become more efficient and profitable by restructuring, combining or separating businesses and assets. Many industries, including the chemical, pharmaceutical, high-tech and communications industries have faced the challenge of rearranging businesses and assets in corporate solution. The Administration's Morris Trust proposal would impinge on these efforts by forcing companies to either maintain inefficient business structures or risk incurring another layer of tax.
Business inefficiencies and multiple layers of tax raise the cost of capital for corporations and impede investment in plant, equipment and jobs. Overall it damages America's economic and job growth. In addition, multiple levels of taxation hurt our global competitiveness and undermine efforts to reduce burdens on U.S. companies competing in international markets.
Page 419 PREV PAGE TOP OF DOC Segment 2 Of 2
3. The Proposal Is Overly Broad
Many corporations spend great amounts of time and effort considering a variety of ways to improve their business structures. Some of these actions are seen through to completion while others involve many ''starts'' and ''stops.'' Some of the activities are ''pre-arranged,'' while others take time to fully develop. From a tax policy perspective, whether a series of independent tax-free transactions take place back-to-back should not change the results of what are each legitimate tax-free restructuring arrangements.
If the intent of the Administration is to attack abusive ''disguised sales'' of businesses, the proposal is overly broad. The proposal goes well beyond addressing any specific anecdotal abuses which may occur as a result of so-called ''debt stuffing,'' in which companies have used the traditional Morris Trust format to restructure, but have allocated a disproportionate share of debt to one of the entities in the process. The Administration's proposal is not targeted to such situations, but rather applies to all Morris Trust transactions that occur pursuant to a ''common plan or arrangement'' or that may be ''negotiated (in whole or in part)'' before the ''spin-off.'' If there is a perceived abuse with ''debt stuffing'' transactions, the legislation should target that abuse and not apply to all Morris Trust situations.
Further, by disallowing back-to-back tax-free transactions (e.g., a tax-free ''spin-off'' followed by a tax-free reorganization) using a subjective test to determine whether a ''common plan or arrangement'' existed at the time of the ''spin-off'' will result in uncertainty and confusion. Under such a test, any taxpayer which engages in a ''spin-off'' will face continuous, unwarranted scrutiny by the IRS if within 2 years the taxpayer (or the ''spun-off'' corporation) enters into another legitimate tax-free transaction. This intrusive scrutiny will exist even if there was never a thought about a subsequent restructuring at the time of the ''spin-off.'' The taxpayer in any case will still have to spend time and money proving that there was never a ''common plan or arrangement'' to enter into the subsequent transaction at the time of the ''spin-off.'' This needlessly imposes additional costs and burdens on U.S. taxpayers.
Page 420 PREV PAGE TOP OF DOC Segment 2 Of 2
More disturbing is the issue of whether of not a subsequent tax-free friendly acquisition resulted from an ''arrangement negotiated (in whole or in part)'' prior to the ''spin-off.'' With no guidance in the proposal or under current law as to what is meant by ''negotiated (in whole or in part),'' taxpayers are left in the dark and subject to unwarranted IRS scrutiny of legitimate tax-free transactions. If the proposal moves forward these subjective tests must be further clarified and narrowed.
4. Potential Revenue Is Not Worth the Costs
Finally, if these transactions are subjected to a new layer of tax many of the reorganizations will simply not take place. Not only will Treasury not recognize the estimated revenue, but any revenue collected will be at the cost of burdening the efficient reorganizing of many industries.
In sum, the proposal as drafted is anti-business, anti-growth, misguided, overly broad, and will result in a tax increase on legitimate corporate transactions.
V. Proposal Does Not Provide Transition Relief
The most disturbing aspect of the Administration's Morris Trust proposal is its failure to provide any ''transition relief'' for taxpayers who are fully complying with current law. The failure to provide such relief either would result in a retroactive tax increase on affected corporations or would force such corporations to forego transactions which would be very disruptive to the marketplace.
Many taxpayers are incurring substantial transactional costs and are dutifully relying on current law as they enter into restructuring arrangements. To retroactively tax such taxpayers who have fully complied and detrimentally relied on current law would be fundamentally unfair and inconsistent with the goals of the tax legislative process.
Page 421 PREV PAGE TOP OF DOC Segment 2 Of 2
Monsanto agrees with the sentiments expressed by Chairman Archer in announcing this hearing that he is ''concerned that several of the new proposals from the Administration still have retroactive effective dates or retroactive impact.'' We firmly believe that any fundamental change in tax policy should not be made on a retroactive basis.
Finally, the proposed effective date of ''first committee action'' with no ''transition relief'' is extremely arbitrary and capricious. Taxpayers who entered into binding written contracts long before the date the proposal was first announced can be affected, while other taxpayers who have yet to enter into a transaction may not be affected.
Should the Congress move forward with a Morris Trust type proposal, Monsanto strongly urges that it provide transition relief which will fairly treat taxpayers who have detrimentally relied on and are complying with current law. The transition relief should be at least as broad as that which was provided in the Administration's FY 1997 Budget plan and cover taxpayers who have either: (1) entered into a binding written contract, (2) submitted a ruling request to the IRS, or (3) made a public announcement or SEC filing.
VI. Conclusion
Monsanto opposes the Morris Trust proposal contained in the Administration's FY 1998 Budget plan. The proposal is anti-business, anti-growth, misguided, overly broad, and will result in a tax increase on legitimate corporate transactions. It also contains unworkable subjective tests (e.g., the determination of what is meant by ''negotiated (in whole or in part)'') which would cause uncertainty and confusion.
Moreover, the failure of the Administration to provide ''transition relief'' either would result in a retroactive tax increase on affected corporations or would force such corporations to forego transactions which would be very disruptive to the marketplace.
Page 422 PREV PAGE TOP OF DOC Segment 2 Of 2
Should the Congress move forward with a Morris Trust-type proposal, Monsanto strongly urges that it provide transition relief which will fairly treat taxpayers who have detrimentally relied on and are complying with current law. The transition relief should be at least as broad as that which was provided in the Administration's FY 1997 Budget plan and cover taxpayers who have either: (1) entered into a binding written contract, (2) submitted a ruling request to the IRS, or (3) made a public announcement or SEC filing.
INSERT OFFSET FOLIOS 20 TO 29 HERE
[The official Committee record contains additional material here.]
—————
Statement of National Association of Manufacturers
I. Introduction
The National Association of Manufacturers (NAM) wishes to express its appreciation to the Committee's Chairman, Mr. Archer, for holding a hearing on the revenue raising provisions in the Administration's FY 1998 budget proposal. The NAM is the nation's oldest and largest broad-based industrial trade association. Its 14,000 member companies and subsidiaries, including approximately 10,000 small manufacturers, are in every state and produce about 85 percent of U.S. manufactured goods. Through its member companies and affiliated associations, the NAM represents every industrial sector and the interests of more than 18 million employees.
The NAM is firmly committed to a balanced federal budget. However, we do not believe that the Administration's FY 1998 budget proposal appropriately accomplishes that goal. According to Administration estimates, the Administration's FY 1998 budget proposal contains approximately $78 billion in tax increases, largely to fund new spending programs. Under the guise of targeting inappropriate tax benefits, the Administration proposes that more than half of this revenue be generated from the corporate community, largely the manufacturing sector. Although the Joint Committee on Taxation (JCT) scores these increases at $73 billion, this is still a significant tax increase. Furthermore, the types of tax increases proposed are anti-growth and run counter to sound tax policy. They would discourage savings and investment and significantly raise the cost of capital. Although this is not an exhaustive list, the NAM opposes the following revenue raising proposals.
Page 423 PREV PAGE TOP OF DOC Segment 2 Of 2
II. Provisions Relating to Shareholder-Corporation Multiple Taxation
A. Dividends-Received Deduction
The dividends-received deduction (DRD) was designed to alleviate the impact of multiple layers of corporate taxation. Without the DRD, income would be taxed three times: 1) when it is earned by a corporation; 2) when the income is paid as a dividend to a corporate shareholder, and 3) when the income of the receiving corporation is paid as a dividend to an individual shareholder. The DRD was enacted to provide for full deductibility of intercorporate dividends.
The Administration proposes to lower the corporate DRD from 70 percent to 50 percent. The NAM believes that the Administration's DRD proposal runs counter to sound tax policy principles. The proposal would exacerbate the multiple levels of taxation placed on corporate taxpayers. The proposal would also increase the amount of income subject to triple taxation. Most U.S. trading partners have adopted a single level of corporate taxation as a goal and provide some relief from double or triple taxation through corporate integration. Unlike the United States, other G7 countries generally exclude from tax altogether dividends received by corporations. Adopting provisions that accentuate the problem of multiple taxation, rather than ameliorating this problem, would harm the international competitive position of U.S.-based corporations.
The proposal would also penalize investment by corporations and individuals. Cutting back on the DRD would increase the cost of equity financing for U.S. corporations, thereby discouraging new capital investment.
The Administration is not targeting abusive tax situations with the DRD proposal. The Administration has suggested that some taxpayers may be able to take advantage of the 70 percent deduction in a way that ''undermines the separate corporate income tax.'' To the extent Treasury can demonstrate that the deduction may be subject to misuse, targeted anti-avoidance rules can be provided. The indiscriminate approach of sharply cutting back on the DRD goes beyond addressing inappropriate transactions and unnecessarily penalizes legitimate corporate investment activity. Simply stated it is very bad tax policy.
Page 424 PREV PAGE TOP OF DOC Segment 2 Of 2
The NAM urges the Ways and Means Committee to reject the Administration's proposal to reduce the DRD. A more appropriate approach would be to reduce or eliminate the multiple taxation of corporate income, rather than further accentuate the inefficiencies and inequities of the current corporate tax system.
B. Average Cost-Basis for Securities
Under current Treasury regulations, if a taxpayer sells a portion of his holdings in stocks or bonds, the taxpayer is allowed to identify the securities disposed of for purposes of determining gain or loss on the disposition. If the stock or bonds sold cannot be identified, the taxpayer is generally deemed to have disposed of the securities first acquired. Mutual fund investors are also allowed to determine the adjusted bases of their shares based on the average cost of all such shares.
The Administration's proposal to require cost-basis averaging would raise taxes on individual investors and result in larger capital gains tax liabilities than under current law. The United States already has some of the highest capital gains rates in the world, and this proposal would further heighten such taxes and, consequently, penalize investment. Additionally, the proposal would greatly complicate calculation of gains and losses by requiring taxpayers to determine the cost basis for any share of stock by averaging the costs of all ''substantially identical securities.'' Such a requirement would be particularly problematic for investors who incrementally invest in securities through reinvestment plans or through employee stock option plans. The NAM is strongly opposed to the adoption of such a requirement.
III. Corporate Provisions
Page 425 PREV PAGE TOP OF DOC Segment 2 Of 2
A. Net Operating Loss Carry-Back and Carry-Forward Rules
The current three-year carry-back period for net operating losses (NOLs) has been in place for nearly 40 years. As Congress has emphasized when previously extending the carry-back period, the ability to carry losses back rather than forward serves as an effective counterweight to economic reverses by allowing businesses to recover previously paid taxes when they need it most in order to carry on business operations.
The Administration's proposal would reduce the carry-back period for NOLs from three years to one year, and extend the carry-forward period from fifteen to twenty years. The proposal effectively operates as a tax increase on business activity and kicks in at the worst possible time: when a company is down due to poor economic conditions.
The Administration's proposal would also extend the total period in which NOLs could be used. The extension is of virtually no practical significance because a business insufficiently profitable to use an NOL over a fifteen year carry-forward period is unlikely to turn around in an additional five years.
By contrast, the reduction in the carry-back 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 has been offset by losses at a time when their financial resources are least able to handle an incremental tax burden.
The NAM believes there is no credible tax policy justification for shortening the NOL carry-back period. On the contrary, the considerable revenue generated by this proposal would, by definition, be a tax on non-existent profits. The practical effect would be to force businesses to pay tax when they can least afford it. Such a policy would have a negative effect on employment during economic downturns, thereby hurting workers when they can least afford it. Furthermore, with a reduced loss carry-back period, companies will be forced to borrow money for continuing operations and put their credit ratings at risk. This proposal would increase their cost of capital and further exacerbate the situation.
Page 426 PREV PAGE TOP OF DOC Segment 2 Of 2
The three-year NOL carry-back period has served its purpose well for nearly 40 years. The NAM strongly urges that it be retained.
B. Superfund Taxes
Superfund has historically been funded by three taxes the corporate environmental tax, the petroleum excise tax, and the chemical feed stock tax all of which expired as of December 31, 1995. The Administration's budget proposal would reinstate both the petroleum excise tax and the chemical feed stock tax at their previous levels from the date of enactment through September 30, 2007. The corporate environmental tax would be reinstated at its previous level for taxable years beginning after December 31, 1996 and before January 1, 2008.
Under the proposal, these taxes, which were previously dedicated to the Superfund program, would be used to generate general revenues to balance the budget. The use of such tax revenues which have been historically dedicated to funding specific programs for deficit reduction purposes should be rejected. The decision whether to re-impose these taxes dedicated to financing Superfund should instead be made as part of a comprehensive examination of reforming the entire Superfund program. While the NAM understands that the Superfund taxes are not technically within the scope of this hearing, we believe the Administration's proposals in this area represent particularly bad tax policy and would set a bad precedent for all dedicated taxes.
IV. Foreign Provisions
A. Treatment of Foreign Oil and Gas Income and Dual-Capacity Taxpayers
The NAM supports the general principle of restoring a full, effective foreign tax credit to the Internal Revenue Code. The complexities of current law, particularly the multiplicity of separate ''baskets,'' should be eliminated, while deferral of U.S. tax on income earned by foreign subsidiaries should not be further eroded. However, the Administration's budget proposal moves in the opposite direction with regard to foreign oil and gas income. It would limit use of the foreign tax credit and repeal deferral of U.S. tax on foreign oil and gas income.
Page 427 PREV PAGE TOP OF DOC Segment 2 Of 2
This selective attack on a single industry's utilization of the foreign tax credit and deferral is not justified. U.S.-based oil companies are already at a competitive disadvantage under current law since most of their foreign-based competition pay little or no home country tax on foreign oil and gas income. The proposal increases the risk of foreign oil and gas income being subject to double taxation, which will severely hinder U.S. oil companies in the global oil and gas exploration, production, refining, and marketing arena.
Under the Administration's proposal, so-called ''deferral'' would be eliminated. That would result in the current taxation of foreign subsidiary oil and gas income before it is ever repatriated. All foreign oil and gas income would be treated as ''Subpart F'' income as defined under I.R.C. section 904(d). Furthermore under the proposal, in those situations where taxpayers are subject to a foreign tax and also receive an economic benefit from the foreign country (so-called ''dual-capacity taxpayers''), such taxpayers would be able to claim a credit for foreign taxes under I.R.C. section 902 only 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 that generally applicable income tax.
The Administration's proposal would further tilt the playing field against the U.S. petroleum industry's foreign exploration and production efforts, and would increase (or make prohibitive) the U.S. tax burden on foreign petroleum industry operations. It will not only stymie new investment in foreign exploration and production projects, but also change the economics of some past investments. The availability of the foreign tax credit, 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 by alleviating the problem of double taxation. This targeted Administration proposal, which conflicts with sound tax policy, also is in direct conflict with the U.S. trade policy of global integration, embraced by both Democratic and Republican Administrations.
Page 428 PREV PAGE TOP OF DOC Segment 2 Of 2
B. Sales Source Rules (Export Source Rule)
The NAM strongly opposes the Administration's proposal to replace the current export source rule with an activity-based sourcing rule. Since 1922, tax regulations have contained the export source rule, which allows the income from goods that are manufactured in the U.S. and sold abroad to be treated as 50 percent U.S. source income and 50 percent foreign source income. As a result, the export source rule increases the ability of U.S. exporters to utilize foreign tax credits and thus avoid double taxation of foreign earnings.
The Administration contends that the export source rule is not needed to alleviate double taxation because of our tax treaty network. We strongly disagree. The U.S. has tax treaties with fewer than a third of all jurisdictions. More significantly, double taxation is generally caused by the many restrictions in U.S. tax laws on crediting foreign taxes paid on the international operations that U.S. companies must have to compete in the global marketplace. Among these restrictions are the allocation rules for interest and R&D expenses, the many foreign tax credit ''baskets,'' and the treatment of domestic losses.
By reducing double taxation, the export source rule encourages U.S.-based manufacturing and exports. A recent Hufbauer/DeRosa study 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 $1.7 billion to worker payrolls in the form of export-related wage premiums. (This study is an analysis of the economic impact of the export source rule, a document submitted as part of Gary Hufbauer's testimony on March 12, 1997.) The Administration's proposal would essentially eliminate this WTO-consistent (World Trade Organization) export incentive. Such action would be harmful to U.S. economic growth and high-paying, export-related jobs. This proposal would also take away the administrative simplicity of the export source rule and require enormously complex factual determinations which would add administrative burdens and create controversies. The NAM strongly urges Congress to retain the current export source rule.
Page 429 PREV PAGE TOP OF DOC Segment 2 Of 2
V. Accounting Provisions
A. Lower of Cost or Market Inventory Accounting Method
A taxpayer that sells goods in the active conduct of its trade or business generally must maintain inventory records in order to determine the cost of goods it sold during the taxable period. Cost of goods sold generally is determined by adding the taxpayer's inventory at the beginning of the period to purchases made during the period and subtracting from that sum the taxpayer's inventory at the end of the period. Because of the difficulty of applying the specific identification method of accounting, taxpayers often use methods such as ''first-in, first-out'' (FIFO) and ''last-in, first-out'' (LIFO). Taxpayers not using a LIFO method are allowed to determine the carrying values of their inventories by applying the lower of cost or market (LCM) method and by writing down the cost of goods that are unsalable at normal prices or unusable in the normal way because of damage, imperfection or other causes (the ''subnormal goods'' method).
The Administration's proposal would repeal the LCM method. The NAM is opposed to repeal of LCM because, particularly in a time of rapid technological advance, the value of items accounted for in inventory is often diminished due to external factors. LCM allows this loss of value to be accounted for in the period in which it occurs. To retain the historic cost basis in such instances would be both unfair and fail to achieve a proper matching of costs and revenue, resulting in a failure to clearly reflect income. The NAM strongly urges the retention of the LCM method.
B. Components of Cost Inventory Accounting Method
Page 430 PREV PAGE TOP OF DOC Segment 2 Of 2
Finally, the NAM opposes the Administration's proposal to repeal the Components of Cost (COC) method used to determine inventory accounting values, typically under ''last-in, first-out'' (LIFO) accounting. The COC method has been in use for over 50 years by many companies, both large and small, chiefly manufacturing firms. Its use predominates in industries where specialized and customized products are manufactured and where products change to a high degree from one year to the next. For those companies, the method has been indispensable. In fact, the American Institute of Certified Public Accountants (AICPA) states that it is the only practical method for a manufacturer with substantial work in process to use.
Absent COC, many manufacturers would be forced to determine their LIFO inventory using current alternatives such as the inventory price index computation or total product cost. However, both of these methods are enormously complex and unworkable. Accordingly, the repeal of COC as proposed by the Administration would effectively force many manufacturers off LIFO.
Equally troubling to the NAM is the fact that the manufacturers impacted by this repeal will have to incur exorbitant costs to install and operate a totally new, redundant, cost accounting method for financial reporting and internal management purposes since COC has been deemed by the AICPA as the preferable method under GAAP and endorsed by the Securities and Exchange Commission (SEC). For many of our members, the installation cost alone of a new accounting system would be tens of millions of dollars.
VI. Effective Dates
Certain proposed corporate revenue raising provisions contained in the Administration's FY 1998 budget proposal would be effective on the date of first committee action, but with no provision to exclude transactions-in-process [e.g., proposals to treat certain preferred stock as ''boot,'' to reform the tax treatment of certain corporate stock transfers (section 304), and to require gain recognition on certain distributions of controlled stock (section 355)]. This obviously creates uncertainty in the business community, and, as former President Lyndon Johnson stated, ''the most damaging thing you can do to any businessman in America is to keep him in doubt, and to keep him guessing, on what our tax policy is.''
Page 431 PREV PAGE TOP OF DOC Segment 2 Of 2
The NAM concurs with the statements made last year by the chairmen of the congressional tax-writing committees, in connection with the FY 1997 budget proposals, that the effective dates of any new revenue raising tax proposals should not disrupt market activities and normal business transactions. In this regard, the completion of many contractually binding business transactions, predating the first committee action, can be subject to delays or contingencies, such as shareholder approval or government antitrust or tax clearances. Nevertheless, these bona fide transactions would fail the Administration's effective date rule if final closing were to occur after such date even though the transactions were contractually bound prior to the effective date. This disrupts on-going commercial activities and ultimately amounts to a retroactive tax increase on pending but not completed transactions.
The NAM believes it would be highly inappropriate to adversely impact pending business transactions in this way. Accordingly, the NAM urges that if Congress adopts any revenue raisers, whatever effective date it chooses (e.g., enactment date, first committee action, etc.), it should include an exception for pending transactions that are publicly announced, subject to binding contracts or contingent upon necessary third party approvals.
VII. Conclusion
While the NAM fully supports balancing the federal budget and, in fact, believes such action is necessary to the economic health of the country, we believe that the revenue raisers discussed above would provide disincentives to savings and investment and raise the cost of capital for manufacturers. The NAM not only doesn't support these and other tax increases in the Administration's budget, but we believe that pro-growth policies, such as alternative minimum tax (AMT) reform, capital gains tax decreases, estate tax repeal, permanent extension and improvement of the research and experimentation tax credit, and S corporation rate relief, combined with spending reductions, would stimulate economic growth, leading to both a healthier overall economy and a balanced budget.
Page 432 PREV PAGE TOP OF DOC Segment 2 Of 2
—————
Statement of the National Association of Real Estate Investment Trusts, Milton Cooper, NAREIT Chair; and Chairman and Chief Executive Officer, Kimco Realty Corp.
As requested in Press Release No. FC–4 (February 25, 1997), the National Association of Real Estate Investment Trusts ® (''NAREIT'') respectfully submits these comments in connection with the Ways and Means Committee's review of certain revenue provisions presented to the Ways and Means Committee as part of the President's Fiscal Year 1998 Budget. NAREIT's comments will address the Administration's proposal to amend section 1374 of the Internal Revenue Code to treat an ''S'' election by a large C corporation as a taxable liquidation of that C corporation. We appreciate the opportunity to present these comments.
NAREIT represents over 240 real estate investment trusts (known as ''REITs''), about 200 of which trade on the New York Stock Exchange, the American Stock Exchange, or the National Market System of the NASDAQ. In addition, NAREIT represents over 1,600 analysts, investment bankers, lawyers, accountants, and others that provide services related to the REIT industry.
Congress established REITs in 1960 to allow small investors to obtain the diversification and professional management of capital-intensive real estate that beforehand were only available to large, sophisticated investors.(see footnote 124) The market capitalization of publicly traded REITs has blossomed from under $9 billion at the beginning of 1991 to about $100 billion today, as hundreds of thousands of small investors assisted in the recapitalization of portions of America's premier commercial real estate properties.
Page 433 PREV PAGE TOP OF DOC Segment 2 Of 2
This growth in the use of the public equity market as a source of funds for real estate has played a critical role in solidifying the foundation of many quality real estate operating companies, as well as improving the assets of banks, insurance companies and pension plans. It also has resulted in an opportunity for achieving Congress' goal of providing small investors with the opportunity to become owners of those properties along with the best real estate managers in the country.
I. Application of Section 1374 To REITs
As the Committee knows, prior to its repeal as part of the Tax Reform Act of 1986, the holding in an old court case named General Utilities permitted a C corporation to elect S corporation or REIT status (or transfer assets to an S corporation or REIT in a carryover basis transaction) without incurring a corporate-level tax. With the repeal of the General Utilities doctrine, such transactions arguably would have been subject to tax but for Congress' enactment of section 1374. Under section 1374, a C corporation making an S corporation election can elect to have the S corporation pay any tax that otherwise would have been due on the ''built-in gain'' of the C corporation's assets, but only if those assets were sold or otherwise disposed of during a 10-year ''recognition period.'' The application of the tax upon the disposition of the assets, as opposed to the election of S status, worked to distinguish legitimate conversions to S status from those made for purposes of tax avoidance.
In Notice 88–19,1988–1 C.B. 486 (the ''Notice''), the Internal Revenue Service (the ''IRS'') announced that it intended to issue regulations under section 337(d)(1) that in part would address the avoidance of the repeal of General Utilities through the use of REITs and RICs. In addition, the IRS noted that those regulations would permit the REIT to be subject to rules similar to the principles of section 1374. Thus, under regulations that have to yet been issued, C corporations would have the ability to elect REIT status and incur a corporate-level tax only if the REIT sells assets during the ''recognition period.''
Page 434 PREV PAGE TOP OF DOC Segment 2 Of 2
In a release issued February 22, 1996, the Department of the Treasury (the ''Treasury Department'') announced that it intends to revise Notice 88–19 to conform to the Administration's proposed amendment to limit section 1374 to corporations worth less than $5 million, with an effective date similar to the statutory proposal. This proposal would result in a double layer of tax: once to the shareholders of the C corporation in a deemed liquidation and again to the C corporation itself upon such deemed liquidation. The Administration's 1998 proposal reiterates this amendment.
Because of the Treasury Department's intent to extend the proposed amendment of section 1374 to REITs, the remainder of these comments addresses the proposed amendment as if it applied to both S corporations and REITs.
II. Arguments in Support of the Current Application of Section 1374 To REITS
As stated above, the Administration's proposed amendment would limit use of the 10-year election to REITs valued at less than $5 million. NAREIT believes that this proposed amendment would contravene Congress' original intent regarding the formation of REITs, would be both inappropriate and unnecessary in light of the statutory requirements governing REITs, would impede the recapitalization of commercial real estate, likely would result in lower tax revenues, and ignores the basic distinction between REITs and partnerships.
A fundamental reason for a continuation of the current rules regarding a C corporation's decision to elect REIT status is that the primary rationale for the creation of REITs was to permit small investors to make investments in real estate without incurring an entity level tax, and thereby placing those persons in a comparable position to larger investors. H.R. Rep. No. 2020, 86th Cong., 2d. Sess. (1960).
By placing a toll charge on a C corporation's REIT election, the proposed amendment would directly contravene this congressional intent, as C corporations with low tax bases in assets (and therefore a potential for a large built-in gains tax) would be practically precluded from making a REIT election. As previously noted, the purpose of the 10-year election was to continue to allow C corporations to make S corporation and REIT elections when those elections were supported by non-tax business reasons (e.g., access to the public capital markets), while protecting the Treasury from the use of such entities for tax avoidance.
Page 435 PREV PAGE TOP OF DOC Segment 2 Of 2
Additionally, REITs, unlike S corporations, have several characteristics that support a continuation of the current section 1374 principles. First, there are statutory requirements that make REITs long-term holders of real estate. The REIT ''thirty-percent gross income test''(see footnote 125) and prohibited transactions tax(see footnote 126) are direct compliments to the 10-year election mechanism.
Second, while S corporations may have no more than 35 shareholders, a REIT faces no statutory limit on the number of shareholders it may have, are required to have at least 100 shareholders, and in fact some REITs have hundreds of thousands of beneficial shareholders. NAREIT believes that the large number of shareholders in a REIT and management's responsibility to each of those shareholders preclude the use of a REIT as a vehicle to be used primarily in the circumvention of the repeal of General Utilities. Any attempt to benefit a small number of investors in a C corporation through the conversion of that corporation to a REIT is impeded by the REIT widely-held ownership requirements.
In addition, REIT management has a legal and fiduciary responsibility to determine the timing and reasons for the disposition or distribution of the entity's assets with the intention of benefiting all shareholders. Thus, there is no tax avoidance if a REIT sells assets in the first 10 years, but rather only a deferral.
The consequence of this proposal would be to preclude C corporations in the business of managing and operating income-producing real estate from accessing the substantial capital markets infrastructure comprised of investment banking specialists, analysts, and investors that has been established for REITs. In addition, other C corporations that are not primarily in the business of operating commercial real estate would be precluded from recognizing the value of those assets by placing them in a professionally managed REIT. And in both such scenarios, the hundreds of thousands of shareholders owning REIT stock would be denied the opportunity to become owners of quality commercial real estate assets.
Page 436 PREV PAGE TOP OF DOC Segment 2 Of 2
Furthermore, the $5 million dollar threshold that would limit the use of the current principles of section 1374 is unreasonable for REITs. While many S corporations are small or engaged in businesses that require minimal capitalization, REITs as owners of commercial real estate have significant capital requirements. As previously mentioned, it was Congress' recognition of the significant capital required to acquire and operate commercial real estate that led to the creation of the REIT as a vehicle for small investors to become owner's of such properties. The capital intensive nature of REIT's makes the $5 million threshold essential meaningless for REITs.
It should be noted that this proposed amendment is unlikely to raise any substantial revenue with respect to REITs, and may in fact result in a loss of revenues. Because of the high cost that would be associated with making a REIT election if this amendment were to be enacted, it is unlikely that any C corporations would make the election and incur the associated double level of tax without the benefit of any cash to pay the taxes. In addition, by remaining C corporations, those entities would not be subject to the REIT requirement that they make a taxable distribution of 95% of their income each tax year. While the REIT is a single-level of tax vehicle, it does result in a level of tax on nearly all of the REIT's income each year.
Last but far from least, the Administration justifies its de facto repeal of section 1374 by stating that ''[t]he tax treatment of the conversion of a C corporation to an S corporation generally should be consistent with the treatment of its conversion to a partnership.'' Regardless of whether this stated reason for change is justifiable for S corporations, in any event it should not apply to REITs because of the differences between REITs and partnerships.
Unlike partnerships, REIT cannot (and have never been able) to pass through losses to its investors. Further, REITs can and do pay corporate level income and excise taxes. Simply put, REITs are C corporations. Thus, REITs indirectly are less susceptible to the tax avoidance concerns raised by the 1986 repeal of the General Utilities doctrine.
Page 437 PREV PAGE TOP OF DOC Segment 2 Of 2
III. Summary
The 10-year recognition period of section 1374 currently requires a REIT to pay a corporate-level tax on assets acquired from a C corporation with a built-in gain, if those assets are disposed of within a 10-year period. Combined with the statutory requirements that a REIT be a long-term holder of assets and be widely-held, current law assures that the REIT is not a vehicle for tax avoidance. The proposal would frustrate Congress' intent to allow the REIT to permit small investors to benefit from the capital-intensive real estate industry in a tax efficient manner.
Accordingly, NAREIT believes that tax policy considerations are better served if the Administration's section 1374 proposal is not enacted as it applies to REITs. If you would like to discuss this in greater detail, feel free to contact Tony M. Edwards, NAREIT's Vice President and General Counsel, at (202) 785–8717.
—————
Statement of Fred F. Murray, Vice President for Tax Policy, National Foreign Trade Council, Inc.
Mr. Chairman, and Members of the Committee:
The National Foreign Trade Council, Inc. (the ''NFTC'' or the ''Council'') is appreciative of the opportunity to present its views on the impact on international competitiveness of certain of the revenue raising foreign provisions in the administration's fiscal year 1998 budget proposal.
The NFTC is an association of businesses with some 550 members, originally founded in 1914 with the support of President Woodrow Wilson and 341 business leaders from across the U.S. Its membership now consists primarily of U.S. firms engaged in all aspects of international business, trade, and investment. Most of the largest U.S. manufacturing companies and most of the 50 largest U.S. banks are Council members. Council members account for at least 70% of all U.S. non-agricultural exports and 70% of U.S. private foreign investment. The NFTC's emphasis is to encourage policies that will expand U.S. exports and enhance the competitiveness of U.S. companies by eliminating major tax inequities in the treatment of U.S. companies operating abroad.
Page 438 PREV PAGE TOP OF DOC Segment 2 Of 2
The founding of the Council was in recognition of the growing importance of foreign trade to the health of the national economy. Since that time, expanding U.S. foreign trade and incorporating the United States into an increasingly integrated world economy has become an even more vital concern of our nation's leaders. The value of U.S. international trade (imports plus exports) as a percentage of GDP has more than doubled in recent decades: from 7 percent in the 1960's to 17 percent in the 1990's. The share of U.S. corporate earnings attributable to foreign operations among many of our largest corporations now exceeds 50 percent of their total earnings. Direct investment by U.S. companies in foreign jurisdictions continues to exceed foreign direct investment in the United States (in spite of the net debtor status of the U.S.) by some $180 billion in 1994. In 1995, U.S. exports of goods and services totaled $805 billion—11.1 percent of GDP.(see footnote 127) In 1993, 58 percent of the $465 billion of merchandise exports from the U.S. were associated with U.S. multinational corporations: $110 billion of the exports went to foreign affiliates of the U.S. companies, and another $139 billion of the exports were shipped directly to unrelated foreign buyers.(see footnote 128) Even these numbers in and of themselves do not convey the full importance of exports to our economy and to American-based jobs, because they do not address the additional fact that many of our smaller and medium-sized businesses do not consider themselves to be exporters although much of their product is supplied as inventory or components to other U.S.-based companies who do export.
Foreign trade is fundamental to our economic growth and our future standard of living.(see footnote 129) Although the U.S. economy is still the largest economy in the world, its growth rate represents a mature market for many of our companies. 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. Today, some 96% of U.S. firms' potential customers are outside the United States, and in the 1990's 86% of the gains in worldwide economic activity occurred outside the United States. Over the past three years, exports have accounted for about one-third of total U.S. economic growth; and, projected exports of manufactured goods reached a record level in 1996 of $653 billion.(see footnote 130)
Page 439 PREV PAGE TOP OF DOC Segment 2 Of 2
The Council's Concerns
The NFTC is concerned that this and previous Administrations, as well as previous Congresses, have often turned to the international provisions of the Internal Revenue Code to find revenues to fund domestic priorities, in spite of the pernicious effects of such changes on the competitiveness of United States businesses in world markets. The Council is further concerned that such initiatives may have resulted in satisfaction of other short-term goals to the serious detriment of longer-term growth of the U.S. economy and U.S. jobs through foreign trade policies long consistent in both Republican and Democratic Administrations, including the present one.
United States policy in regard to trade matters has been broadly expansionist for many years, but its tax policy has not followed suit. The provisions of Subchapter N of the Internal Revenue Code of 1986 (Title 26 of the United States Code is hereafter referred to as the ''Code'') impose rules on the operations of American business operating in the international context that are much different in important respects than those imposed by many other nations upon their companies. Some of these differences, described in more detail in the sections that follow, may make American business interests less competitive in foreign markets when compared to those from our most significant trading partners:(see footnote 131)
• The United States taxes worldwide income of its citizens and corporations who do business and derive income outside the territorial limits of the United States. Although other important trading countries also tax the worldwide income of their nationals and companies doing business outside their territories, such systems generally are less complex and subject to less significant limitations under their tax statutes or treaties than their U.S. counterparts.
Page 440 PREV PAGE TOP OF DOC Segment 2 Of 2
• The United States has more complex rules for the limitation of ''deferral'' than any other major industrialized country. Although the United States taxes the worldwide income of its companies, it permits deferral of the tax on unrepatriated foreign earnings of controlled foreign corporations, except where one of six complex, overlapping series of ''anti-deferral'' provisions of the Code apply. In addition, the anti-deferral provisions of most countries do not tax active business foreign income of their companies, while those of the U.S. inappropriately impose current U.S. tax on some active business foreign income as well as on passive foreign income.
• The current U.S. Alternative Minimum Tax (AMT) system imposes numerous rules on U.S. taxpayers that seriously impede the competitiveness of U.S. based companies. For example, the U.S. AMT provides a cost recovery system that is inferior to that enjoyed by companies investing in our major competitor countries; additionally, the current AMT 90-percent limitation on foreign tax credit utilization imposes an unfair double tax on profits earned by U.S. multinational companies—in some cases resulting in a U.S. tax on income that has been taxed in a foreign jurisdiction at a higher rate than the U.S. tax.
• The U.S. foreign tax credit system is very complex, particularly in the computation of limitations under the provisions of section 904 of the Code. While the theoretic purity of the computations may be debatable, the significant administrative costs of applying and enforcing the rules by taxpayers and the government is not. Systems imposed by other countries are in all cases less complex.
• The United States has more complex rules for the determination of U.S. and foreign source net income than any other major industrialized country. In particular, this is true with respect to the detailed rules for the allocation and apportionment of deductions and expenses. In many cases, these rules are in conflict with those of other countries, and where this conflict occurs, there is significant risk of double taxation.
Page 441 PREV PAGE TOP OF DOC Segment 2 Of 2
As noted above, the United States system for the taxation of the foreign business of its citizens and companies is more complex than that of any of our trading partners, and perhaps more complex than that of any other country.
That result is not without some merit. The United States has long believed in the rule of law and the self-assessment of taxes, and some of the complexity of its income tax results from efforts to more clearly define the law in order for its citizens and companies to apply it. Other countries may rely to a greater degree on government assessment and negotiation between taxpayer and government—traits which may lead to more government intervention in the affairs of its citizens, less even and fair application of the law among all affected citizens and companies, and less certainty and predictability of results in a given transaction. In some other cases, the complexity of the U.S. system is simply ahead of development along similar lines in other countries—many other countries have adopted an income tax similar to that of the United States, and a number of these systems have eventually adopted one or more of the significant features of the U.S. system of taxing transnational transactions: taxation of foreign income, anti-deferral regimes, foreign tax credits, and so on. However, while difficult to predict the ultimate evolution, none of these other country systems seems prone to the same level of complexity that affects the United States system. This reluctance may be attributable may be attributable in part to recognition that the U.S. system has required very significant compliance costs of both taxpayer and the Internal Revenue Service, particularly in the international area where the costs of compliance burdens are disproportionately higher relative to U.S. taxation of domestic income and to the taxation of international income by other countries.(see footnote 132)
Many foreign companies do not appear to face the same level of costs in their operations. The European Community Ruding Committee survey of 965 European firms found no evidence that compliance costs were higher for foreign source income than for domestic source income.(see footnote 133) Lower compliance costs and simpler systems that often produce a more favorable result in a given situation are competitive advantages afforded these foreign firms relative to their American counterparts.
Page 442 PREV PAGE TOP OF DOC Segment 2 Of 2
Short of fundamental reform—a reform in which the United States federal income tax system is eliminated in favor of some other sort of system—there are many aspects of the current system that could be reformed and greatly improved. These reforms could significantly lower the cost of capital, the cost of administration, and therefore the cost of doing business for American firms. For example, the NFTC strongly supported the International Tax Simplification and Reform Act of 1995, H.R. 1690 (104th Cong., 1st Sess.), introduced by Mr. Houghton (R–NY) and Mr. Levin (D–MI) of this Committee. The NFTC continues to similar efforts in the 105th Congress.
In the light of this background, the NFTC would today like to specifically address three of the President's Fiscal Year 1998 proposals: (1) Modification of the Export Source Rule (also known as the ''Inventory Sales Source Rule,'' and sometimes as the ''Title Passage Rule''); (2) Modification of so-called ''deferral'' as it currently applies to foreign oil and gas income; and, (3) Modification of the rules for foreign tax credit carrybacks and carryovers.
Modification of the Export Source Rule
Description of the Rule(see footnote 134)
The ''Export Source Rule,'' as it is commonly called, is but one of a number of sales source rules found in sections 861, 862, and 863 of the Internal Revenue Code of 1986 (the ''Code''), and the Treasury regulations thereunder. In fact, the Export Source Rule is not in the statute, but it is instead found in Treasury Regulations § 1.863–3(b), and has been there or in its predecessor provisions for more than 70 years.
Page 443 PREV PAGE TOP OF DOC Segment 2 Of 2
As noted above, the United States taxes U.S. citizens and residents and U.S. corporations on their worldwide income. That is, a U.S.-based enterprise is taxed by the United States not only on the income from its operations and sales in the United States, but also on the income from its operations and sales in other countries. This worldwide taxation creates ''double taxation'' when that same foreign income is taxed in the other country where it is derived. Each of the affected countries has its own internal tax rules to determine the ''source'' of the income involved, the application of which rules may determine whether the income in question may be taxed under its laws and to what extent.
To mitigate double taxation of income earned abroad, the United States, like many other countries, has since 1918 allowed a credit for income taxes paid to foreign countries with respect to foreign source income the ''foreign tax credit.'' That is, in cases where it applies, the United States cedes its jurisdiction in favor of the foreign country where the income is sourced, (i.e., the source country taxes the income and the U.S. does not).
Since 1921, foreign tax credits have been subject to a limitation in some form. Generally, the limitation is intended to allow a credit to be claimed only to the extent that the credit does not exceed the amount of U.S. income tax that would be due on the foreign-source income absent the credit. In other words, the United States does not allow a credit for the entire amount of foreign tax imposed only that amount that would have been the U.S. tax if it had chosen to impose its tax on the income. For example, a U.S. company paying a tax at a 40% rate in a foreign country would only receive a foreign tax credit up to the maximum 35% U.S. rate. The general limitation can be expressed in an algebraic equation: U.S. tax (pre-credit) on worldwide income × foreign source taxable income worldwide taxable income.
Under the formula, as foreign source taxable income increases (e.g., by operation of the Export Source Rule), the limitation on foreign tax credits available to offset U.S. tax increases (and therefore the foreign tax credit that can be utilized in most cases increases, up to the full amount of foreign taxes paid or accrued).
Page 444 PREV PAGE TOP OF DOC Segment 2 Of 2
To the extent that the foreign income tax is less than the limitation, the United States collects a residual tax on the foreign source income. If the foreign income tax exceeds the limitation, the taxpayer pays tax, in the current year, on foreign source income at the effective foreign tax rate (rather than the lower U.S. tax rate). This results in foreign tax credits in excess of the general limitation in the current year (an ''excess foreign tax credit position''). These excess credits may, under current law, be ''carried back'' for up to two years and ''carried forward'' for up to five years, subject to the general limitation in each of those years.(see footnote 135)
Higher foreign tax rates are only one reason many companies are in an excess foreign tax credit position. A multitude of other U.S. tax rules place restrictions on crediting foreign taxes.
As noted above, the amount of the credit is dependent on the amount of income designated as ''foreign source'' under U.S. tax law. For example, under restrictions in U.S. law, a portion of U.S. interest, as well as research and development costs, must be allocated to and reduce foreign source taxable income (even though no deduction may actually be allowed for these amounts in the foreign country). On the other hand, if a company incurs a loss in its domestic operations, it is never able to use foreign source earnings from that year to claim foreign tax credits.
The system is further complicated by other rules, such as the ''basket'' limitation rules of section 904 of the Code. Under these provisions, foreign source income is divided into separate baskets for various situations and types of income to each of which the limitation is applied. These rules may result in hundreds of separate limitations being applied to the credits. (Thus, a U.S. company might nevertheless end up with excess foreign tax credits, even though without such rules the company would have been able to fully utilize its foreign tax credits.)
Page 445 PREV PAGE TOP OF DOC Segment 2 Of 2
These U.S. rules are orders of magnitude more complex than the similar limitation systems of any of our foreign trading partners. Lost credits and the cost of compliance only add to the disparity in tax burden between U.S.-based and foreign-based multinationals, mitigated in part by the Export Source Rule.
The Code contains two source rules for the sale of inventory property that are of particular importance to U.S. exporters. One rule is for inventory property that the exporter produces and sells; and, the other is for inventory property that the exporter purchases and sells.(see footnote 136)
The source of income derived from the sale of property produced(see footnote 137) in the U.S. and sold outside the U.S. (or vice versa) is determined under section 863 of the Code. Treasury Regulations promulgated in 1996, following regulations that date back to 1922, and which implement section 863 and its predecessor statutes, provide three rules for making the determination of the amount of income that is foreign source. The first and most commonly used of these is known as the ''50–50 Method'' (also known as the ''Export Source Rule'').(see footnote 138)
Under the so-called ''50–50 Method,'' 50 percent of the income to be allocated between U.S. source and foreign source is allocated based on the location of the taxpayer's property used in the production of the inventory, and the source of the other 50 percent is based on the title-passage rule. Assuming title to the inventory passes outside the United States, this generally allows U.S. manufacturers to treat at least half of their export income from manufacture and sale of their products as derived from foreign sources, even though the manufacturer's production activity is located in the U.S.
Page 446 PREV PAGE TOP OF DOC Segment 2 Of 2
Example:(see footnote 139)
American Widget Company exports widgets to European markets and is in an excess foreign tax credit position. It costs American $90 to produce, sell, and transport a unit from one of its 14 U.S. plants, but only $88 to produce and sell a unit in the Czech Republic where it has located a plant to make widgets for the East European market. The U.S. made units sell for $100 each in West European markets.
Assume American produces a widget in the U.S. with U.S. jobs and manufacturing plant, and passes title to the widget in Romania, paying no tax in Romania on the sale. American has $10 of pre-tax income, $5.00 of which is considered foreign source income. Assuming a 35% U.S. tax rate, it may utilize $1.75 additional foreign tax credits, and therefore has $8.25 of after-tax income from the sale [($10.00 × 65%) + $1.75].
As an alternative, American could produce a widget in the Czech Republic for sale in Romania. American would have $12.00 of net income. Assume again that American would pay no Romanian tax and that the Czech tax rate is 35%. American would have $7.80 of after-tax income.
With the Export Source Rule, American has an incentive to maintain production in the U.S. ($8.25 > $7.80). Without the Rule, American would have an incentive to increase its Czech production. ($7.80 > $6.50):
As another way to view the situation, if American requires an 8.25% Return On Sales to support its capital structure, without the Export Source Rule, American would have to raise its unit price at least $2.69 to obtain the same $8.25 return. If the market would not support this new price, it would have to shift production to a location where a lower cost structure can be found, or lose its market to lower cost competitors.
Page 447 PREV PAGE TOP OF DOC Segment 2 Of 2
For example, the following two structures result with and without the Export Source Rule:
The Administration's Proposal
The President's Fiscal Year 1998 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.
In addition to introducing considerable administrative complexity and cost into the system,(see footnote 140) this modification essentially eliminates the benefits of the rule. 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. The NFTC believes that these arguments are flawed.
The Export Source Rule does not provide a competitive advantage to multinational exporters vis-à-vis exporters who conduct all their operations in the United States. First, exporters with domestic only operations do not incur foreign taxes and therefore do not suffer double taxation. Also, domestic-only exporters are able to claim the full benefit of deductions for U.S. expenses for U.S. tax purposes (e.g., interest on borrowings and Research & Development costs) because they are also not subject to the rules applied to multinational operations that require allocation of a portion of these expenses against foreign source income. Absent the Export Source Rule, the current Code would have even more of a bias against foreign operations. Second, this is important because the Administration argument also ignores the fact that export operations ultimately lead to foreign operations for U.S. companies. Exporting companies conduct foreign operations to enter and serve foreign markets; marketing, technical and administrative services, and even specialized manufacturing activities are necessary to gain markets and to keep them to compete with foreign-based companies. Further, and importantly, the Export Source Rule, by alleviating the cost of double taxation, encourages U.S. companies to locate production in the United States. Tax costs are like other costs (e.g., labor, material, and transportation) affecting the production and marketing of these products and services; a recent study suggests that these decisions are now much more tax-sensitive in fact than was previously the case.(see footnote 141)
Page 448 PREV PAGE TOP OF DOC Segment 2 Of 2
Although the FSC regime of the Code(see footnote 142) is itself valuable to promoting U.S. exports, these provisions do not in themselves afford relief to U.S. exporters with foreign operations that face double taxation because of limited use of foreign tax credits. Further, because the FSC benefits are less than those attributable to the loss of foreign tax credits in a situation where the Export Source Rule may be applicable, they may be insufficient to keep an exporter from moving its production overseas to generate foreign source income.(see footnote 143)
Our tax treaty network, valuable as it is, is no substitute for the Export Source Rule. First, the countries with which the U.S. currently has double taxation agreements number approximately forty-eight.(see footnote 144) The current international consensus favoring income tax treaties is derived from sixty years of evolution, starting with the model income tax treaty drafted by the League of Nations in 1927, culminating in its ''London Model'' treaty in 1946, and carried on later by the United Nations, and the Committee on Fiscal Affairs of the Organization for Economic Cooperation and Development (''OECD''). The U.S. first signed a bilateral tax treaty in 1932 with France, which treaty never went into force. The first effective treaty, also with France, was signed July 25, 1939, and came into force on January 1, 1945.A hearing intended to be held in early September of this year is expected to deal with four new treaties, and the termination of an existing one. These nations tend to be our most developed trading partners, and relatively few developing nations are included. Much of the world is not yet covered by these treaties. Further, the treaties provide relief from double taxation in such cases only where the export income is solely allocable to the U.S. i.e., where the U.S.-based exporter does not have a permanent establishment in the foreign jurisdiction to which income is allocable. These circumstances only occur where a U.S. company exports to a foreign treaty partner, and has no operations in that host country that have anything to do with its export sales.
Page 449 PREV PAGE TOP OF DOC Segment 2 Of 2
To the contrary, the Export Source Rule supports significant additional U.S. exports and worker earnings. For example, in 1999, for an adjusted net tax revenue cost of $1.1 billion, the U.S. 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.(see footnote 145)
Modification of ''Deferral'' and Limitation of Foreign Tax Credits From Foreign Oil and Gas Income
The Concept and Policy of Deferral
As noted above, the United States exerts jurisdiction to tax all income, whether derived in the United States or elsewhere, of U.S. citizens, residents, and corporations. By contrast, the United States taxes non-resident aliens and foreign corporations only on income with a sufficient nexus to the United States. U.S. citizens and residents and U.S. corporations (collectively ''U.S. persons'') are taxed currently by the United States on their worldwide income, subject to the foreign tax credit discussed in the last section of this statement. Income earned by a foreign corporation, the stock of which is owned in whole or in part by U.S. persons, generally is not taxed by the United States until the foreign corporation repatriates those earnings by payment to its U.S. stockholders. Therefore, two different sets of U.S. tax rules apply to U.S. taxpayers that control business operations in foreign countries; which rules apply depends on whether the business operations are conducted directly, for example, through a foreign branch, or indirectly through a separately incorporated foreign company.
Page 450 PREV PAGE TOP OF DOC Segment 2 Of 2
U.S. persons that conduct foreign operations directly (i.e., not through a foreign corporation) include income (or loss) from those operations on the U.S. tax return for the year the income is earned or the loss is incurred. The U.S. taxes that income currently, subject to any reductions by credits such as the foreign tax credit.
U.S. persons that conduct foreign operations through a foreign corporation generally pay no U.S. tax on the income from those operations until the foreign corporation repatriates its earnings to the U.S. (i.e., the taxation is ''deferred'' hence the concept of ''deferral). The income is taxed in the year it comes home, again subject to reductions by available foreign tax credits.
In general, two kinds of transactions are repatriations that end deferral and trigger tax. First, in the case of any foreign corporation, an actual dividend payment ends deferral that is, any U.S. recipient must include the dividend in income. Second, in the case of a ''controlled foreign corporation'' or ''CFC,'' an investment in ''U.S. property'' such as a loan back to the parent company or the purchase of certain U.S. property is also treated as a repatriation that ends deferral in an amount measured by the investment. However, realizing the potential for use of deferral for unintended reasons, the Code has since 1937 provided a number of regimes to avoid abuses of the general deferral. Today, the Code contains no less than six complex sets of such rules: the CFC rules (sections 951–964); the foreign personal holding company rules (sections 551–558); passive foreign investment company (''PFIC'') rules (sections 1291–1297); the personal holding company rules (sections 541–547); the accumulated earnings tax (sections 531–537); the foreign investment company rules (sections 1246 and 1247); and, the rules that apply to sales or reorganizations of the shares of a foreign corporation (sections 367(b), 1246, and 1248).
Despite the gradual erosion of deferral through enactment and modification over the decades of the significant limitations noted in the last paragraph, deferral remains a significant component of the competitiveness of U.S. businesses operating abroad. The NFTC has long believed that the anticipatory taxation of earning of foreign subsidiaries would have the following consequences:
Page 451 PREV PAGE TOP OF DOC Segment 2 Of 2
1. An increase in American industry's overall tax burden from foreign operations and loss of revenue over the long term for the U.S. Treasury;
2. Reduction in the ability of U.S. multinational companies to compete abroad;
3. Erosion of the foreign resources of American companies and a decrease in the profitability of these companies;
4. An adverse impact on U.S. exports and employment and on the nation's balance of payments;
5. Reduction of investments abroad by U.S. firms without generating additional investment in the United States; and,
6. Risk of countervailing taxes by foreign governments.
Deferral permits U.S. taxpayers operating through foreign corporations to compete internationally by reinvesting their foreign earnings without subjecting such earnings to current U.S. income taxation. This is significant, as the O.E.C.D. has found that the cost of capital for both domestic (8.0 percent) and foreign investment (8.8 percent) by U.S. companies is significantly higher than the averages for the other G–7 countries (7.2 percent domestic anbd 8.0 percent foreign). In fact, the O.E.C.D. determined that the U.S. is tied with Japan as the least competitive G–7 countries in which a multinational company may be headquartered, taking into account taxation at the individual and corporate levels.(see footnote 146)
Unlike the anti-deferral regimes of other developed countries, that generally eliminate deferral only for passive income,(see footnote 147) the U.S. anti-deferral regimes have been inappropriately modified to eliminate deferral on some types of active trade or business income: including financial services income,(see footnote 148) oil-related refining income, international shipping and aircraft income, and certain other types of non-passive income.
Page 452 PREV PAGE TOP OF DOC Segment 2 Of 2
The anti-deferral regimes reflect a series of responses to the need to raise revenue and/or to correct perceived shortcomings in the general rule of deferral existing at the time of enactment. However, the resulting hodgepodge of overlapping rules create disparate limitations on deferral that require current taxation of certain types of income by reference to different factors or criteria, and in other cases impose interest charges or other additions to the taxation of such income otherwise allowed deferral. The various regimes have different rules of priority, different attribution rules, and contain other issues making their application difficult and costly. The regimes are to a substantial degree redundant, and impose on both the taxpayer and the government overlapping and expensive compliance requirements, unlike the anti-deferral regimes of the other developed countries.(see footnote 149)
The Administration's Proposals
The President's Fiscal Year 1998 Budget contains a proposal to repeal deferral for all ''foreign oil and gas income.'' Such income would be treated as subpart F income (and taxed currently), and additionally would be trapped in a new separate FOGI basket under the separate basket foreign tax credit limitations of section 904. In situations where taxpayers are subject to a foreign tax and also receive an economic benefit from the foreign country (e.g., a royalty on production), taxpayers would be able to claim a foreign tax credit for such taxes under section 902 only if the country has a ''generally applicable income tax'' that has ''substantial application'' to all types of taxpayers and then only up to the level of taxation that would be imposed under the generally applicable income tax. Treaty provisions to the contrary (for foreign tax credit calculations) would be respected. The NFTC opposes these proposals. In addition to creating significant new limitations on the foreign tax credits attributable to foreign oil and gas income, the proposals represent another piecemeal repeal of deferral.
Page 453 PREV PAGE TOP OF DOC Segment 2 Of 2
Subpart F treatment in theory is generally limited to passive income that is easily manipulated as to source of income, and that may be shifted to low or no tax jurisdictions. The Administration's proposal does not provide any justification for this approach to taxing foreign oil extraction operations. Such income is derived where and when the natural resource is extracted, without tax manipulation, in an active business.
Further, potential abuses of deferral and the foreign tax credit have been addressed previously in sections 901(f), 907(a) and (b) and (c), and 954(g) of the Code, and in the ''dual capacity'' income tax regulations under section 901 of the Code.(see footnote 150) The Administration has not demonstrated that these provisions of law and regulation are not adequate and should be amended.
The proposals go well beyond amendment of these provisions to total elimination of deferral for the natural resources industry and significant limitation of the foreign tax credits available to this specific industry. This piecemeal repeal of deferral will significantly increase the cost of capital in that industry and make U.S. companies less competitive vis-à-vis their foreign competitors.
Modification of the Rules for Foreign Tax Credit Carrybacks and Carryovers
As noted above, if a foreign income tax exceeds the limitation, the taxpayer pays tax, in the current year, on foreign source income at the effective foreign tax rate (rather than the lower U.S. tax rate). This results in foreign tax credits in excess of the general limitation in the current year (an ''excess foreign tax credit position''). These excess credits may, under current law, be ''carried back'' for up to two years and ''carried forward'' for up to five years, subject to the general limitation in each of those years.(see footnote 151)
Page 454 PREV PAGE TOP OF DOC Segment 2 Of 2
The Administration's Proposal
The President's Fiscal Year 1998 Budget contains a proposal to reduce the carryback period for excess foreign tax credits from two years to one year. The proposal also would extend the excess foreign tax credit carryforward period from five years to seven years.
As noted by the Joint Committee on Taxation,(see footnote 152) one of the purposes of the carryover of foreign tax credits is to address timing differences between U.S. tax rules and foreign tax rules. Income may be subject to tax in one year under U.S. rules and in another tax year under applicable foreign rules. The carryback and carryover of foreign tax credits helps to ensure that foreign taxes will be available to offset U.S. taxes on the income in the year in which the income is recognized for U.S. purposes. Shortening the carryback period and increasing the carryforward period also could have the effect of reducing the present value of foreign tax credits and therefore increasing the effective tax rate on foreign source income.
In Conclusion
Again, the Council applauds the Chairman and the Members of the Committee for giving careful consideration to the proposals raised by the Administration. The NFTC is appreciative of the opportunity to work with the Committee and the Congress in going forward into this process of consideration of various alternatives, and the Council would hope to make a contribution to this important business of the Committee.
—————
Page 455 PREV PAGE TOP OF DOC Segment 2 Of 2
Statement of the National Mining Association
The National Mining Association (NMA) appreciates the opportunity to submit this statement for the Committee's record on the President's Fiscal 1998 tax proposals. The NMA is an industry association representing most of the Nation's producers of coal, metals, industrial and agricultural minerals. Our membership also includes equipment manufacturing firms and other providers of products and services to the mining industry. The NMA has not received a Federal grant, contract or subcontract in Fiscal years 1997, 1996 or 1995.
Mining employs some 300,000 workers directly and supports three million jobs in allied industries. Processed material of mineral origin such as coal, copper, gold, zinc and silver total $391 billion, or about 5 percent of the United States gross domestic product. The headquarters of operations of NMA member companies are located in nearly every state of the Union and some form of mining represented by the NMA occurs in all 50 states.
The U.S. Department of Labor reports that the mining industry provides some of the highest paying non-supervisory jobs in the United States. The average mining wage in 1995 was $45,270 (not including benefits)—far above the nation-wide average wage of $27,845. We believe that tax policy should foster the creation of more of these high-paying jobs. Unfortunately, the Administration's proposals to repeal the percentage depletion allowance for certain minerals and the sunset of the placed-in-service date for Section 29 Nonconventional Fuel Credit do just the opposite.
Depletion
Of primary concern to our industry is the proposal in the Administration's budget to repeal the percentage depletion allowance for minerals mined on lands where mining rights were originally acquired under the Mining Law. We are adamantly opposed to this proposal.
Page 456 PREV PAGE TOP OF DOC Segment 2 Of 2
Repeal of the allowance is a major tax increase on companies that have mines located primarily in the western United States. As it is not uncommon for ownership of mineral deposits to change hands, the proposal would especially penalize mining companies who purchased their properties from original claimants or other intermediary mining concerns.
From our perspective, the President's depletion proposal has more to do with mining on public lands in the western states than it does with tax policy. The NMA and its member companies continue to support responsible amendments to the Mining Law, including a reasonable royalty provision. This reform effort has been stymied at every turn by anti-mining groups. Those opposing responsible amendment to the Mining Law seek changes that would make mining on public lands nearly impossible. The Administration's proposal to increase the tax burden on certain hardrock mines would appear to be a coordinated effort to accomplish that goal.
Increasing the tax burden on the mining industry is effectively an increase in production costs. Because minerals are commodities traded in the international marketplace at prices determined by the world-wide supply and demand factors, mining companies cannot recover higher costs by raising prices. Most mines affected by this proposal will see their tax burden increase by as much as 8 percent to 10 percent.
This tax increase is likely to have the following short- and long-term disruptive effects on the industry:
• Reduce the operating lives of many mines by increasing the ore cut-off grade. Minerals that would otherwise have been economic to extract will remain in the ground and not be recovered, resulting in poor stewardship of our natural resources. Existing jobs, federal, state and local tax revenues will be lost.
• Higher taxes will reduce the ability of companies to make the necessary investment in existing operations to improve production efficiencies and respond to constantly changing environmental, reclamation, health and safety standards.
Page 457 PREV PAGE TOP OF DOC Segment 2 Of 2
• Investment in new projects will decline. This change to long-standing tax policy will adversely affect the economics of new projects and lower expected after-tax rates of return. Many new projects will become uneconomic, resulting in lost opportunities for new jobs and tax revenues.
The long-term consequences of this tax increase are serious. Without continuous investment in new domestic projects to replace old mines, mineral production in the United States will decline. The increasing short-fall between the nation's demand for mineral products and domestic supply will be satisfied by imports of minerals mined by foreign workers. Our exports will be jobs and many areas of the country will experience declining economies and erosion of state and local tax bases.
The mining industry is characterized by relative rarity of commercially viable mineral deposits, high economic risks, geologic unknowns, extreme costs and long lead times for development of new mines. The depletion allowance recognizes the unique nature of mineral extraction by providing a rational and realistic method of measuring the decreasing value of a deposit as minerals are extracted. As the replacement cost of a new mine is always higher in real terms than the mine it replaces, the allowance helps generate the capital needed to bring new mines into production.
A significant amount of capital is needed to develop and operate a mine, be it on federal or non-federal land. It is not uncommon to spend in excess of $400 million to bring a domestic world-scale mine into production. The cost of processing facilities is high: A state-of-the-art smelter can have capital costs approaching $1 billion. To argue that minerals are ''free for the taking'' and mining companies are recipients of so-called corporate welfare is fallacious at best.
The mining industry (and other capital-intensive industries) already pay high effective tax rates through the application of the corporate alternative minimum tax (AMT). The General Accounting Office in a 1995 study reported that the average effective tax rate for mining companies under the AMT is 32 percent. As the Ways and Means Committee is well aware, the AMT gives the United States the worst capital cost recovery system in the industrialized world. Rather than increasing the tax burden on mining, as proposed by the Administration, it should be reduced by reform of the corporate AMT.
Page 458 PREV PAGE TOP OF DOC Segment 2 Of 2
Section 29: Credit for Producing Fuel From a Nonconventional Source
Section 29 (c) was enacted to provide incentives for alternative or non-conventional fuels produced from coal or biomass. It provides that synthetic fuel produced form coal and biomass produced from a facility placed in service before July 1, 1998, pursuant to a binding contract entered into before January 1, 1997, are eligible for a tax credit, if produced before January 1, 2008. The credit encourages clean technologies that provide significant environmental benefits.
The Administration's budget contains a proposal to shorten the placed in service date by one year to July 1, 1997. This proposal is unfair will have a devastating impact on producers who have entered into contacts based on the specifications in the 1996 Small Business Tax Bill. The very existence of the proposal has had a chilling effect on the ability of companies to raise the capital needed to successfully complete the contracts they entered into based on current law. We urge the Committee to reject this arbitrary reduction in the placed-in-service date.
The fact is that because of the long lead time, up to two years or more, needed for plant planning, permitting and construction, many clean coal projects may not meet the July 1, 1998, deadline. Therefore, rather than shortening the placed-in-service date, we advocate that Congress build on the compromise reached in 1996 and extend the placed-in-service date to July 1, 1999. Extension of the placed-in-service date will help ensure that companies with binding contracts in place under current law have a reasonable amount of time to complete projects that otherwise would qualify for the credit.
Conclusion
Page 459 PREV PAGE TOP OF DOC Segment 2 Of 2
We urge the Committee and the Congress to reject these job-killing and self-defeating tax increases targeted at the mining industry. Instead, Congress should pass tax legislation designed to foster investment and economic growth in mining and other capital intensive industries and should include reform of the corporate AMT and extension of the Section 29 placed-in-service date.
—————
Statement of John J. Doherty, Commissioner, New York City Department of Sanitation
The New York City Department of Sanitation (''the Department'') respectfully urges the House Committee on Ways and Means to protect an extension of the Alternative Fuel Tax Credit in the Internal Revenue Service Code, Section 29 as passed in 104th Congress, Second Session, House of Representatives Report 104–737 to accompany H.R. 3448.
Protection of the Alternative Fuel Tax Credit in its present form would allow New York City's reclamation of methane gas from the nation's largest landfill, Fresh Kills, located on Staten Island. The landfill receives approximately 13,000 tons per day of residential municipal solid waste.
Background
Refuse contained in landfills decomposes producing methane gas and odors that can be recovered through United States Environmental Protection Agency (''EPA'') approved landfill gas technologies. EPA's Methane Outreach Program encourages municipal landfill operators like New York City to implement landfill gas recovery projects. These projects reduce greenhouse gas emissions and provide a clean source of fuel. The tax credit extension, in its present form, continues a valuable private sector incentive for recovering methane gas emissions.
Page 460 PREV PAGE TOP OF DOC Segment 2 Of 2
The City has initiated a methane gas recovery project at Fresh Kills. Based on an estimated cost of approximately twenty five million dollars in infrastructure to set up the technology, the credit is the only tangible financial incentive left for companies to build, maintain and operate a recovery facility.
The Department has diligently pursued both contractual and infrastructure commitments—to secure the tax credit for New York City with a placed in service date of July 1, 1998. Any acceleration of that date would prevent the Department and New York City from qualifying for the tax credit. In December 1996, the Department entered into a contractual agreement with a private firm in an effort to comply with the requirements of Section 29, in reliance on meeting the July 1, 1998 deadline. If that date were changed to June 30, 1997, the Department's ability to qualify for the tax credits would fail for several reasons including: it would be impossible to complete construction within three months; without assistance from the private sector costs to install a gas control system are prohibitive; and the Department's proposal submission dates, based on existing deadlines as referenced above in the House Conference Report on Section 29, would be inadequate.
As currently structured, the tax credit would provide a one million dollar per year payment to New York City's landfill gas recovery program for the next twenty years. Failure to obtain this credit would result in a deficit and disqualify the program as a concession. As a consequence New York City would be responsible for the full cost of a program.
In closing, the New York City Department of Sanitation respectfully urges the House Committee on Ways and Means to protect an extension of the Alternative Fuel Tax Credit.
—————
Statement of the New York Clearing House Association, the Securities Industry Association, Independent Bankers Association of America, and America's Community Bankers
Page 461 PREV PAGE TOP OF DOC Segment 2 Of 2
Regarding a Proposal in President Clinton's Fiscal Year 1998 Budget To Increase Penalties for Failure To File Correct Information Returns
The undersigned associations, which represent a broad range of financial institutions, including both large and small institutions, reiterate their strong opposition to the Administration's proposal to increase penalties for failing to file correct information returns. As included in the President's fiscal year 1998 budget, the proposal generally would increase the penalty for failure to file correct information returns on or before August 1 following the prescribed filing date from $50 for each return to the greater of $50 or 5 percent of the amount required to be reported.(see footnote 153) We believe the proposal is overly broad in that it applies to all types of information returns, including Forms 1099–INT, –DIV, –OID, –B, –C, and –MISC, as well as Form W–2.
The proposed penalties are unwarranted and place an undue burden on already compliant taxpayers. The financial services community devotes an extraordinary amount of resources to comply with current information reporting and withholding rules and is not compensated by the U.S. government for these resources. The proposed penalties are particularly inappropriate in that (i) there is no evidence of significant current non-compliance and (ii) the proposed penalties would be imposed upon financial institutions while such institutions were acting as integral parts of the U.S. government's system of withholding taxes and obtaining taxpayer information.
Current Penalties Are Sufficient
Page 462 PREV PAGE TOP OF DOC Segment 2 Of 2
We believe the current penalty regime already provides ample incentives for filers to comply with information reporting requirements. In addition to penalties for inadvertent errors or omissions,(see footnote 154) severe sanctions are imposed for intentional reporting failures. In general, the current penalty structure is as follows:
• The combined standard penalty for failing to file correct information returns and payee statements is $100 per failure, with a penalty cap of $350,000 per year.
• Significantly higher penalties generally 20 percent of the amount required to be reported (for information returns and payee statements), with no penalty caps may be assessed in cases of intentional disregard.(see footnote 155)
• Payors also may face liabilities for failure to apply 31 percent backup withholding when, for example, a payee has not provided its taxpayer identification number (TIN).
There is no evidence that the financial services community has failed to comply with the current information reporting rules and, as noted above, there are ample incentives for compliance already in place. It seems, therefore, that most of the revenue raised by the proposal would result from higher penalty assessments for inadvertent errors, rather than from increased compliance with information reporting requirements. Thus, as a matter of tax compliance, there appears to be no justifiable policy reason to substantially increase these penalties.
Page 463 PREV PAGE TOP OF DOC Segment 2 Of 2
Penalties Should Not Be Imposed To Raise Revenue
Any reliance on a penalty provision to raise revenue would represent a significant change in Congress current policy on penalties. A 1989 IRS Task Force on Civil Penalties concluded that penalties ''should exist for the purpose of encouraging voluntary compliance and not for other purposes, such as raising of revenue.''(see footnote 156) Congress endorsed the IRS Task Force's conclusions by specifically enumerating them in the Conference Report to the Omnibus Budget Reconciliation Act of 1989.(see footnote 157) There is no justification for Congress to abandon its present policy on penalties, which is based on fairness, particularly in light of the high compliance rate among information return filers.
Safe Harbor Not Sufficient
Under the proposal, utilization of a 97 percent substantial compliance ''safe harbor''(see footnote 158) is not sufficient to ensure that the higher proposed penalties apply only to relatively few filers. Although some information reporting rules are straightforward (e.g., interest paid on deposits), the requirements for certain new financial products, as well as new information reporting requirements,(see footnote 159) are often unclear, and inadvertent reporting errors for complex transactions may occur. Any reporting ''errors'' resulting from such ambiguities could easily lead to a filer not satisfying the 97 percent safe harbor.
Application of Penalty Cap to Each Payor Entity Inequitable
Page 464 PREV PAGE TOP OF DOC Segment 2 Of 2
We view the proposal as unduly harsh and unnecessary. The current-law $250,000 penalty cap for information returns is intended to protect the filing community from excessive penalties. However, while the $250,000 cap would continue to apply under the proposal, a filer would reach the penalty cap much faster than under current law. For institutions that file information returns for many different payor entities, the protection offered by the proposed penalty cap is substantially limited, as the $250,000 cap applies separately to each payor.
In situations involving affiliated companies, multiple nominees and families of mutual funds, the protection afforded by the penalty cap is largely illusory because it applies separately to each legal entity. At the very least, any further consideration of the proposal should apply the penalty cap provisions on an aggregate basis. The following examples illustrate why aggregation in the application of the penalty cap provisions is critical.
Example I—Paying Agents
A bank may act as paying agent for numerous issuers of stocks and bonds. In this capacity, a bank may file information returns as the issuers agent but the issuers, and not the bank, generally are identified as the payors. Banks may use a limited number of information reporting systems (frequently just one overall system) to generate information returns on behalf of various issuers. If an error in programming the information reporting system causes erroneous amounts to be reported, potentially all of the information returns subsequently generated by that system could be affected. Thus, a single error could, under the proposal, subject each issuer for whom the bank filed information returns, to information reporting penalties because the penalties would be assessed on a taxpayer-by-taxpayer basis. In this instance, the penalty would be imposed on each issuer. However, the bank as paying agent may be required to indemnify the issuers for resulting penalties.
Page 465 PREV PAGE TOP OF DOC Segment 2 Of 2
Recommendation: For the purposes of applying the penalty cap, the paying agent (not the issuer) should be treated as the payor.
Example II—Retirement Plans
ABC Corporation, which services retirement plans, approaches the February 28th deadline for filing with the Internal Revenue Service the appropriate information returns (i.e., Forms 1099–R). ABC Corporation services 500 retirement plans and each plan must file over 1,000 Forms 1099–R. A systems operator, unaware of the penalties for filing late Forms 1099, attempts to contact the internal Corporate Tax Department to inform them that an extension of time to file is necessary to complete the preparation and filing of the magnetic media for the retirement plans. The systems operator is unable to reach the Corporate Tax Department by the February 28th filing deadline and files the information returns the following week. This failure, under the proposal, could lead to substantial late filing penalties for each retirement plan that ABC Corporation services (in this example, up to $75,000 for each plan).(see footnote 160)
Recommendation: Retirement plan servicers (not each retirement plan) should be treated as the payor for purposes of applying the penalty cap.
Example III—Related Companies
A bank or broker dealer generally is a member of an affiliated group of companies which offer different products and services. Each company that is a member of the group is treated as a separate payor for information reporting and penalty purposes. Information returns for all or most of the members of the group may be generated from a single information reporting system. One error (e.g., a systems programming error) could cause information returns generated from the system to contain errors on all subsequent information returns generated by the system. Under the proposal, the penalty cap would apply to each affiliated company for which the system(s) produces information returns.
Page 466 PREV PAGE TOP OF DOC Segment 2 Of 2
Recommendation: Each affiliated group(see footnote 161) should be treated as a single payor for purposes of applying the penalty cap.
While these examples highlight the need to apply the type of penalty proposed by the Treasury on an aggregated basis, they also illustrate the indiscriminate and unnecessary nature of the proposal.
Conclusion
The undersigned associations represent the preparers of a significant portion of the information returns that would be impacted by the proposal to increase penalties for failure to file correct information returns. In light of the current reporting burdens imposed on our industries and the significant level of industry compliance, we believe it is highly inappropriate to raise penalties. Thank you for your consideration of our views. The New York Clearing House Association, New York, NY; The Securities Industry Association, Washington, DC; Independent Bankers Association of America, Washington, DC; and America's Community Bankers, Washington, DC.
—————
| Pace Carbon Fuels, L.L.C. |
| 4401 Fair Lakes Court, Suite 400 |
| Fairfax, Va 22033 |
| March 26, 1997 |
The Honorable Bill Archer
Chairman of the Committee on Ways and Means
Page 467 PREV PAGE TOP OF DOC Segment 2 Of 2
United States House of Representatives
1236 Longworth House Office Building
Washington, D.C. 20510
Re: March 12, 1997 Hearing on Revenue Raising Provisions in the Administration's Fiscal Year 1998 Budget Proposal
Dear Chairman Archer:
Pace Carbon Fuels, L.L.C. (''Pace Carbon Fuels'') is an energy-related project company focusing on the development of synthetic fuel facilities. Pace Carbon Fuels recently received summaries of the Administration's Fiscal Year 1998 Budget. We were extremely disappointed to learn the Administration is proposing to retroactively turn back the project in-service date that is part of the eligibility requirement under Section 29 of the Internal Revenue Code. We are writing to you today to solicit your support in removing language from the Budget that would unfairly overturn the eligibility deadline passed just last year and on which Pace Carbon has relied.
Section 29 provides tax credits for producers of alternative or synthetic fuels, thereby encouraging the conservation of our natural resources and reducing American dependence on foreign oil. As background, the early 1996 drafts of the Small Business Job Protection Act called for a January 1, 1999 placed-in-service deadline for projects to produce synthetic fuel to qualify for the tax credit. As a compromise, the deadline was shortened to July 1, 1998 and passed as a part of the Minimum Wage Bill of 1996. In reliance upon this legislation, Pace Carbon Fuels has incurred significant expenses and undertaken substantial financial commitments to build and put synthetic fuel plants into operation by the July 1, 1998 deadline. In fact, we signed in December 1996 binding construction contracts (with termination penalty clauses as required by the IRS) to build as many as fourteen (14) synthetic fuel production facilities creating nearly 1000 jobs in the process.
Page 468 PREV PAGE TOP OF DOC Segment 2 Of 2
The construction schedule alone is at least 6 months long, not including permitting, site development and financing that must serve as a predicate to construction. The Administration recommended retroactively ''shortening'' of the placed-in-service deadline would defeat our efforts and the significant dollars spent to date. The viability of our company is put in jeopardy by the budget proposal. This is clearly an unfair situation. At a minimum, we need the placed-in-service deadline to be retained at its current date (July 1, 1998).
In support of our efforts to protect the July 1, 1998 in-service deadline as the fair and equitable course to pursue, we urge you to review the letter sent to Secretary of Treasury Rubin on March 17, 1997, signed by a bipartisan group of nineteen Senators and strongly supported by senior members of the Senate Finance Committee. Please let us know if you would like us to provide you with a copy of the letter.
We would like to discuss with your office the potential action that can be taken to retain the current placed-in-service deadline and to remove as quickly as possible the cloud created by the budget proposal over our projects. Again, we made significant expenditures and commitments based on last year's legislation and believe it would be extremely unfair to be placed in the position that the proposed budget would create. We thank you for your efforts and trust that you will support this important policy.
Sincerely,
| James R. Treptow |
| Principal |
—————
Statement of Sun Coal and Coke Co., Inland Steel Co., and Northern Indiana Public Service
Page 469 PREV PAGE TOP OF DOC Segment 2 Of 2
Mr. Chairman and Members of the Committee, we are pleased to submit testimony concerning a specific revenue initiative involving the Section 29 alternative fuels tax credit and its importance to the American environment.
Summary
President Clinton's recent budget proposal includes an ill conceived and unjust 12-month roll-back of the placed-in-service date for biomass and coal facilities under I.R.C. Section 29, which was approved by Congress just last year. Having enacted a binding contract rule in conjunction with the extended placed-in-service date last year, Congress, if it were to adopt the Administration's proposal, would unfairly penalize stakeholders in facilities currently under construction pursuant to a pre-1997 binding contract. Such action would also be at odds with the joint statement last year of the two Chairmen of the tax writing committees declaring that none of the revenue proposals included in the Clinton Administration's fiscal 1997 budget plan would be effective earlier than the date of appropriate congressional action so as not to disrupt normal market activities and business transactions.
The Committee should not adopt any proposal to roll-back the Section 29 placed-in-service date because:
• Companies have made binding economic decisions based on current law and a change in the ''rules of the game'' is neither fair nor equitable.
• A change in current law would place a financial burden on companies that made investments in reliance on the actions of the 104th Congress.
• The Section 29 credit promotes production of environmentally sound, non-conventional fuels.
• Congress has recognized the value of Section 29 in the past and extended it as a matter of desirable and appropriate policy.
Page 470 PREV PAGE TOP OF DOC Segment 2 Of 2
Project Specifics
The glaring inequity of retroactive effective dates is best illustrated by a complex, real-world business transaction. Multiple parties have made substantial capital commitments and entered into long-term supply contracts based upon the extension of Section 29 last year. This transaction, referred to as the Indiana Harbor project, involves capital investments totaling approximately $350 million by three companies which are each independently owned and operatedThis project will secure a long-term, economically and environmentally advantageous coke supply for the Inland Steel Company No. 7 blast furnace. Coke, which is a fuel for the iron-making process, will be produced by a proprietary coke-making process which is environmentally benign and produces heat that can be converted to electricity. The project will create approximately 135 new jobs with an estimated annual payroll (including benefits) in excess of $5 million annually in an economically depressed area. It is estimated that the project will generate an additional 600 full-time equivalent jobs during construction.
The three companies investing capital in the Indiana Harbor project are Sun Coal Company, NIPSCO Industries and Beemsterboer Slag & Ballast Corp. Inland Steel Company is the purchaser of the predominant portion of the coke produced by the Project.
• Sun Coal Company, headquartered in Tennessee, is in the business of coal production from mines in Virginia and Kentucky and coke manufacturing at a facility in Vansant, Virginia. It is a subsidiary of Sun Company, Inc., an independent refiner and marketer of petroleum products, headquartered in Philadelphia.
• NIPSCO Industries, with headquarters in Hammond, Indiana, is an energy-based holding company whose regulated subsidiaries provide natural gas and electric services throughout northern Indiana. The company's non-regulated businesses are primarily energy focused.
Page 471 PREV PAGE TOP OF DOC Segment 2 Of 2
• Beemsterboer Slag & Ballast Corp.,a privately held company headquartered in South Holland, Illinois, is in the coal and slag handling and processing business.
• Inland Steel Company is the fifth-largest integrated steel producer in the U.S. with a 1,900 acre steel-making complex located in East Chicago, Indiana. It annually produces more than 5.5 million tons of steel, which it sells to automobile, appliance, and office furniture makers, and is headquartered in Chicago, Illinois.
On October 27, 1996, Sun Coal Company, through its affiliates, entered into a binding written contract with Raytheon for the construction of a 1.22+ million ton per year coke making facility to be built on a 95-acre site in East Chicago, Indiana. It is anticipated that construction of the coke ovens will be completed by June 30, 1998, thereby qualifying its production for the Section 29 tax credit. Coke qualifies for the Section 29 credit as a synthetic product of coal. Capital committed by Sun Coal under this contract equals approximately $185 million. This aspect of the Indiana Harbor project consists of 268 state-of-the-art Jewell design Thompson coke ovens and supporting facilities using Sun Coal's proprietary ''non-recovery'' coke technology.
Sun Coal has refined the technology for this environmentally benign method of making coke. Pursuant to the 1990 amendments to the Clean Air Act, the EPA has promulgated regulations which establish MACT (maximum achievable control technology) standards for new coke oven batteries based on the use of the Sun Coal non-recovery process. This aspect of the project will, upon completion, employ approximately 108 persons in an area with high unemployment and a high poverty rate that was designated as an Economic Enterprise Zone with the approval and support of local and state government.
Concurrent with the execution of the binding construction contract, Sun Coal entered into a 15-year take-or-pay contract to supply Inland Steel with 1.22 million tons of coke annually. Thus, Sun made multiple strategic business commitments in 1996: first, a commitment of capital of $185 million; second, a contractual commitment to supply coke to a customer for 15 years; third, a contractual commitment to provide waste heat to a co-generation facility as described below; and finally, a requirement for a $28 million coal-handling facility to be constructed and operated by a third party based on a long-term coal-handling commitment from Sun Coal.
Page 472 PREV PAGE TOP OF DOC Segment 2 Of 2
A second component of this sizable joint-venture project includes construction of a co-generation facility to capture the waste heat from the coking facility. A unit of NIPSCO Industries will design, build, finance and operate an 87-megawatt co-generation plant that will remove sulfur from the coke plant's flue gas and use the heat from the coke plant to produce steam and electricity. Capital employed is estimated to be $137 million. Concurrent with the execution of the construction contract for the coke facility, Sun Coal entered into a contractual commitment to provide NIPSCO's facility with waste heat for 15 years.
The third part of the Indiana Harbor Project capital investment will be made by a unit of Beemsterboer. Beemsterboer is constructing a coal blending and handling facility at a $28 million projected cost. This front-end plant will store, crush and blend various coals to supply the proper quality of coal for charging the coke ovens. The coal will be owned by Sun Coal, but the facility will be independently owned and operated by Beemsterboer. This facility will cover 49 acres of the common site. The NIPSCO and Beemsterboer portions of the project are expected to employ an additional 25 to 30 persons.
Inland Steel Company has contractually agreed to purchase 1.22 million tons of coke produced by the Inland Harbor project to supply the largest of its three iron-making blast furnaces. Inland closed the last of its coke ovens in 1993, necessitated by the inability of the facilities to meet environmental regulations and their deteriorating condition and performance. A major consideration in Inland's entering into this 15-year purchase arrangement was the anticipation that production from the project would qualify for the Section 29 tax credit. If so, this project will make Inland more competitive in an intensely competitive international marketplace by dramatically reducing its costs for coke, a key raw material in the production of iron. If, however, there is a retroactive change in law, the cost of coke to Inland will increase pursuant to the terms of the take-or-pay contract, negatively impacting the economics of its supply of a major raw material component of its business through 2007. It would adversely affect the project's core concept, that of securing a long-term economically and environmentally advantageous coke supply for the Inland Steel Company which employs 10,000 employees at its East Chicago facility, thereby removing the opportunity for Inland to compete more effectively with foreign steel-makers who have historically hurt the U.S. steel industry by systematic dumping in the U.S.
Page 473 PREV PAGE TOP OF DOC Segment 2 Of 2
Reasons for Retaining Current Law
Binding Economic Decisions Have Been Made Based on Current Law
President Clinton's fiscal 1998 budget submission to the Congress is punitive and inequitable in its roll-back of the placed-in-service date for fuel production from nonconventional sources. Moving the current-law placed-in-service-date back twelve months, from July 1, 1998 to July 1, 1997, would be unjust since companies had written binding contracts for projects in effect before 1997.
In reliance on Section 29 tax credit provisions, Sun, Inland, and NIPSCO in this instance—but a number of other companies in other cases—entered into a venture project to build and produce efficient coke. The contracts to build the coke plant and supply Inland with domestically produced fuel were signed (and construction began) before President Clinton's 1998 budget proposal was announced. To change that treatment mid-stream with total disregard to the taxpayer's reliance on the law would not only be inequitable, but also irresponsible.
Change Will Be a Financial Burden for Companies Which Relied on the Actions of the 104th Congress
It has long been recognized that Federal tax treatment of capital expenditure is a critical part of investment planning decisions and project pricing. Not surprisingly, tax provisions motivate behavior, and the Sun Project utilized the Section 29 credit as allowed under the law. Taxpayers should not be unfairly penalized for relying on the law. Retroactively rolling back the economic benefits associated with the credit would be financially compromising to the parties involved who acted in good-faith reliance on current law.
Page 474 PREV PAGE TOP OF DOC Segment 2 Of 2
As noted, well over a quarter of a billion dollars of capital investment has been committed to this project, which is already under way and scheduled to be completed by the July 1, 1998 statutory deadline. In addition to Sun's capital investment, Inland has entered into a binding 15-year long-term supply contract with Sun for coke from the new plant. The tax credit was important in providing coke at a substantially lower price than from other coke facilities.
Rolling back the date under which projects must be constructed and completed is unfair. Why? Because meeting a retroactive deadline is not possible. Multi-million dollar construction projects cannot be accelerated to (12 months) early completion to meet an arbitrary deadline. Certainly, such retroactive action could have a chilling effect in the future should the Administration and/or the Congress seek again to encourage new technologies to protect the environment and U.S. competitiveness.
The Section 29 Credit Is Environmentally Sound
The Section 29 credit applies to the production and sale of certain nonconventional fuels produced by a facility placed in service by July 1, 1998. The fuels made possible by this credit have been proven to be highly effective, technologically innovative, internationally efficient, and clean burning.
1. Sun's specific benign coke technology is state-of-the-art and technologically innovative. The technology employed by the new Sun plant is far and away more environmentally sound than that used in existing batteries. The favorable environmental implications of Sun's benign coke technology are striking. When this new plant opens, the Sun facilities will be the only coke plants in the U.S. to meet the EPA's newly proposed air-quality standards. The non-recovery process incinerates all the volatile gases produced during coking. The only remaining contaminant, sulfur dioxide, is removed from the flue gas in the co-generation process. Chemical by-products from coking by these ovens are not recovered but are incinerated harmlessly during the coking process by Jewell's unique coke technology, which virtually eliminates pollutants.
Page 475 PREV PAGE TOP OF DOC Segment 2 Of 2
2. The import of foreign coke would harm the environment. If the tax benefits of Section 29 are eliminated, industrial users will be forced to consider purchasing foreign produced coke. Domestic capacity for coke production has declined since enactment of the Clean Air Act amendments in 1990. The negative environmental and competitive implications of increased foreign production—from China, for example, which has no equivalent air standards—and increased domestic use of this coke are significant.
3. Change in Section 29 law is inconsistent with the 1990 Clean Air Act and the EPA's proposed regulations on air quality. It is inconsistent to eliminate Section 29 credits for the Sun coke process, which the 1990 Clean Air Act specifically identified as setting the industry standard for coke-emission controls. Moreover, if the EPA's new rules for air quality are adopted, the Sun Project would be the only coke plant in the country that does not produce carcinogenic emissions. Congress should not remove a tax provision which motivates the very behavior that produces sound environmental policy sought by the Administration.
4. The project is being constructed on a potential ''brownfield'' site. Under current environmental law, prior industrial use of the Inland East Chicago site effectively prohibits sale of the land. The Sun project utilizes environmentally sound technology and puts the land to productive use. The project has been described as the largest brownfield project in the State of Indiana.
Congress Has Valued the Section 29 Credit in the Past
The credit was originally enacted in 1980, during the aftermath of the oil embargo, as an inducement for Americans to look for fuel in unusual places. The country had just gone through oil shortages, gas lines, spiraling inflation, and record-high interest rates driven by increasing energy prices. The Section 29 credit was part of a strategy intended to use what fuel we have more efficiently and give business incentives to tap resources for fuel that could not be economically produced without the credit.
Page 476 PREV PAGE TOP OF DOC Segment 2 Of 2
The credit was initially intended to expire in 1989. It has been extended three times. In 1992, Congress cut back the list of fuels that qualify to two: gas from biomas and synthetic fuel from coal. But in retaining a credit for viable coal and gas technologies Congress reaffirmed a rational strategy to develop coal based fuels and land fill gas to protect the environment and reduce dependence on foreign oil.
Conclusion
The overall economics of this multi-party, multi-faceted project utilized the Section 29 credit as allowed and contemplated under the law. To retroactively ''roll back'' the economic benefits associated with the credit would not only be unjust, but financially compromising to all the parties involved who acted in good-faith reliance on the actions of the 104th Congress. Certainly such an abrupt policy reversal would have a chilling effect on the investment marketplace in the future.
The reason the roll-back of the placed-in-service date is harsh and oppressive is that the rest of the world does not roll-back. The taxpayer has entered into a binding written contract to construct the facility in reliance on Congressional action last year. This construction contract does not roll back. It is by definition binding. Foundations have been poured and persons employed. They cannot be rolled back. Long-term supply arrangements have been signed. These cannot be rolled back. Negative competitive impacts in the global marketplace cannot be rolled back.
Congress has often used the existence of a binding contract as a standard for a determination of whether application of a tax change would be fair. How ironic it would be if Congress repealed a provision, in effect punishing taxpayers who are parties to a binding-contract rule which Congress only months ago enacted. Such an action could aptly be described as bait-and-switch taxation.
Page 477 PREV PAGE TOP OF DOC Segment 2 Of 2
To deny the use of the credit to those who have binding contracts for facilities designed to produce fuels in compliance with current law is blatantly wrong and would penalize American taxpayers who relied in good-faith on the laws passed by the U.S. Congress. The Administration's proposal is misguided and will seriously impact ongoing transactions and jeopardize American jobs and businesses.
—————
Statement of the Tax Council
Introduction
Mr. Chairman and Members of the Committee:
The Tax Council is pleased to present its views on the Administration's Budget proposals and their impact on the international competitiveness of U.S. businesses and workers. The Tax Council is an association of senior level tax professionals representing many of the largest corporations in the United States, including companies involved in manufacturing, mining, energy, electronics, transportation, public utilities, consumer products and services, retailing, accounting, banking, and insurance. We are a nonprofit, business supported organization that has been active since 1967. We are one of the few professional organizations that focus exclusively on federal tax policy issues for businesses, including sound federal tax policies that encourage both capital formation and capital preservation in order to increase the real productivity of the nation.
The Tax Council applauds the House Ways & Means Committee for scheduling these hearings on the Administration's budget proposals involving taxes. We do not disagree with all of these proposals, for example, we support expanded individual retirement accounts and extension of the tax credit for research. These provisions will go a long way toward increasing our declining savings rate and improving the competitive advantage of U.S. companies. However, in devising many of its other tax proposals, the Administration replaced sound tax policy with a short sighted call for more revenue.
Page 478 PREV PAGE TOP OF DOC Segment 2 Of 2
Many of the revenue raisers found in the Administration's latest Budget proposals lack a sound policy foundation. Although they may be successful in raising revenue, they do nothing to achieve the objective of retaining U.S. jobs and making the U.S. economy stronger. For example, provisions are found in the Budget to reduce the carryback rules for foreign tax credits and net operating losses, extend Superfund taxes without attempting to improve the cleanup programs, arbitrarily change the sourcing of income rules on export sales by U.S. based manufacturers, eliminate so-called ''deferral'' for multinationals engaged in vital petroleum exploration and production overseas, and restrict the ability of so-called ''dual capacity taxpayers'' to take credit for certain taxes paid to foreign countries.
In its efforts to balance the budget, the Administration was unwise to target publicly held U.S. multinationals doing business overseas, and the Tax Council urges that such proposals not be adopted by Congress. The predominant reason that businesses establish foreign operations is to serve local overseas markets so they are able to compete more efficiently. Investments abroad provide a platform for the growth of exports and indirectly create jobs in the U.S., along with providing help in the U.S. balance of payments. The creditability of foreign income taxes has existed in the Internal Revenue Code for over 70 years as a way to help alleviate the double taxation of foreign income. Replacing such credits with less valuable deductions will greatly increase the costs of doing business overseas, resulting in a competitive disadvantage to U.S. multinationals versus foreign based companies.
In order that U.S. companies can better compete with foreign-based multinationals, Congress should work with the Administration to instead do all it can to make the U.S. tax code more friendly. Rather than making proposals that reward some industries and penalize others, the budget should be written with the goal of reintegrating sound tax policy into decisions about the revenue needs of the government. Provisions that merely increase business taxes by eliminating legitimate business deductions should be avoided. Ordinary and necessary business expenses are integral to our current income based system, and needless elimination of them will only distort that system. Higher business taxes impact all Americans, directly or indirectly. For example, they result in higher prices for goods and services, stagnant or lower wages paid to employees in those businesses, and smaller returns to shareholders. Those shareholders may be the company's employees, or the pension plans of other middle class workers.
Page 479 PREV PAGE TOP OF DOC Segment 2 Of 2
Corporate tax incentives, like export sourcing incentives, have allowed companies to remain strong economic engines for our country, and have enabled them to fill even larger roles in the health and well being of their employees. For these reasons, sound and justifiable tax policy should be paramount when deciding on taxation of business—not mere revenue needs.
Positive Tax Proposals
As stated above, two of the Administration's tax proposals will have a positive impact on the economy. They are:
Expanded IRAs
One proposal would expand IRAs by increasing the income limits on deductible IRA contributions and indexing the contribution limit for inflation. Special IRAs would be available for higher income taxpayers. This would help turn around the serious saving crisis that the United States currently faces. Not only are we saving considerably less than at any time since World War II, we are also saving considerably less than all of our major international competitors. It is firmly established that the restrictions imposed on IRAs in 1986 have played an important role in the decline of U.S. saving. The personal saving rate has averaged 4.5 percent since 1936, compared to 7.2 percent when the IRA was available to all taxpayers.
Over the last few years, there has been an abundance of academic research produced on the effectiveness of IRAs. A long list of top academic economists have found that IRAs do increase saving. The list includes Martin Feldstein (Harvard), David Wise (Harvard), James Poterba (MIT), Steven Venti (Dartmouth), Jonathan Skinner (UVA), Glenn Hubbard (Columbia), Richard Thaler (Cornell)), and former Harvard economist Lawrence Summers, now the Deputy Treasury Secretary. The IRA is a proven savings vehicle that is popular with Americans and good for the economy. IRAs promote self-reliance by encouraging Americans to prepare for retirement while at the same time providing the economy with the investment capital it needs to grow.
Page 480 PREV PAGE TOP OF DOC Segment 2 Of 2
Extension of Research Tax Credit
Another proposal would extend the research tax credit and also is to be applauded. The credit, which applies to amounts of qualified research in excess of a company's base amount, has served to promote research that otherwise may never have occurred. The buildup of ''knowledge capital'' is absolutely essential to enhance the competitive position of the U.S. in international markets—especially in what some refer to as the Information Age. Encouraging private sector research work through a tax credit has the decided advantage of keeping the government out of the business of picking specific winners or losers in providing direct research incentives. The Tax Council recommends that Congress work together with the Administration to extend the research tax credit on a permanent basis.
Provisions That Should Not Be Adopted
The Tax Council offers the following comments on certain specific tax increase proposals set forth in the Administration's budget:
Foreign Oil And Gas Income
The Tax Council's policy position on foreign source income is clear—''A full, effective foreign tax credit should be restored and the complexities of current law, particularly the multiplicity of separate ''baskets,'' should be eliminated. Deferral of U.S. tax on income earned by foreign subsidiaries should not be further eroded.''
The President's budget proposal dealing with foreign oil and gas income moves in the opposite direction by limiting use of the foreign tax credit and repealing deferral of U.S. tax on foreign oil and gas income. This selective attack on a single industry's utilization of the foreign tax credit and deferral is not justified. U.S. based oil companies are already at a competitive disadvantage under current law since most of their foreign based competition pay little or no home country tax on foreign oil and gas income. The proposal increases the risk of foreign oil and gas income being subject to double taxation which will severely hinder U.S. oil companies in the global oil and gas exploration, production, refining and marketing arena.
Page 481 PREV PAGE TOP OF DOC Segment 2 Of 2
Change in Carryover/Carryback Periods
Two of the Administration's proposals would decrease the time period for carrying back foreign tax credits (''FTCs'') from 2 years to 1 year, and decrease the net operating loss (''NOL'') carryback period from 3 years to 1 year. At the same time, the FTC carryforward period would be extended from 5 to 7 years while the NOL carryforward period would be increased from 15 to 20 years. Although these changes were arguably made to simplify tax administration, they are clearly mere revenue raisers that will actually cause highly inequitable results.
When companies invest overseas, they often receive very favorable local tax treatment from foreign governments, at least in the early years of operation. For example, companies are often granted rapid depreciation write-offs, and low or even zero tax rates, for a period of years until the new venture is up and running. This results in a very low effective tax rate in those foreign countries for those early years of operation. For U.S. tax purposes, however, those foreign operations must utilize much slower capital recovery methods and rates, and are still subject to residual U.S. tax at 35 percent. Thus, even though those foreign operations may show very little profit from a local standpoint, they may owe high incremental taxes to the U.S. government on repatriations or deemed distributions to the U.S. parent. However, once such operations are ongoing for some length of time, this tax disparity often turns around, with local tax obligations exceeding residual U.S. taxes. At that point, the foreign operations generate excess FTCs but without an adequate carryback period, those excess FTCs will just linger and expire. Extending the carryforward period will not alleviate the problem since the operation will likely continue to generate excess FTCs in comparison with the U.S. residual tax situation, resulting in additional FTCs for eventual expiration.
Page 482 PREV PAGE TOP OF DOC Segment 2 Of 2
The U.S. tax system is based on the premise that FTCs help alleviate double taxation of foreign source income. By granting taxpayers a credit against their U.S. liability for taxes paid to local foreign governments, the U.S. government allows its taxpayers to compete more fairly and effectively in the international arena. However, by imposing limits on carrying back excess FTCs to earlier years, the value of these FTCs diminish considerably (if not entirely in many situations). Thus, the threat of double taxation of foreign earnings becomes much more likely. A similar argument can be made for NOLs. If Congress truly intends to allow taxpayers to offset positive earning years with loss years, fewer limits should be placed on the ability to utilize those NOLs.
Repeal of Section 863(b)
When products manufactured in the U.S. are sold abroad, § 863(b) enables the U.S. manufacturer to treat half of the income derived from those sales as foreign source income, as long as title passes outside the U.S. Since title on export sales to unrelated parties often passes at the point of origin, this provision is more often applied to export sales to foreign affiliates. Unless a U.S. manufacturer has foreign affiliates or subsidiaries, it will not generally benefit from accumulating additional foreign source income.
The Administration proposes to repeal Sec. 863(b) because it believes that it gives multinational corporations a competitive advantage over U.S. exporters that conduct all of their business activities in the U.S. It also believes that replacing § 863(b) with an allocation based on actual economic activity will raise $7.5 billion over five years. This proposal has two critical defects.
First, to compete effectively in overseas markets, most U.S. manufacturers find that they must have operations in those foreign markets to sell and service their products. Many find it necessary to manufacture products specially designed for a foreign market in the country of sale, importing vital components of that product from the U.S. wherever feasible. Thus, the supposed competitive advantage over a U.S. exporter with no foreign assets or employees is a myth. There are many situations in which a U.S. manufacturer with no foreign activities simply cannot compete effectively in foreign markets.
Page 483 PREV PAGE TOP OF DOC Segment 2 Of 2
Second, except in the very short term, this proposal would reduce the Treasury's revenues rather than increase them. This is because the multinational corporations, against which this proposal is directed, may have a choice. Instead of exporting their products from the U.S., they may manufacture them abroad. If even a small percentage of U.S. exporters are in a position to avail themselves of this option, the proposal will fail to achieve the desired result and taxes on manufacturing profits and manufacturing wages will pour into foreign treasuries, instead of to the U.S. In fact, the Administration seems to encourage this result by calling for an allocation based on ''actual economic activity.'' More economic activity in foreign jurisdictions means more foreign jobs, investment, and profits.
At present, the U.S. has few tax incentives for exporters, especially compared to foreign countries with VAT regimes. Given our continuing trade deficit, it would be unwise to remove one of the few remaining tax incentives for multinational corporations to continue making export sales from the United States. Ironically, this proposal could result in multinationals using foreign manufacturing operations instead of U.S. based operations to produce export products. We encourage Congress not to adopt it.
Average Stock Basis
The Administration also proposes to eliminate the long-standing ''identification rule'' under which a taxpayer who buys shares of the same stock at different times and later sells less than all of the shares may identify which shares are being sold (usually the shares with the highest basis). Instead, the taxpayer would be treated as having sold shares with an ''average basis.
The Tax Council is opposed to this proposal for three reasons. First, we believe it runs directly counter to the broader federal income tax treatment of sales of stock and securities, and therefore leads to anomalous results. If a taxpayer purchases shares of stock A on day one and stock B on day two, the taxpayer is perfectly entitled to choose to sell the shares of stock B, which have a higher basis, rather than the shares of stock A, which have a lower basis. There is no good tax policy rational for changing the rule merely because stock A and stock B are substantially identical. Although this proposal may have something to do with the Administration's concern about short-against-the-box transactions, the Administration has already addressed this concern with a more direct proposal.
Page 484 PREV PAGE TOP OF DOC Segment 2 Of 2
Second, the Tax Council believes the provision would lead to greater complexity in the record-keeping and reporting of purchases and sales of stock. Taxpayers (and their agents) would have to maintain and consult with historical records for all of the taxpayer's transactions relating to a given stock each time a taxpayer undertook to sell a few shares. Each sale would change the basis of the remaining shares (presumably under detailed regulations which would explain precisely how the average basis rule works), so that the basis calculations for subsequent sales would depend in part on the mechanics of previous sales. We do not think this approach would be well-suited to routine equity transactions given their sheer volume and the number of individuals they affect.
Third, if 100 shares of stock A were held long term, while another 100 shares of stock A were held short term, and 50 shares were sold, we are not sure what the rule would be regarding the holding period of the sold shares, i.e., whether all 50 would be treated as long term, all 50 as short term, or averaged. Tax fairness and policy is best served by a direct matching of the actual basis of the item being sold with the proceeds of the sale, so that neither phantom gain nor loss is deemed to be realized on the transaction, and there is no question of the appropriate holding period for the sale.
Lowering the Dividend Received Deduction
The Administration proposed to both lower the corporate dividends received deduction (DRD) from 70% to 50% for dividends received by corporations that own less than 20 percent of other corporations, and to have taxpayers establish a separate and distinct 46 day holding period in a stock in order for each dividend to qualify for the DRD. We believe that both of these proposals will be making changes to the law that are not in the best interests of public policy. Currently, the U.S. is the only major western industrialized nation that subjects corporate income to multiple levels of taxation. Over the years, the DRD has been decreased from 100% for dividends received by corporations that own over 80 percent of other corporations, to the current 70% for less than 20 percent owned corporations. As a result, corporate earnings have become subject to multiple levels of taxation, thus driving up the cost of doing business in the U.S. To further decrease the DRD would be another move in the wrong direction.
Page 485 PREV PAGE TOP OF DOC Segment 2 Of 2
Since the DRD is intended to avoid multiple levels of taxation, the imposition of any holding period in the stock cannot be justified. Again, over time, the requisite holding period requirement has risen from 16 to 46 days. The reason for the adoption of this rule was to stop taxpayers from purchasing the stock just prior to a dividend record date and selling the stock shortly thereafter, resulting in both a tax-preferenced dividend and a capital loss. However, imposing a separate holding period requirement for each dividend does not enhance the rule and, in fact, just adds further needless complexity.
Superfund Taxes
The three taxes that fund Superfund (corporate environmental tax, petroleum excise tax, and chemical feed stock tax) all expired on December 31, 1995. The President's budget would reinstate the two excise taxes at their previous levels for the period after the date of enactment through September 30, 2007. The corporate environmental tax would be reinstated at its previous level for taxable years beginning after December 31, 1996 and before January 1, 2008.
These taxes, which were previously dedicated to Superfund, would instead be used to generate revenue to balance the budget. This use of taxes historically dedicated to funding specific programs for deficit reduction purposes should be rejected. The decision whether to re-impose these taxes dedicated to financing Superfund should instead be made as part of a comprehensive examination of reforming the entire Superfund program.
Modification of the Substantial Understatement Penalty
The Administration proposed to make any tax deficiency greater than $10 million ''substantial'' for purposes of the penalty, rather than applying the existing test that such tax deficiency must exceed 10% of the taxpayer's liability for the year. While to the individual taxpayer or even a privately-held company, $10 million may be a substantial amount of money—to a publicly-held multinational company, in fact, it may not be ''substantial.'' Furthermore, a 90% accurate return, given the agreed-upon complexities and ambiguities contained in our existing Internal Revenue Code, should be deemed substantial compliance, with only additional taxes and interest due and owing. There is no policy justification to apply a penalty to publicly-held multinational companies which are required to deal with much greater complexities than are all other taxpayers.
Page 486 PREV PAGE TOP OF DOC Segment 2 Of 2
The difficulty in this area is illustrated by the fact that the Secretary of the Treasury has yet to comply with Section 6662(d)(2)(D) of the IRC, which requires the Secretary to publish a list of positions being taken for which the Secretary believes there is not substantial authority and which would affect a significant number of taxpayers. The list is to be revised not less frequently than annually. Taxpayers still await the Secretary's FIRST list.
Applying Assumptions to Credit Card Receivables
The Administration proposed to apply a prepayment assumption to credit card receivables. Such a change would impose a tax on grace period interest even where no financial benefit has been received or accrued. This proposal ignores the accrual rules and goes beyond even the doctrine of constructive receipt. For accrual method taxpayers, the recognition of income depends on when the taxpayer's right to receive the income becomes fixed and determinable. In the case of ''grace period interest,'' however, unless and until payment of a credit card balance is delayed beyond the grace period, even the doctrine of constructive receipt would not apply (because no income is available).
The Administration's stated goal of ''equalizing'' the treatment of REMIC interests and credit card receivables is misplaced. The REMIC prepayment rule applies solely for purposes of determining the inclusion of OID, amounts that the payee is entitled to receive. The proposal ignores the fact that the federal income tax is calculated on an annual basis so that income is determined and reported at fixed intervals of a year and the accrual method requires taxpayers to determine income under the ''all events'' test at year-end. There is no precedent for departing from the annual accounting period where income has not been constructively received.
Pro Rata Disallowance
Page 487 PREV PAGE TOP OF DOC Segment 2 Of 2
The Tax Council strongly opposes the Administration's proposal to extend the pro rata disallowance of tax-exempt interest expense to all corporations. By reducing corporate demand for tax-exempts, this proposal only serves to increase the financing costs of state and local governments. The application of the pro rata rule on an affiliated company basis penalizes companies that hold tax-exempt bonds to satisfy state consumer protection statutes, such as state money transmitter laws, but happen to be affiliated with other businesses that have interest expense totally unrelated to the holding of the tax-exempt bonds. These corporate investors, holding principally long-term bonds, are critical to the stable financing of America s cities and states. Treasury currently has the authority to prevent any abuse in this area by showing that borrowed funds were used to carry tax-exempt securities; this more targeted approach provides appropriate protection without disrupting the public securities market.
Secondly, corporations often invest some operating funds in tax-exempt bonds for cash management reasons. No evidence exists that these corporations are engaged in improper interest-rate arbitrage. Not only are there no tax-motivated abuses in this area which merit increasing the borrowing costs of states and local governments, these investors help support an active and liquid short-term municipal bond market vital to states and localities. Again, the result of the Administration's proposal would be to reduce demand for tax-exempt bonds and drive up costs for states and local governments. This is something that Congress should not do when it is looking to these very same state and local governments to do more.
Increased Penalties for Failure To File Returns
The Administration also proposed to increase penalties for failure to file information returns, including all standard 1099 forms. IRS statistics bear out the fact that compliance levels for such returns are already extremely high. Any failures to file on a timely basis generally are due to the late reporting of year-end information or to other unavoidable problems. Under these circumstances, an increase in the penalty for failure to timely file returns would be unfair and would fail to recognize the substantial compliance efforts already made by American business.
Page 488 PREV PAGE TOP OF DOC Segment 2 Of 2
Effective Dates
Before concluding, we would like to make one last comment regarding the effective dates of tax proposals. The Tax Council believes that it is bad tax policy to make significant tax changes in a retroactive manner that impose additional burdens on businesses. Businesses should be able to rely on the tax rules in place when making economic decisions, and expect that those rules will not change while their investments are still ongoing. It seems plainly unfair to encourage businesses to make economic decisions based on a certain set of rules, but then change those rules midstream after the taxpayer has made significant investments in reliance thereon.
Conclusion
The Tax Council strongly urges Congress not to adopt the provisions identified above when formulating its own proposals, since they are based on unsound tax policy. Congress, in considering the Administration's budget, should elevate sound and justifiable tax policy over mere revenue needs. Revenue can be generated consistent with sound tax policy, and that is the approach that should be followed as the budget process moves forward.
—————
Statement of Texas Utilities Co., W.M. Griffin, Vice President, Governmental Affairs
Texas Utilities Company (''Company'') submits this written statement to the House Committee on Ways and Means in opposition to the provisions in the Administration's Revenue Proposal that require gain recognition on certain distributions of controlled corporation stock.
Page 489 PREV PAGE TOP OF DOC Segment 2 Of 2
The Company is a diversified holding company. The Company has a wholly-owned subsidiary, Texas Utilities Electric Company (''TU Electric''), which is engaged in the operation of an electric public utility system involving the generation, transmission, distribution and sale of electric energy in Texas. The Company is currently in the final stages of completing a merger with ENSERCH Corporation, an integrated company focused on natural gas gathering, processing and marketing.
Background
Under present law, Section 355 of the Internal Revenue Code allows corporations or shareholders to treat certain distributions of stock in a controlled corporation as non-taxable provided that certain requirements are met. More specifically, it allows corporations to separate unwanted businesses to facilitate a tax-free acquisition of an wanted business. Current law includes restrictions relating to acquisitions and dispositions of stock of the distributing corporation or the controlled corporation both before and after the distribution.
The Administration Proposal
The Administration proposal would adopt additional restrictions on acquisitions and dispositions of stock under Section 355. The proposal would require a corporation distributing shares in its subsidiary to recognize gain on the distribution of stock of the controlled corporation unless certain conditions are met. In order for Section 355 treatment to apply, the direct and indirect shareholders of the distributing corporation, as a group, must control both the distributing and the controlled corporation at all times during a four year period commencing two years prior to the distribution and ending two years after. Control for purposes of this proposal means ownership of stock possessing at least 50 percent of the total value of all classes of stock.
Page 490 PREV PAGE TOP OF DOC Segment 2 Of 2
In determining whether shareholders retain control during the entire four-year period, transactions unrelated to the distribution of stock will be disregarded. A transaction is considered unrelated to the distribution if it is not pursuant to a common plan or arrangement that includes the distribution. Public trading of stock is disregarded even if done in contemplation of the distribution. Similarly, an acquisition of either the distributing or controlled corporation is considered unrelated to the distribution if it is not pursuant to a common plan or arrangement existing at the time of the distribution as in the case of a hostile acquisition. A friendly acquisition, however, will generally be viewed as related to the distribution, and therefore the control requirement would not be satisfied for purposes of the proposal.
Section 355 Provides Needed Flexibility for Corporations Responding to Changes in the Market and Government Regulation
The electric utility industry has traditionally been a fully-regulated, vertically-integrated monopoly. Electric utilities are generally granted an exclusive retail franchise service territory under state law in return for an absolute obligation to serve all customers in that territory and a requirement to provide reliable power at all times. In addition to state regulation of retail electric power sales, the Federal Energy Regulatory Commission (FERC) regulates wholesale sales of electricity in interstate commerce and the interstate transmission of electricity.
The growth of independent power generators as a result of the enactment of the Public Utilities Regulatory Policy Act of 1978 changed the market for electricity by creating a new category of unregulated wholesale power producers. Last year, the FERC finalized its Order 888 requiring electric utilities to unbundle their services and rates and to allow nondiscriminatory access to transmission lines.
Page 491 PREV PAGE TOP OF DOC Segment 2 Of 2
Over forty States are actively considering the restructuring of their electric industry. The States are pursuing both legislative and regulatory investigations. Several States are currently considering electric utility restructuring legislation in their current legislative sessions. California has adopted a restructuring plan.
Last year, the Senate Energy and Natural Resources Committee and the House Committee on Commerce held a series of hearing on electric utility restructuring. Both Committees are continuing their investigations in this Congress. In this Congress, as well as the previous Congress, several bills have been introduced in the both the Senate and the House to restructure the electric utility industry.
The electric utility industry is responding to changes in the market and to government policy initiatives. As a result, many utilities are assessing their corporate structure and evaluating consolidations, mergers, and strategic alliances. Electric utilities are merging with other electric and gas utilities to enable them to comply with regulatory changes and to compete in new markets. Section 355 provides a necessary tool for utilities to rearrange and modify their business structures in order to meet new priorities and changing economic and competitive environments.
Request for a Transition Rule
We believe the Administration's proposal should be rejected. Provisions under Section 355 provide corporations the option to ''spin off'' certain unwanted businesses, for legitimate business purposes, to facilitate a planned reorganization.
If the Administration's proposal is not rejected, a transition rule is needed to protect pending transactions entered into with the legitimate expectation that any proposal further restricting the availability of Section 355 treatment would be prospective only. Failure to provide a transition rule would scuttle billions of dollars in pending transactions, result in unforeseen tax consequences for many American corporations, and cause disruption within the financial markets.
Page 492 PREV PAGE TOP OF DOC Segment 2 Of 2
Proposed Transition Rule
A transition rule should provide that distributions after the date of enactment are subject to the Administration's provisions unless the distribution is: (1) pursuant to a written agreement which was binding on or before such date and at all times after; (2) described in a ruling request submitted to the IRS on or before such date; or (3) described in a public announcement or SEC filing on or before such date.
Conclusion
Most taxpayers utilize a Morris Trust transaction under Section 355 solely for sound business reasons, not as a tax avoidance scheme. In the case of Texas Utilities Company's current merger, Section 355 allows the Company to spin-off an unwanted business unit of an acquired company. Neither the shareholders of the Company nor the shareholders of the acquired company will ''cash-out'' their ownership and their basis in the stock remains the same. There is no realization of income that would trigger taxable income.
Texas Utilities Company respectfully urges the Committee reject the Administration's proposal. Any changes to Section 355 should recognize the legitimate business purposes of allowing non-taxable distributions of stock to allow corporations to acquire other corporations without being forced to acquire unwanted business units.
—————
Statement of the United States Council for International Business
Page 493 PREV PAGE TOP OF DOC Segment 2 Of 2
Introduction
The United States Council for International Business (USCIB) is pleased to present its views on the Administration's Budget proposals and their impact on the international competitiveness of U.S. businesses and workers. The USCIB advances the global interests of American business both at home and abroad. It is the American affiliate of the International Chamber of Commerce), the Business and Industry Advisory Committee (BIAC) to the OECD, and the International Organisation of Employers. As such, it officially represents U.S. business positions in the main intergovernmental bodies, and vis-a-vis foreign business and their governments.
The USCIB For International Business applauds the House Ways & Means Committee for scheduling these hearings on the Administration's budget proposals. We do not disagree with all of these proposals, as, for example, we support expanded individual retirement accounts and extension of the tax credit for research. These provisions will go a long way toward increasing our declining savings rate and enhancing the competitive advantage of U.S. companies. However, in devising many of its other tax proposals, the Administration replaced sound tax policy with a short sighted call for more revenue.
Many of the revenue raisers found in the Administration's latest Budget proposals lack a sound policy foundation. Although they may be successful in raising revenue, they do nothing to achieve the objective of retaining U.S. jobs and making the U.S. economy stronger. For example, provisions are found in the Budget to reduce the carryback rules for foreign tax credits and net operating losses, arbitrarily change the sourcing of income rules on export sales by U.S. based manufacturers, eliminate so-called ''deferral'' for multinationals engaged in vital petroleum exploration and production overseas, and restrict the ability of so-called ''dual capacity taxpayers'' to take credit for certain taxes paid to foreign countries.
Page 494 PREV PAGE TOP OF DOC Segment 2 Of 2
In its efforts to balance the budget, the Administration has unwisely targeted publicly held U.S. multinationals doing business overseas, and The USCIB strongly urges that such proposals not be adopted by Congress. The predominant reason that businesses establish foreign operations is to serve local overseas markets so as to compete more efficiently and effectively. Investments abroad provide a platform for the growth of exports and indirectly create jobs in the U.S., along with providing help in the U.S. balance of payments. The creditability of foreign income taxes has existed in the Internal Revenue Code for over 70 years as a way to help alleviate the double taxation of foreign income. Replacing such credits with less valuable deductions will greatly increase the costs of doing business overseas, resulting in a competitive disadvantage to U.S. multinationals versus foreign based companies.
For U.S. companies to better compete with foreign-based multinationals, Congress should work with the Administration to do all it can to make the U.S. tax code more user-friendly. Rather than engaging in gimmicks that reward some industries and penalize others, the budget should be written with the goal of reintegrating sound tax policy into decisions about the revenue needs of the government. Provisions that merely increase business taxes by eliminating legitimate business deductions should be avoided. Ordinary and necessary business expenses are integral to our current income based system, and needless elimination of them will only distort that system. Higher business taxes impact all Americans, directly or indirectly. For example, they result in higher prices for goods and services, stagnant or lower wages for employees in those businesses, and smaller returns to shareholders. Those shareholders may be the company's employees, or the pension plans of other workers.
Corporate tax incentives, like export sourcing incentives, have allowed companies to remain strong economic engines for our country, and have enabled them to fulfill even larger roles in the health and well being of their employees, and for society generally . For these reasons, sound and justifiable tax policy should be paramount when deciding on taxation of business—not mere revenue needs.
Page 495 PREV PAGE TOP OF DOC Segment 2 Of 2
Positive Tax Proposals
As stated above, two of the Administration's tax proposals will have a positive impact on the economy, expanded IRAs, and extension of the research tax credit.
Expanded IRAs
One proposal would expand IRAs by increasing the income limits on deductible IRA contributions and indexing the contribution limit for inflation. Special IRAs would be available for higher income taxpayers. This would help turn around the serious saving crisis that the United States has faced for many years now. Not only are we saving considerably less than at any time since World War II, we are also saving considerably less than all of our major international competitors. It has been firmly established that the restrictions imposed on IRAs in 1976 played an important role in the decline of the U.S. saving rate. The personal saving rate has averaged 4.5 percent since 1976, compared to 7.2 percent when the IRA was available to all taxpayers.
Over the last few years, there has been an abundance of academic research on the effectiveness of IRAs. A long list of top academic economists have found that IRAs do increase saving. The list includes Martin Feldstein (Harvard), David Wise (Harvard), James Poterba (MIT), Steven Venti (Dartmouth), Jonathan Skinner (UVA), Glenn Hubbard (Columbia), Richard Thaler (Cornell)), and former Harvard economist Lawrence Summers, now the Deputy Treasury Secretary. The IRA is a proven savings vehicle that is popular with Americans as well as good for the economy. IRAs promote self-reliance by encouraging Americans to prepare for retirement while at the same time providing the economy with the investment growth capital it needs.
Page 496 PREV PAGE TOP OF DOC Segment 2 Of 2
Extension of Research Tax Credit
Another proposal which we support would extend the research tax credit. The credit, which applies to amounts of qualified research in excess of a company's base amount, has served to promote research that otherwise may never have occurred. The buildup of ''knowledge capital'' is absolutely essential to enhance the competitive position of the U.S. in international markets—especially in what some refer to as the ''Information Age.'' Encouraging private sector research work through a tax credit has the decided advantage of keeping the government out of the business of picking specific winners or losers in providing direct research incentives. The USCIB recommends that Congress work together with the Administration to extend the research tax credit on a permanent basis.
Provisions That Should Not Be Adopted
We set forth below our comments on certain specific tax increase proposals in the Administration's budget.
Foreign Oil and Gas Income
The USCIB's policy position on foreign source income is clear. We strongly believe that a full, effective foreign tax credit should be restored and the complexities of current law, particularly the multiplicity of separate 'baskets,' should be eliminated. Deferral of U.S. tax on income earned by foreign subsidiaries should not be further eroded.
The President's budget proposal dealing with foreign oil and gas income moves in the opposite direction by limiting use of the foreign tax credit and repealing deferral of U.S. tax on foreign oil and gas income. This selective attack on a single industry's utilization of the foreign tax credit and deferral is not justified. U.S. based oil companies are already at a competitive disadvantage under current law since most of their foreign based competition pay little or no home country tax on foreign oil and gas income. The proposal increases the risk of foreign oil and gas income becoming subjected to double taxation which will severely handicap U.S. oil companies in the global oil and gas exploration, production, refining and marketing arena.
Page 497 PREV PAGE TOP OF DOC Segment 2 Of 2
Change in Carryover/Carryback Periods
Two of the Administration's proposals would decrease the time period for carrying back foreign tax credits (''FTCs'') from 2 years to 1 year, and decrease the net operating loss (''NOL'') carryback period from 3 years to 1 year. At the same time, the FTC carryforward period would be extended from 5 to 7 years while the NOL carryforward period would be increased from 15 to 20 years. Although these changes were arguably made to simplify tax administration, they are clearly revenue raisers that will actually cause highly inequitable results.
When companies invest overseas, they often receive very favorable local tax treatment from foreign governments, at least in the early years of operation. For example, companies are often granted rapid depreciation write-offs, and low or even zero tax rates, for a period of years until the new venture is up and running. This results in a very low effective tax rate in those foreign countries for those early years of operation.
For U.S. tax purposes, however, those foreign operations must utilize much slower capital recovery methods and rates, and are still subject to residual U.S. tax at 35 percent. Thus, even though those foreign operations may show very little profit from a local standpoint, they may owe high incremental taxes to the U.S. government on repatriations or deemed distributions to the U.S. parent. However, once such operations are ongoing for some length of time, this tax disparity often turns around, with local tax obligations exceeding residual U.S. taxes. At that point, the foreign operations generate excess FTCs but without an adequate carryback period, those excess FTCs will just linger and expire. Extending the carryforward period will not alleviate the problem since the operation will likely continue to generate excess FTCs in comparison with the U.S. residual tax situation, resulting in additional FTCs for eventual expiration.
Page 498 PREV PAGE TOP OF DOC Segment 2 Of 2
The U.S. tax system is based on the premise that FTCs alleviate double taxation of foreign source income. By granting taxpayers a credit against their U.S. liability for taxes paid to local foreign governments, the U.S. government allows its MNCs to compete more effectively in the international arena. However, by imposing limits on carrying back excess FTCs to earlier years, the value of these FTCs diminish considerably (if not entirely, in many situations). Thus, the threat of double taxation of foreign earnings becomes more likely. A similar argument can be made for NOLs. If Congress truly intends to allow taxpayers to offset positive earning years with loss years, fewer limits should be placed on the ability to utilize those NOLs.
Repeal of Section 863(b)
When products manufactured in the U.S. are sold abroad, § 863(b) enables the U.S. manufacturer to treat a substantial portion (usually one-half) of the income derived from those sales as foreign source income, as long as title passes outside the U.S. Since title on export sales to unrelated parties often passes at the point of origin, this provision is more often applicable on export sales to foreign affiliates. Additionally, unless a U.S. manufacturer has foreign affiliates or subsidiaries, it will not generally benefit from generating additional foreign source income.
The Administration proposes to repeal Sec. 863(b) because it believes that it gives MNCs a competitive advantage over U.S. exporters that conduct all of their business activities in the U.S. It also believes that replacing § 863(b) with an allocation based on actual economic activity will raise $7.5 billion over five years.
The proposal has one glaring defect. To compete effectively in overseas markets, most U.S. manufacturers find that they must carry on activities in those foreign markets to sell and service their products. Many find it necessary to manufacture products specially designed for a foreign market in the country of sale, although, importantly, importing vital components of that product from the U.S. Thus, the purported competitive advantage over a U.S. exporter with no foreign assets or employees is unrealistic. There are many situations in which a U.S. manufacturer with no foreign activities simply cannot compete effectively in foreign markets.
Page 499 PREV PAGE TOP OF DOC Segment 2 Of 2
At present, the U.S. law has very limited tax incentives for exporters. Given our continuing trade deficit, it would be unwise to remove one of the few remaining tax incentives for MNCs to continue making export sales from the United States. Ironically, this proposal could result in multinationals attempting to use foreign manufacturing operations instead of U.S. based operations to produce export products. We encourage Congress not to adopt it.
Lowering the Dividend Received Deduction
The Administration proposes to both lower the corporate dividends received deduction (DRD) from 70% to 50% for dividends received by corporations that own less than 20 percent of a dividend paying corporation, and to have taxpayers establish a separate and distinct 46 day holding period in a stock before its dividends qualify for the DRD. We believe that both of these proposals will be making changes to the law that are ill advised. Currently, the U.S. is the only major western industrialized nation that subjects corporate income to multiple levels of taxation. Over the years, the DRD has been decreased from 100% for dividends received from over 80 percent owned corporations, to the current 70% for less than 20 percent owned corporations. As a result, corporate earnings have become subject to multiple levels of taxation, driving up the cost of doing business in the U.S. To further decrease the DRD would continue a trend which heads in the wrong direction.
Since the DRD is intended to avoid multiple levels of corporate taxation, the imposition of any holding period in the stock cannot be justified. Again, over time, the requisite holding period requirement has risen from 16 to 46 days. The reason for the adoption of this rule was to stop taxpayers from purchasing the stock just prior to a dividend record date and selling the stock shortly thereafter, resulting in both a tax-preferenced dividend and a capital loss. However, imposing a separate holding period requirement for each dividend does not enhance the rule and, in fact, just adds needless complexity.
Page 500 PREV PAGE TOP OF DOC Segment 2 Of 2
Modification of the Substantial Understatement Penalty
The Administration proposes to make any tax deficiency greater than $10 million ''substantial'' for purpose of the penalty, rather than applying the existing test that such tax deficiency must exceed 10% of the taxpayer's liability for the year. While to the individual taxpayer or even a privately-held company, $10 million may be a substantial amount of money—to a publicly-held MNC such amount is usually not ''substantial.'' Furthermore, a 90% accurate return, given the agreed-upon complexities and ambiguities contained in our existing Internal Revenue Code, should be deemed substantial compliance, with only additional taxes and interest due and owing. There is no policy justification to apply a penalty to publicly-held multinational companies which are required to deal with much greater complexities than are most other taxpayers.
The difficulty in this area is illustrated by the fact that the Secretary of the Treasury has yet to comply with Section 6662(d)(2)(D) of the IRC, which requires the Secretary to publish a list of positions being taken for which the Secretary believes there is not substantial authority and which would affect a significant number of taxpayers. The list is to be revised not less frequently than annually. Taxpayers still await the Secretary's FIRST list.
Increased Penalties for Failure To File Returns
The Administration also proposes to increase penalties for failure to file information returns, including all standard 1099 forms. IRS statistics bear out the fact that compliance levels for such returns are extremely high. Any failures to file on a timely basis generally are due to the late reporting of year-end information or to other unavoidable problems. Under these circumstances, an increase in the penalty for failure to timely filed returns would be unfair and would fail to recognize the high level of existing compliance by the U.S. business community.
Page 501 PREV PAGE TOP OF DOC Segment 2 Of 2
Effective Dates
The USCIB believes that it is unsound tax policy to effect significant tax changes retroactively . Business should be able to rely on the tax rules in place when making economic decisions, and to expect that those rules will not change substantially while their investments are still ongoing. It is ill advised and inequitable to encourage businesses to make economic decisions based on a certain set of rules, and change those rules after the taxpayer has made significant investments in reliance thereon. Thus, whenever possible, we call on Congress to assure that significant tax changes do not have retroactive application.
Conclusion
The USCIB strongly urges Congress, when formulating its own proposals, not to adopt the provisions identified above, which, as noted, are based on unsound tax policy. Congress, in considering the Administration's budget, should elevate sound and justifiable tax policy over mere revenue needs. Revenue can be generated consistent with sound tax policy, and that is the approach that should be followed as the budget process moves forward.
Contact Person on Behalf of the United States Council: Joseph Feuer, Manager, Taxation
—————
Statement of the United States Telephone Association
Page 502 PREV PAGE TOP OF DOC Segment 2 Of 2
The United States Telephone Association (''USTA'') is pleased to have this opportunity to submit testimony on the Administration's tax proposals to the Committee on Ways and Means. USTA is the primary trade association of local telephone companies serving more than 98 percent of the access lines in the United States and represents over 1100 members from the smallest of independents to the large regional companies.
We have carefully reviewed all of the tax proposals submitted as part of the Administration's budget package for their impact on our industry. However, the proposals we comment on in this submission are only those which most profoundly impact USTA members and the economic environment in which our industry operates.
1. Extension of the Research and Experimentation Tax Credit
The Administration has recommended a one-year extension of the credit from June 1, 1997 to May 31, 1998. USTA has long been a supporter of this credit and has previously provided testimony endorsing a permanent extension. As the information age continues to advance in both technology and reach, the credit becomes increasingly important. It provides a real incentive for U.S. companies in our rapidly changing industry to increase and expand the level of commitment to tomorrow's world of communication. The presence of a stable, unchanging credit mechanism is the best assurance that the United States will continue as the world's leader in new products and technology despite the risks associated with their development.
Over the last several years, Congress has always extended the credit, but at times with narrowing modifications and at times retroactively because the credit had been allowed to expire. This has had the impact of reducing its attractiveness as an incentive upon which strategic planning could be premised. USTA urges Congress not to let this important provision lapse. While we are mindful of the budgetary issues confronting the Committee, we would urge its extension at least on the basis proposed by the Administration, if not longer. The extension of the research and experimentation credit is one of the intelligent choices Congress can make in order to insure that the U.S. remains a world leader in communications.
Page 503 PREV PAGE TOP OF DOC Segment 2 Of 2
2. Require Gain Recognition on Certain Distributions of Controlled Corporation Stock
The Administration has proposed additional restrictions under IRC sec. 355 on acquisitions and dispositions of the stock of the distributing and controlled corporations in tax-free transactions. The effect of the proposal is to disallow tax-free acquisitions of the kind generally described as ''Morris Trust'' transactions—transactions long thought to be sound and sensible means by which businesses may restructure themselves to better compete, or in circumstances mandated by regulatory requirements.
In the classic Morris Trust transaction no gain or loss is recognized under current law since shareholders do not ''cash out'' their investments. Any corporate asset gain will continue to be built into the assets of a controlled and distributing corporation, and shareholders' built-in gain will continue in the stock of the acquiring corporation received in the transaction. Under current law sufficient safeguards exist to protect against transactions that do not have a valid business purpose or are simple devices entered into to distribute earnings and profits tax-free.
The effect of adoption of the proposal on our industry, and any other industry undergoing rapid change and transformation to meet modern competitive forces, would be to deny an important ability to meet business needs and opportunities. In effect, the Administration would impose a tax ''tollcharge'' on corporate reorganizations, unnecessarily impeding what has been a remarkable adaptation to global market demands in this country. In some cases, this proposal would make it impossible for companies to shed unwanted subsidiaries or divisions while attempting to combine complementary elements in a more efficient and productive enterprise. In addition, the proposal would undermine the international competitiveness of U.S. companies. The unfortunate result would be a tax system at odds with the real needs of the economy, promoting inefficiency.
Page 504 PREV PAGE TOP OF DOC Segment 2 Of 2
Every day companies in our industry face the challenges of high-velocity technological change, fast-changing market demands and new and increasing competition. What appeared to be solid business strategy a year ago may have a totally new reality today. Good tax policy must coexist with and support these realities. USTA urges, therefore, that this proposal be rejected both for its unsound tax policy rationale and for its destructive economic effect.
3A. Reduce the Dividends Received Deduction From 70% to 50%
The Administration has proposed to reduce the dividends-received-deduction (''DRD'') from 70 percent to 50 percent for corporations owning less than 20 percent of the stock of a U.S corporation. The Administration believes 70 percent to be too generous. However, USTA strongly believes a 70 percent DRD is the bare minimum deduction that should be available considering that dividends paid to corporate shareholders are already subject to taxation at least twice: at the corporate level when the income is earned and at the individual shareholder level when dividend distributions are made. Where a corporate shareholder receives dividends, a third level of taxation is present absent the DRD. The DRD has long been intended to mitigate the negative economic effects associated with this third level of taxation of corporate earnings.
Multiple levels of taxation on corporate earnings raise financing costs for corporations, create global competitiveness problems, and generally reduce incentives for capital formation. Scaling back the DRD would exacerbate the effects of multiple taxation. The change would be tantamount to a tax increase on corporate earnings with the burden of such tax increase ultimately falling upon issuers of stock. The reduction of the DRD also would create an incentive for corporations to issue excessive amounts of debt in order to receive at least one corporate level deduction (i.e., the interest deduction).
In response to a reduced DRD, corporations could be incited to move capital raising and employment overseas. Many of our largest economic competitors have already adopted integrated tax systems (single level of corporate taxation) under which inter-corporate dividends are largely or completely untaxed. The Administration proposal would put American companies, whose earnings would be subject to increased multiple taxation, at a competitive disadvantage.
Page 505 PREV PAGE TOP OF DOC Segment 2 Of 2
Because the proposal would apply to instruments that were issued and purchased under an assumption of a 70-percent DRD, reducing the DRD to 50 percent would also 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. We remain vigorously opposed to the proposal.
The Administration has articulated no convincing defense for such a fundamental change to longstanding tax policy. To the extent Treasury can demonstrate that the DRD has been subject to misuse, targeted anti-avoidance rules can and should be designed and implemented. In the absence of any such evidence, Congress should reject the Administration's current proposal.
3B. Modify Holding Period for Dividends-Received Deduction
The Administration would modify the DRD holding period requirement for corporations that hold stock in other corporations. USTA opposes this proposal and urges Congress to reject it. Currently, a corporate shareholder is entitled to the DRD only if it holds the dividend-paying stock for at least 46 days (91 days for certain types of preferred stock). The holding period is tolled for any period during which the shareholder corporation is protected from risk of loss (i.e., has hedged its position). Once the holding period is met, it need not be satisfied again for future dividends paid on the same stock.
The Administration's proposal would deny the DRD to a corporate shareholder where the required holding period is not met during the time immediately before and after each dividend is received. Congress should not adopt such a proposal until there is sufficient evidence that more than a minimal amount of undesirable activity would be captured by the proposal.
Page 506 PREV PAGE TOP OF DOC Segment 2 Of 2
Congress and the IRS have already done much to address inappropriate taxpayer behavior in this area. The present rules are sufficient to prevent pure short-term corporate investments for the purpose of reaping largely tax-free income eligible for the DRD and creating potential artificial losses. Currently, a DRD-eligible investor must hold the instrument at risk for at least one dividend period. The modified holding period proposal would increase the complexity of the tax code without sufficient results to show for it. The proposal would merely serve to interfere with prudent market-driven hedging practices, reduce the efficiency of the financial market and unnecessarily expose investors to increased risks.
4. Modify Foreign Tax Credit Carryover Rules
The Administration has proposed that foreign tax credit carrybacks be limited to one year and carryforwards be extended to seven years. USTA opposes the limitation on carrybacks since it hampers and in some cases denies taxpayers the ability to use foreign tax credits—credits provided in the first place to avoid double taxation of the same income.
When taxpayers incur foreign taxes they also have the potential of being taxed by the United States in the exercise of its jurisdiction over world-wide income earned by U.S. multi-national corporations. In the process of avoiding this phenomenon, tax policy should try to match as closely in time as possible the payment of tax with the credit offset mechanism. By limiting the ability to apply credits against prior tax years' liability, a distortion is created in favor of deferring the avoidance of double taxation (in effect, increasing the effective tax rate on foreign source income) to the detriment of the taxpayer. The Treasury Department's stated rationale is that carrybacks are associated with more complexity and administrative burden than carryforwards. Rather than address these problems specifically, the proposal simply cuts in half the period of carryback available. If, as Treasury states in justifying its proposal to lengthen the carryforward period, taxpayers need more time to utilize their foreign tax credits, it should support more time both before and after the point of double taxation.
Page 507 PREV PAGE TOP OF DOC Segment 2 Of 2
USTA's member companies maintain world-wide operations. They face constant competition. This proposal would tend to make it harder, rather than easier, to compete globally—all in the name of simplification and easing the burden on U.S. tax authorities. A better course would be to work cooperatively on new directions in U.S. foreign tax policy rather than restricting or eliminating taxpayer-friendly provisions one by one.
To the extent that Congress proceeds with this proposal, it would be USTA's position that the proposal for an extended carryforward period be applied to existing credits.
5. Expansion of Estate Tax Extension Provisions for Closely Held Businesses
The Administration would increase the amount eligible for the special low interest rate that applies to estate tax installment payments to the tax deferred on the first $2.5 million of value of a closely held business. It would also reduce the rate itself from 4% to 2%, and reduce to 45% of the usual IRS rate on underpayments the tax rate applied to values over $2.5 million. USTA applauds the spirit of the Administration's proposal, and others that have recently been proposed that are like it. However, USTA would urge that more extensive measures be taken to protect the ability of small businesses to survive the imposition of estate taxes, including total repeal of the estate tax.
In particular, USTA takes note of proposals recently made in Congress that would increase the estate and gift tax unified credit from the current law $600,000 to $1,000,000 or more. This provision of law has not been modified since 1987. If the unified credit had been indexed since 1987, it would now effectively exempt up to approximately $830,000 in lifetime transfers. This one change would benefit millions of surviving taxpayers. However, a further change, also the subject of recent proposals, would directly affect small businesses by permitting family-owned interests an exclusion of up to $1,500,000 in addition to the unified credit amount (subject to certain qualifying criteria). Such proposals would give millions of small, family-owned, enterprises hope that the death of a founder or central figure will not mean the end of the business. At the same time, USTA believes that any legislation in this area should not impose uneconomic restrictions on small business management in an effort to test the family relationship remaining in the business. USTA encourages the Committee to work with our organization and others that represent small businesses to craft meaningful change in this area.
Page 508 PREV PAGE TOP OF DOC Segment 2 Of 2
6. Extend the Exclusion for Employer-Provided Educational Assistance
As part of its education and job training tax initiatives, the Administration has proposed that the IRC sec. 127 exclusion be extended through December 31, 2000. USTA strongly endorses this proposal.
In the past the sec. 127 credit has been allowed to expire temporarily, leaving employers in a difficult position with regard to their withholding obligations. This, in turn, has caused unnecessary anxiety and disruption for both recipients of benefits and those at the company level who must administer them. USTA urges that the Committee and the Congress act before the expiration of the current credit on June 1, 1997. This is one of the most useful and practical means of encouraging educational opportunity and to react to the changing needs of the workplace and it should not be hampered by frequent disruptions. The longer term extension advocated by the Administration is especially well received in the telecommunications industry where many employers offer such assistance. In addition, we support the simplification involved in eliminating the need to distinguish between job-related expenses and other employer-provided educational assistance.
7. Extension of the FUTA Surcharge Tax and Required Monthly Deposits
USTA opposes the Administration's proposal to extend of the .2 percent FUTA surtax through December 31, 2007. The surtax currently is scheduled to expire on December 31, 1998. The proposal is unnecessary because there already are adequate FUTA funds into the foreseeable future, and there is no reason for another extension of the surcharge. The significant current balances in the Federal unemployment insurance administrative accounts and the continuing state frustration with federal policies and practices regarding reimbursement of administrative expenses need to be addressed prior to a determination of whether an extension of the surtax is appropriate.
Page 509 PREV PAGE TOP OF DOC Segment 2 Of 2
In addition, this proposal violates a promise to employers that the surtax was a temporary measure that would expire automatically upon repayment of the deficit in the Unemployment Trust Fund. That deficit has now been repaid.
USTA also opposes the Administration's proposal to increase the frequency of FUTA (and state unemployment insurance) deposits from quarterly to monthly for employers with 20 or more full-time employees. This proposal would triple the number of required submissions and attendant paperwork, greatly increasing the already substantial FUTA administrative costs of employers. While the proposal would be scored as a one-time federal budget revenue increase, it actually captures no net additional revenue, but merely is a budget device that requires the same amount of money be collected in an earlier fiscal year. Furthermore, the one-time budget score-keeping gain will be more than offset by the real additional long-term administrative costs to the IRS resulting from more-frequent FUTA tax collection.
8. Reform Treatment of Captive Insurance Arrangements
The Administration has proposed restricting the use of captive insurance arrangements. Captive insurers serve a useful function in providing an economic alternative to commercial insurance, and should not be discouraged by subjecting them to unfavorable tax rules. Further, the proposal does not add enough clarity to present law, because whether an insurer that has both insurance and non-insurance businesses is subject to the provision would still depend on the application of the amorphous ''primary and predominant'' test of present law.
Furthermore, the proposal's 10-percent ownership test is an arbitrary determination of when a payment should be considered as made to oneself. In addition, the proposal does not address the issue of whether experience-rated (including retrospectively rated) policies, or other similar arrangements, should be treated as insurance.
Page 510 PREV PAGE TOP OF DOC Segment 2 Of 2
9. Reimpose Superfund Corporate Environmental Tax
The Administration's proposal would reinstate, for taxable years beginning after December 31, 1996 and before January 1, 2008, a corporate environmental income tax imposed at a rate of 0.12% on the amount by which the modified alternative taxable income of a corporation exceeded $2 million. USTA, while clearly in favor of environmental programs benefitting society, opposes the reinstatement of the Superfund tax in this manner at this time. Superfund currently faces no budgetary crisis. The Congressional Budget Office recently reported there is an unobligated balance of prior tax collections in the Superfund trust fund that together with anticipated interest payments, cost recoveries, and general revenues is sufficient to support the Superfund program at about $1.34 billion a year, the level of current annual appropriation, through September 30, 2000.
In addition, 70 percent of all Superfund cleanup costs are financed directly by Potentially Responsible Persons (''PRP'') through per-site payments totalling between $1.5 and $2.0 billion annually. The obligation to continue making these payments was not suspended when the Superfund taxes expired. Between the PRP per-site payments and the aforementioned $1.34 billion annual superfund appropriation, approximately $2.84 to $3.34 billion will be available annually to fund the Superfund cleanup program through September 30, 2000. For these reasons, there is no compelling fiscal need to reinstate the Superfund tax.
As the Chairman of this Committee has noted, programmatic reform must take place prior to reinstating Superfund taxes that have expired. USTA supports this concept. In addition, USTA supports a simplified calculation of alternative minimum taxable income for purposes of computing the Superfund Corporate Environmental tax.
Page 511 PREV PAGE TOP OF DOC Segment 2 Of 2
—————
Statement of Valero Energy Corp.
I. Introduction
Valero Energy Corporation (''Valero'') is pleased to have the opportunity to submit comments to the House Committee on Ways and Means as it holds its first public hearings of the 105th Congress on the revenue provisions contained in the President's FY 1998 budget package. Valero is a publicly-traded diversified energy company engaged in the production, transportation and marketing of environmentally clean fuels and products. Late last year, Valero decided to narrow its business focus to its refining and marketing operations while seeking a strategic merger partner for its natural gas operations. In a transaction described more fully in Section II of these comments below, Valero entered into a binding merger agreement with PG&E Corporation (''PG&E'') to merge its natural gas operations with a subsidiary of PG&E.
The retroactive impact of the Administration's recommended effective date for its proposal to alter the requirements for distributions of the stock of a controlled corporation under section 355 of the Internal Revenue Code (the ''Morris Trust'' provision) now threatens to disrupt this transaction. Valero submits these comments in order to provide the Committee with a concrete example of the implications of retroactive application of this shift in tax policy.
To summarize briefly the scope of these comments, Section II details the structure of the Valero-PG&E transaction, Section III discusses Valero's concerns with the retroactive impact of the Administration's proposed effective date for the Morris Trust proposal, and Section IV contains Valero's proposal for providing effective transition relief to avoid retroactive application to transactions entered into in legitimate reliance on the current state of the law.
Page 512 PREV PAGE TOP OF DOC Segment 2 Of 2
II. The Transaction
Valero's two primary businesses are (i) specialized refining and related operations (the ''Refining Business'') and (ii) natural gas gathering, processing, transportation and storage, natural gas liquids extraction, fractionation and transportation, and natural gas, natural gas liquids and electricity marketing (the ''Natural Gas Business''). The Refining Business is owned by Valero Refining and Marketing Company (''R&M'') through various subsidiaries and affiliates and the Natural Gas Business is owned by Valero Natural Gas Company (''VNGC'') through various subsidiaries and affiliates. Both R&M and VNGC are wholly-owned subsidiaries of Valero.
On January 31, 1997, Valero entered into a binding contract [Agreement and Plan of Merger (''Merger Agreement'')] with PG&E Corporation (''PG&E'') whereby Valero's Natural Gas Business will be merged with a PG&E subsidiary. For this purpose, PG&E has agreed to an exchange value of approximately $1.5 billion. The Agreement provides for no substantial restructuring of debt or shifting of assets, although PG&E will acquire significant debt traditionally associated with the parent corporation and the Natural Gas Business. A condition of the Merger Agreement is that, immediately prior to the merger, Valero will spin-off 100% of the R&M shares to Valero's stockholders. Therefore, for each share of common stock, Valero shareholders will receive a fractional share of PG&E common stock and one share of the spun-off R&M common stock. No corporate asset obtains a step-up in basis as a result of the transaction.
On January 31, 1997, and February 7, 1997, respectively, PG&E and Valero filed Form 8–K with the Securities and Exchange Commission (''SEC'') to disclose the Merger Agreement. On February 14, 1997, Valero and PG&E filed their respective Premerger Notification and Report Forms under the Hart-Scott-Rodino (''HSR'') Antitrust Improvements Act of 1976. The early termination of the HSR waiting period was granted by the Federal Trade Commission on February 26, 1997. In mid-March, additional filings were made (i) with the SEC by Valero (Form 10) and PG&E (Form S–4) to register the R&M and PG&E common stock involved in the spin-off and merger, and (ii) with the Federal Energy Regulatory Commission (''FERC'') and Canadian regulatory authorities.
Page 513 PREV PAGE TOP OF DOC Segment 2 Of 2
The spin-off and the merger will be completed when the following conditions are met (or waived):
(a) subsequent to obtaining clearance from the SEC on the proxy material, Valero stockholders holding at least a majority of VEC's outstanding shares must vote to approve the spin-off and merger;
(b) approval by the FERC and Canadian regulatory authorities;
(c) opinions of tax counsel are obtained that (i) the spin-off will qualify as a reorganization within the meaning of § 368(a)(1(D) of the code and as a transaction described in code § 355, and (ii) that the merger will qualify as a reorganization under § 368(a)(1)(B) of the code;
(d) redemption or conversion of all outstanding Valero preferred stock.
A corporation can distribute to its shareholders the stock of another corporation which it controls immediately before the distribution without gain or loss recognition to the shareholder or the distributing corporation pursuant to § 355 of the code. Valero believes the distribution of its R&M common stock to its shareholders will qualify as a tax-free spin-off as a result of meeting the following § 355 requirements:
(a) immediately after the distribution, both Valero and R&M will be engaged in the active conduct of the Natural Gas Business and Refining Business, respectively, and both of these lines of business will have been actively conducted throughout the five-year period ending on the date of distribution;
(b) the distribution consists of all of the R&M common stock;
(c) the transaction is not being used principally as a device for the distribution of Valero's earnings and profits because
i) the corporate business purpose for the distribution is to (i) facilitate the acquisition of the Natural Gas Business by PG&E, and (ii) to redefine the fit and focus of the Refining Business;
Page 514 PREV PAGE TOP OF DOC Segment 2 Of 2
ii) Valero is publicly traded and widely held;
(d) Valero and R&M will continue the active conduct of the historic Natural Gas and Refining Businesses, respectively;
(e) PG&E will not agree to an alternative tax-free transaction to acquire the Natural Gas Business if such transaction results in Valero owning PG&E's common stock.
III. Valero Opposes Retroactive Application of This Change in Tax Policy
Under the Administration's Morris Trust proposal, the significant additional restrictions placed upon distributions of controlled corporation stock under section 355 would be ''effective for distributions after the date of first committee action.''(see footnote 162) While forward-looking on its face, the effective date currently proposed by the Administration would capture many currently pending transactions entered into in reliance on current law. The problem lies in the fact that the date of distribution is not indicative of the amount of time that the transaction itself has been in place. Due to the complex nature of corporate reorganizations, including the many regulatory approvals often required, the Administration's proposal could unfairly capture transactions that were subject to a binding contract or otherwise final long before the date of first committee action. The end result of such retroactive application would be to scuttle many pending deals, create substantial unforeseen tax liabilities for many American corporations, and cause disruption within the financial markets.
IV. An Appropriate Transition Rule
In light of the unfairness associated with retroactive application of the Morris Trust proposal to transactions entered into in reliance on the current state of the law, Valero would urge the Committee to consider the adoption of a transition rule that better protects those transactions that possess sufficient indicia of finality prior to the date of first committee action. An appropriate transition rule would provide that any restrictions on the availability of section 355 treatment shall be effective for distributions after the date of committee action unless the distribution is: (1) made pursuant to a written agreement which was binding on or before such date and at all times after; (2) described in a ruling request submitted to the IRS on or before such date; or (3) described in a public announcement or SEC filing on or before such date. The Administration itself advocated the use of such indicia of finality in its Morris Trust proposal for the FY 1997 budget, although the Administration's rule was keyed to the date of announcement rather than the date of first committee action. Valero believes that taking into consideration these indicia of finality will both protect pending transactions entered into in reliance on present law while at the same time discouraging last minute strategizing.
Page 515 PREV PAGE TOP OF DOC Segment 2 Of 2
Valero offers these comments in hopes that they will prove to be of some assistance to the Committee, and wishes to thank the Committee for the opportunity to participate in these proceedings.
—————
Statement of Washington Counsel, P.C.
President's FY1998 Budget Proposal To Require Gain Recognition on Certain Distributions of Controlled Corporation Stock (the ''Morris Trust Proposal'')
Washington Counsel, P.C. is a law firm based in the District of Columbia that represents a variety of clients on tax legislative and policy issues.
The Morris Trust Proposal is seriously flawed and, if enacted as proposed, would threaten major disruptions in legitimate corporate restructurings. The proposal would effect a fundamental change in tax policy, based on anecdotal reports of a limited number of transactions that are perceived by some as being abusive. In addition, the Morris Trust Proposal is not necessarily consistent with the efforts underway in this Congress—viz., to reduce tax on capital gains, provide increased flexibility for the telecommunication, entertainment, utility, and other industries to respond to the changing regulatory environment, and lay the foundation for fundamental tax reform.
This statement also addresses the need to provide transition relief for taxpayers who are complying with current law—failure to provide transition relief, should the proposal move forward, would result in a retroactive tax increase on affected corporations.
Page 516 PREV PAGE TOP OF DOC Segment 2 Of 2
Summary of the Administration's Morris Trust Proposal
The Morris Trust Proposal would require taxable gain recognition for certain Section 355(see footnote 163) transactions that take the form of ''spin-offs''—i.e., pro rata distributions of subsidiary stock where shareholder-distributees surrender no stock in the distributing corporation. Based on the Administration's stated rationale that ''corporate nonrecognition under Section 355 should not apply to distributions that are effectively dispositions of a business,'' the proposal would deny tax-free treatment to the distributing corporation in a spin-off, unless its shareholders hold stock representing 50 percent of the vote and value in both the distributing and the controlled subsidiary for a four-year period beginning two years prior to the spin-off. Thus, tax-free treatment could be denied where a spin-off is followed by the tax-free merger of the distributing corporation into another corporation, even where the only consideration received by the shareholders is stock representing a continuing proprietary interest in the distributing corporation. In this example, the arbitrary 50-percent test under the proposal would allow tax-free treatment only in the event of a subsequent merger party that is exactly equal in value to—or of lesser value than—the distributing corporation.
Current Law Serves Its Intended Purpose of Allowing Shareholders To Rearrange Their Investments Without Triggering a Tax on the Appreciation in Value of a Business's Underlying Assets
Like other tax-free reorganization provisions, Section 355 is premised on the theory that a corporate restructuring is not an appropriate time to impose a tax, to the extent that a taxpayer's investment remains in corporate solution, and a distribution of stock represents merely a new form of participation in a continuing enterprise.(see footnote 164) Consistent with the theory of tax-free reorganizations, Section 355 permits a corporation to distribute the stock in a controlled subsidiary to shareholders without triggering tax at the shareholder or corporate level.
Page 517 PREV PAGE TOP OF DOC Segment 2 Of 2
Section 355 transactions are better policed than other corporate reorganizations. Under the statutory requirements applicable to a tax-free Section 355 spin-off, the distributing corporation must distribute stock representing an 80-percent controlling interest, and both the distributing corporation and the controlled subsidiary must be engaged in an active five-year old business following the distribution. Moreover, Treasury regulations condition the application of Section 355 on the distributing corporation's ability to establish the existence of a valid business purpose for a spin-off.(see footnote 165) For over thirty years, both the courts and the Internal Revenue Service (''IRS'') have examined these transactions and permitted corporations to utilize tax-free spin-offs of an unwanted business to facilitate the tax-free acquisition of either the distributing corporation or the spun-off subsidiary(see footnote 166)—referred to as a ''Morris Trust'' transaction after the case (cited in note 4 below).
A Morris Trust transaction simply combines two tax-free reorganizations. Consistent with the theory of the reorganization provisions, shareholders who receive stock of a spun-off subsidiary and then participate in a second reorganization, retain continuing proprietary interests via stock received in both transactions. As observed by the court in the Morris Trust case, these transactions involve ''no empty formalism, no utilization of empty corporate structures, no attempt to recast a taxable transaction in nontaxable form, and no withdrawal of liquid assets (emphasis added).''
The Administration's Morris Trust Proposal Is Fundamentally Flawed
The Administration's Morris Trust Proposal is flawed, in that it is overly broad, inconsistent with the movement toward fundamental tax reform and current efforts to reduce the cost of capital and lower the capital gains tax rate, and would impose a ''new'' capital gains tax on legitimate transactions. Moreover, in certain cases, the proposal would tax the wrong capital gain.
Page 518 PREV PAGE TOP OF DOC Segment 2 Of 2
A. The Morris Trust Proposal Is Overly Broad
The Morris Trust Proposal would impinge on the ability of corporations to effect restructurings at a time when many businesses feel compelled to concentrate industries, separate, or combine to remain competitive in changing market and regulatory environments. As an unintended consequence of enacting the proposal, companies would be forced to maintain inefficient business structures or incur additional tax. As explained more fully below, any perceived problems can be addressed without penalizing all Morris Trust transactions.
The Morris Trust Proposal goes far beyond the intended goal of preventing tax-free disguised sales of businesses.(see footnote 167) Reportedly, the Morris Trust proposal was prompted by several widely publicized transactions in which a spin-off was combined with an acquisitive, tax-free reorganization, and it appeared that newly incurred debt was used as a device to pay a cash purchase price for the company acquired in the reorganization. The concern raised by these transactions was highlighted by the use of a spin-off in the disposition of Viacom Inc.'s cable business to TCI, with respect to which the IRS issued a favorable Section 355 ruling in 1996. There, as reported by Newsweek and the April 3, 1996 edition of Tax Notes Today, a Viacom subsidiary holding a cable business incurred $1.7 billion of new debt, spun off its non-cable business plus the cash proceeds of the borrowing to its corporate parent, and was then effectively ''acquired'' by virtue of the issuance of stock to TCI in exchange for cash. In short, it appears that liability for the new debt was assumed by TCI, while the cash generated by the borrowing went to the spun-off business that was retained by historic shareholders. The Viacom transaction was followed by similar deals where the assumption of debt ''overwhelmed'' the value of the stock that exchanged hands e.g., El Paso's acquisition of a Tennoco subsidiary in exchange for stock valued at about $914 million plus the assumption of $3.6 billion in liabilities. The perceived abuse in these cases is that the combined spin-off/reorganization constitutes a ''disguised sale.'' Clearly, the Morris Trust Proposal goes far beyond this type of transaction.
Page 519 PREV PAGE TOP OF DOC Segment 2 Of 2
To the extent that the identified abuse motivating the Morris Trust proposal involves the issuance of new debt that will be repaid by the acquirer, the solution offered is not responsive to the real issue. The proposal goes far beyond what is needed to prevent the use of Section 355 to effect disguised sales, because the proposal would apply even where a debt-free company is acquired. It must also be recognized that the assumption of liabilities in the course of a spin-off is a commonplace transaction, and care should be taken to distinguish cases where a corporation has normal business borrowings that remain with the business that generated the need for the debt.
B. The Morris Trust Proposal Is Antithetical to Fundamental Tax Reform, to the Extent It Would Exacerbate Problems Associated With the Double Taxation of Corporate Income
One of the fundamental goals of Structural Tax Reform is to integrate the corporate and individual tax systems to prevent the imposition of ''double tax'' on income earned by corporations. The effect of the Morris Trust proposal would be to create a new potential for two levels of tax on a corporation's distribution of controlled subsidiary stock one tax based on the distributing corporation's gain and another based on gain at the shareholder level.
Double taxation is particularly egregious when applied to appreciation in value of a corporation's original capital. Current law appropriately avoids double taxation in the case of an in-kind distribution of stock in a controlled subsidiary, where the distribution is made to historic shareholders and the controlled subsidiary is engaged in an ongoing business. Neither should taxation be required if shareholders maintain a continuing equity interest in a combined enterprise that includes the capital originally invested in an on-going business. The proposal, however, would trigger gain recognition by the distributing corporation in a spin-off, where the distributee/shareholders maintain an indirect ownership interest through stock received in a subsequent reorganization of the spun-off subsidiary.
Page 520 PREV PAGE TOP OF DOC Segment 2 Of 2
The existing ''double tax'' regime already places U.S. corporations at a competitive disadvantage in worldwide capital markets. Multiple levels of taxation raise the financing costs for corporations, and generally reduce incentives for capital formation. Moreover, ''double taxation'' creates global competitiveness problems, because many of our major trading partners (e.g., Germany, the United Kingdom, and Japan) have some mechanism for integrating the corporate- and shareholder-level taxes. Thus, the Morris Trust Proposal would undermine efforts to prevent our tax system from unduly burdening U.S. companies competing in international markets.
C. The Morris Trust Proposal Is Clearly Inconsistent With Current Efforts To Lower the Capital Gains Tax Rate
The Morris Trust Proposal would impose a ''new'' capital gains tax on the appreciation in value of underlying corporate assets, representing gain that may be largely inflationary. This proposal is particularly questionable at a time when many in Congress are looking for ways to eliminate the taxation of inflationary gains (e.g., by indexing the basis of capital assets).
Moreover, at a time when Congress is considering a reduction in the capital gains tax, it would be inconsistent and counterproductive to adopt a proposal that creates a ''new'' capital gains tax. A ''new'' capital gains tax would be created because the proposal would trigger recognition of gain that is untaxed under current law. The capital gains tax resulting from application of the proposal would thus further interfere with the market's allocation of capital.
D. The Morris Trust Proposal Would Apply Incorrectly to Tax the Appreciation in Value of Assets Retained by Historic Shareholders
Page 521 PREV PAGE TOP OF DOC Segment 2 Of 2
Upon a subsequent merger of the distributing corporation in a spin-off, the Morris Trust Proposal would apply to treat stock in the controlled subsidiary as ''disqualified'' consideration. Under Section 355(c), the distributing corporation's recognized gain would be measured by the difference between the value of the stock in the spun-off subsidiary and the basis in that stock. Thus, rather than taxing the appreciation in value of the business viewed as disposed of, the proposal would result in a tax on the business that is retained by historic shareholders. These issues clearly require more thought and analysis before the Ways and Means Committee acts to tax ordinary spin-off and merger activity.
E. The Most Troubling Aspect of the Morris Trust Proposal Is Its Retroactive Application to Taxpayers Who Are Complying With Current Law
In any event, Should a Morris Trust Proposal go forward, the Ways and Means Committee should provide for prospective application. As proposed, the Morris Trust Proposal would apply to a transaction that is completed before the date of enactment but after the date of ''first committee action.'' Notably, the proposed effective date is arbitrary and capricious, in that taxpayers who entered into binding commitments before the proposal was announced could be caught, while other taxpayers who have yet to make commitments would be unaffected if they complete transactions before the date of first committee action. In this regard, the Chairmen of both the House Ways and Means Committee and the Senate Finance Committee have expressed concerns that tax changes not be retroactive, and that proposed corporate tax changes be prospective to avoid disrupting normal market activities during the period of deliberation. In announcing the March 12, 1997, Ways and Means Committee hearing on the Administration's Budget Proposals, Chairman Archer specifically noted ''that several of the new proposals from the Administration still have retroactive effective dates or retroactive impact,'' and solicited comments about potential effective dates.
Page 522 PREV PAGE TOP OF DOC Segment 2 Of 2
Failure to provide a prospective effective date, should this proposal move forward, would result in a retroactive tax increase on affected corporations. The only guidance now available to taxpayers caught in the midst of transactions that cannot be completed before the ''date of first committee action'' are the transition rules proposed by the Administration when the Morris Trust Proposal was first offered in the President's FY1997 Budget. Recognizing the need for appropriate transition relief, the Administration proposed grandfather rules for distributions meeting any one of the following three tests:
• made pursuant to a written agreement in effect on the effective date;
• described in a ruling request filed with the IRS on or before that date; or
• described in a public announcement or filing with the Securities and Exchange Commission on or before that date.
We urge the Committee to include, at a minimum, similar transition rules with a ''date of enactment'' effective date. In view of the fact that Morris Trust transactions have been accepted and approved by the courts and the IRS for over 30 years, it would be inappropriate to impose a restrictive effective date with no transition relief treatment that is normally reserved for anti-abuse legislation. Taxpayers who have incurred substantial transactional costs in reliance on current law should not be penalized by a retroactive enactment.
The affected transactions often take months to consummate even after the signing of binding commitments and required filings with government agencies. Similar to the Administration's transition rule proposal in the FY1997 Budget, the parties to a contract should be allowed to condition a written agreement on the buyer's performance of due diligence, or on approval by the target corporation's Board of Directors or shareholders. This result would be consistent with precedents for treating a contract as binding even if subject to a condition, as long as the condition is not within the control of either party.
Page 523 PREV PAGE TOP OF DOC Segment 2 Of 2
Notably, the transition rules proposed in the FY1997 Budget would not constitute ''limited tax benefits'' subject to the Line Item Veto Act (Public Law 104–130). The statute excepts ''binding contract'' rules, and thus the proposal for ''written agreements in effect'' should not implicate the Line Item Veto Act. In the case of other transitional-relief provisions, the number of beneficiaries that triggers veto authority is 10 or fewer. Regarding the grounds for excluding the other two proposed rules (viz., an IRS ruling request and public announcement) from application of the Line Item Veto Act, based on our information and belief, there are many more than 10 transactions to which each of the proposed transition rules would apply.
—————
Statement of Washington Counsel, P.C.
On the Need To Clarify That Short-Against-The-Box Legislation Will Not Create Unrelated Business Taxable Income To Tax Exempt Entities
This testimony is submitted for the purpose of seeking clarification of short-against-the-box legislative proposals submitted by the Clinton Administration and by Congresswoman Barbara Kennelly. Clarification is needed to ensure that the adoption of such legislation not inadvertently result in unrelated business taxable income to tax-exempt entities.
Background
On February 6, 1997, the Clinton Administration released descriptions of proposed changes to federal income tax law in connection with its Fiscal Year 1998 budget proposal. Among those provisions is a proposal to require a taxpayer to recognize gain upon entering into a constructive sale of any appreciated position in either stock, a debt instrument, or a partnership interest. This is the so-called ''short-against-the-box'' proposal. On February 16, 1997, Congresswoman Barbara Kennelly introduced substantially similar legislation, H.R. 846.
Page 524 PREV PAGE TOP OF DOC Segment 2 Of 2
This testimony is not offered for the purpose of commenting on the appropriateness of the Administration and Kennelly proposals. Instead, this testimony is offered for the more narrow purpose of requesting that in the event the Committee decides to adopt short-against-the-box legislation, it clarify the reach of such legislation with respect to the potential unrelated business taxable income of certain tax-exempt entities.
Current Law
Under section 511 of the Internal Revenue Code, tax is imposed on the unrelated business taxable income (''UBTI'') of certain tax-exempt entities. As defined in section 513, UBTI consists generally of gross income from an ''unrelated trade or business'' minus allowable deductions. Unrelated trade or business income includes income from trade or business activities the conduct of which is not substantially related to the performance by such organization of its charitable, educational, or other purpose on which its exemption is based. Section 512(b) sets forth several types of income that are generally not treated as giving rise to UBTI including dividends, interest, gains on dispositions of property other than inventory, real property rent, and royalties. However, as provided for in section 512(b)(4) and defined in section 514, income from property that is otherwise not taxable is treated as taxable UBTI to the extent that the property is debt-financed. Therefore, to the extent that a tax-exempt entity incurs debt with respect to the ownership of property, any income from that property would be considered UBTI to the tax-exempt entity notwithstanding the general rule that such income is not taxable.
This could present an issue in the case of short sales of property if the shares borrowed are considered to create an obligation that would be considered an indebtedness. This issue was clarified in Revenue Ruling 95–8, 1995–1 C.B. 107, where the Internal Revenue Service (the ''Service'') ruled that income of a tax-exempt organization from a short sale of publicly-traded stock is not income attributable to debt-financed property under Section 514. Citing Deputy v. du Pont, 308 U.S. 488, 497–98 (1940), the Service reasoned that, although a short sale creates an obligation on the part of the seller, it does not create indebtedness within the meaning of Section 514.
Page 525 PREV PAGE TOP OF DOC Segment 2 Of 2
Thus, although this issue is clear in current law, without further clarification questions could arise under the short-against-the-box legislation now under consideration. We are concerned that under the current legislative proposals before Congress, a tax-exempt entity could be deemed to have entered into a borrowing with respect to short sales of property. As a result, transactions that are currently not considered to be UBTI, and therefore are not subject to tax, would become taxable.
Clarification Sought
The policy objective behind the short-against-the-box proposals is to require realization of gain where a taxpayer has disposed of the economic risks and rewards of owning appreciated property. Should such legislation be adopted by the Committee, we request clarification that it will be confined to this objective. Specifically, we would like confirmation, similar to that provided in Revenue Ruling 95–8, that a ''constructive sale'' of stock(see footnote 168) for purposes of gain realization will not result in a deemed borrowing on the part of the tax-exempt entity for purposes of Section 514 and the tax on UBTI.
This clarification would permit tax-exempt entities to continue to make investments in the most efficient, profit-maximizing way possible. Tax-exempt entities, such as educational institutions, pension funds, and charities, manage their investment portfolios to limit their risk while maximizing return. In some cases this requires that they engage in the type of short sales that could be affected by the short-against-the-box legislative proposals now before Congress. Because these are tax-exempt entities, and the income from short sales is not UBTI, these investments are obviously not undertaken for tax avoidance purposes. There is no tax payable under current law on the short sales of property by tax-exempt entities and there is no rationale for changing that treatment under the pending proposals.
Page 526 PREV PAGE TOP OF DOC Segment 2 Of 2
Because investments in assets which produce UBTI have a much lower rate of return while creating increased administrative burden, tax-exempt entities avoid such investments. To the extent the treatment of short sales is in doubt, the tax-exempt community is likely to avoid these investments altogether. Such uncertainty artificially and unnecessarily reduces the investment opportunities otherwise available to these organizations and inhibits their ability to generate funding for their tax-exempt purposes.
Summary
In the event that the Committee decides to adopt short-against-the-box legislation which would require a taxpayer to recognize gain upon entering into constructive sales of appreciated property, it should clarify that such constructive sales will not result in a deemed borrowing for purposes of section 514 and the tax on UBTI. This clarification would permit tax-exempt entities to continue to manage their investments by the most efficient means without interfering with the intentions of Congress in enacting short-against-the-box legislation. This clarification has broad support within the tax-exempt community. We hope the Committee will carefully consider this request as tax legislation moves through the Congress this year.
—————
Statement of Washington Counsel, P.C., Attorneys-at-Law, Submitted on Behalf of An Ad Hoc Group of U.S.-Owned Foreign Finance and Credit Companies Relating to the President's FY1998 Budget Proposal To Expand Subpart F Provisions Regarding Income From National Principal Contracts and Stock Lending Transactions
The President's FY1998 Budget proposes to expand the anti-deferral rules of Subpart F,(see footnote 169) to create a new category of Subpart F income from notional principal contracts. The President's proposal to amend Subpart F presents the opportunity to address a serious inequity created by the application of Subpart F to the U.S. financial services industry. The balance of this statement sets forth the analysis underlying the proposal by an ad hoc group of U.S. Finance and Credit Companies(see footnote 170) to amend Subpart F to restore deferral for active financial services income.
Page 527 PREV PAGE TOP OF DOC Segment 2 Of 2
While deferral of current U.S. taxation is the general rule for foreign-source business income earned by controlled foreign corporations, the Tax Reform Act of 1986 ended deferral for financial services income derived from the active conduct of a securities, insurance, banking, financing, or similar business. The growing interdependence and integration of world financial markets, coupled with the international expansion of U.S.-based financial services entities, warrants a reexamination of whether the foreign activities of the financial services industry should be eligible for deferral on terms comparable to that of manufacturing and other non-financial businesses. Much of the recent debate has focused on the activities of banking, insurance, and securities firms. This statement is submitted on behalf of an ad hoc group of leading finance and credit companies whose activities fall outside of these specific categories but within the catch-all concept of a ''financing or similar business.''
The ad hoc group of finance and credit companies includes entities providing a full range of financing, leasing, and credit services to consumers and other unrelated businesses, including the financing of third-party purchases of products manufactured by affiliates (collectively referred to as ''Finance and Credit Companies''). The treatment of Finance and Credit Companies under the current U.S. international tax regime raises the very same tax policy concern that has been identified by other sectors of the financial services industry viz., U.S. tax rules that hinder international competitiveness by, inappropriately, subjecting active financial services businesses to anti-deferral rules that were originally enacted to reach passive investment funds.
This statement sets forth the analysis underlying the proposal by the ad hoc group of Finance and Credit Companies to amend Subpart F to restore deferral for active financial services income. Specifically, the statement highlights the particular concerns of Finance and Credit Companies, describes the ordinary business transactions conducted by these entities, provides information regarding the unique role these companies play in expanding U.S. international trade, and explains how the current U.S. tax rules hinder the ability of Finance and Credit Companies to compete effectively with their foreign counterparts.
Page 528 PREV PAGE TOP OF DOC Segment 2 Of 2
Finance and Credit Companies Conduct Active Financial Services Businesses
Finance and Credit Companies are financial intermediaries that borrow to engage in all the activities in which banks customarily engage when issuing and servicing a loan or entering into other financial transactions. Indeed, many countries (e.g., Germany, Austria, and France) actually require that such a company be chartered as a regulated bank. For example, one member of the ad hoc group has a European Finance and Credit Company that is regulated by the Bank of England and, under the European Union (''EU'') Second Banking Coordination Directive, operates in branch form in Austria, France, and a number of other EU jurisdictions. The principal difference between a typical bank and a Finance and Credit Company is that banks normally borrow through retail or other forms of regulated deposits, while Finance and Credit Companies borrow from the public market through commercial paper or other publicly issued debt instruments. In some cases, Finance and Credit Companies operating as regulated banks are required to take deposits, although they may not rely on such deposits as a primary source of funding. In every important respect, Finance and Credit Companies compete directly with banks to provide loan and lease financing to retail and wholesale consumers.
A. Finance and Credit Company's Activities Include a Full Range of Financial Services
The active financial services income derived by a Finance and Credit Company includes income from financing purchases from third parties; entering into leases; making personal, mortgage, industrial or other loans; factoring; providing credit card services; and hedging interest rate and currency risks with respect to active financial services income. These activities include a full range of financial services across a broad customer base and can be summarized as follows:
Page 529 PREV PAGE TOP OF DOC Segment 2 Of 2
• Specialized Financing
Loans and leases for major capital assets, including aircraft, industrial facilities and equipment and energy-related facilities; commercial and residential real estate loans and investments; loans to and investments in management buyouts and corporate recapitalizations.
• Consumer Services
Private label and bank credit card loans; time sales and revolving credit and inventory financing for retail merchants; auto leasing and lending and inventory financing; and mortgage servicing.
• Equipment Management
Leases, loans and asset management services for portfolios of commercial and transportation equipment, including aircraft, trailers, auto fleets, modular space units, railroad rolling stock, data processing equipment, telecommunications equipment, ocean-going containers, and satellites.
• Mid-Market Financing
Loans and financing and operating leases for middle-market customers, including manufacturers, vendors, distributors, and end-users, for a variety of equipment, such as computers, data processing equipment, medical and diagnostic equipment, and equipment used in construction, manufacturing, office applications, and telecommunications activities.
Each of the financial services described above is widely and routinely offered by foreign- owned finance companies in direct competition with Finance and Credit Companies.
Finance and Credit Companies finance wholesale and retail sales of products by manufacturers to unrelated customers. In some cases, the Finance and Credit Company is an affiliate of the product manufacturer, and in other cases, the Finance and Credit Company is unrelated to the manufacturer. By way of example, Finance and Credit Companies affiliated with a U.S. auto maker provide wholesale financing and capital loans to franchised dealers and other dealers associated with such franchisees, purchase retail installment sales contracts and retail leases from these dealers, and make loans to vehicle leasing companies (the majority of which are affiliated with such dealers). A Finance and Credit Company affiliated with the same U.S. auto maker is actively engaged in non-affiliate product financing.
Page 530 PREV PAGE TOP OF DOC Segment 2 Of 2
As another example, a Finance and Credit Company is a leading provider of financial services to automotive customers worldwide; offering retail financing to consumers, inventory financing to dealers, and private label programs to manufacturers. In 1995, the U S. Parent of this Finance and Credit Company acquired the finance arm (a private label credit business) of the largest retailer in Australia. The same U.S. parent acquired the French finance company that supports Peugeot Citroen throughout Europe and owns one of Hong Kong's leading installment sales finance companies.
Further, as a third example, a Finance and Credit Company provides financing and servicing support to unrelated multinational equipment manufacturers as these companies expand their sales efforts around the globe. In order to provide local financing capabilities in the international markets in which these manufacturers sell their products, this U.S.-based company has established an extensive network of Finance and Credit Companies through which local financing support is provided.
As an alternative to traditional lending, leasing has developed into a common means of financing acquisitions of fixed assets, and is growing at double digit rates in international markets. Consistent with this trend, a Finance and Credit Company acquired a leading provider of vendor leasing services in the United Kingdom, and one of the Finance and Credit Company's affiliates provides a full range of aircraft financing products and related services to more than 150 airlines around the globe, including operating leases, spare parts, and maintenance support.
B. Finance and Credit Companies Are Located in the Major Markets in Which They Conduct Business and Compete Head-On Against ''Name Brand'' Local Competitors
Finance and Credit Companies provide services to foreign customers or U.S. customers conducting business in foreign markets. The customer base for Finance and Credit Companies is widely dispersed; indeed, a large Finance and Credit Company may have a single customer that itself operates in numerous jurisdictions. As explained more fully below, rather than operating out of regional, financial centers (such as London or Hong Kong), Finance and Credit Companies must operate in a large number of countries to compete effectively for international business and provide local financing support for foreign offices of U.S. multinational vendors. Finance and Credit Company affiliated with a U.S auto maker, for example, provide services to customers in Australia, India, Korea, Germany, the U.K., France, Italy, Belgium, China, Japan, Indonesia, Mexico, and Brazil, among other countries. Another member of the ad hoc group conducts business through Finance and Credit Companies in virtually all the major European countries, in addition to maintaining headquarters in Hong Kong, Europe, India, Japan, and Mexico. Yet another member of the ad hoc group currently has offices that provide local leasing and financing products in 22 countries.
Page 531 PREV PAGE TOP OF DOC Segment 2 Of 2
Finance and Credit Companies are legally established, capitalized, operated, and managed locally, as either branches or separate entities, for the business, regulatory, and legal reasons outlined below:
1. Marketing and supervising loans and leases generally require a local presence. The provision of financial services to foreign consumers requires a Finance and Credit Company to have a substantial local presence to establish and maintain a ''brand name,'' develop a marketing network, and provide pre-market and after-market services to customers. A Finance and Credit Company must be close to its customers to keep abreast of local business conditions and competitive practices. Finance and Credit Companies analyze the creditworthiness of potential customers, administer and collect loans, process payments, and borrow money to fund loans. Inevitably, some customers have trouble meeting obligations. Such cases demand a local presence to work with customers to ensure payment and, where necessary, to terminate the contract and repossess the asset securing the obligation. These active functions require local employees to insure the proper execution of the Finance and Credit Company's core business activities indeed, a single member of the ad hoc group has approximately 15,000 employees in Europe. From a business perspective, it would be almost impossible to perform these functions outside a country of operation and still generate a reasonable return on the investment. ''Paper companies'' acting through computer networks would not serve these local business requirements.
In certain cases, a business operation and the employees whose efforts support that operation may be in separate, same-country affiliates for local business or regulatory reasons. For example, in some Latin American jurisdictions where profit sharing is mandatory, servicing operations and financing operations may be conducted through separate entities. Even in these situations, the active businesses of the Finance and Credit Companies are conducted by local employees.
2. Like other financial services entities, a Finance and Credit Company requires access to the debt markets to finance its lending activities, and borrowing in local markets often affords a lower cost of funds. Small Finance and Credit Companies, in particular, may borrow a substantial percentage of their funding requirements from local banks. Funding in a local currency reduces the risk of economic loss due to exchange rate fluctuations, and often mitigates the imposition of foreign withholding taxes on interest paid across borders.
Page 532 PREV PAGE TOP OF DOC Segment 2 Of 2
Alternatively, a Finance and Credit Company may access a capital market in a third foreign country, because of limited available capital in the local market Australian dollar borrowings are often done outside Australia for this reason. The latter mode of borrowing might also be used in a country whose government is running a large deficit, thus ''soaking up'' available local investment.
A Finance and Credit Company may also rely for funding on its U.S. parent company, which issues debt and on-lends to affiliates (with hedging to address foreign exchange risks). By way of example, one member of the ad hoc group uses the world's capital markets to finance its operations, balancing costs and availability in conducting its funding. Short-term funds are raised in six different markets, for example: A Canadian affiliate issues commercial paper sold through all major dealers; its European commercial paper program is one of that market's largest; and an Indian affiliate participates in the Indian rupee inter-corporate deposit market, in which short-term funds are raised directly from major Indian corporate investors. This company uses interest rate and currency derivatives (primarily swaps) to reduce interest rate and currency risk all such transactions are related to specific business transactions.
3. In many cases, consumer protection laws require a local presence. Finance and Credit Companies must have access to credit records that are maintained locally. Many countries, however, prohibit the transmission of consumer lending information across national borders. Additionally, under ''door-step selling directives,'' other countries preclude direct marketing of loans unless the lender has a legal presence.
4. Banking or currency regulations may also dictate a local presence. Finance and Credit Companies must have the ability to process local payments and where necessary take appropriate action to collect a loan or repossess collateral. Foreign regulation or laws regarding secured transactions often require U.S. companies to conduct business through local companies with an active presence. For example, as noted above, French law generally compels entities extending credit to conduct their operations through a regulated ''banque'' approved by the French central bank. Other jurisdictions, such as Spain and Portugal, require retail lending to be performed by a regulated entity, but it need not be a full-fledged bank.
Page 533 PREV PAGE TOP OF DOC Segment 2 Of 2
In addition, various central banks preclude movements of their local currencies across borders. In such cases, a Finance and Credit Company's local presence (in the form of either a branch or a separate entity) is necessary to the execution of its core activities of lending, collecting, and funding.
As noted above, EU directives allow a regulated bank headquartered in one EU jurisdiction to have branch offices in another EU jurisdiction, with the ''home'' country exercising the majority of the bank regulation. Thus, for example, one Finance and Credit Company in Europe operates in branch form, engaging in cross-jurisdictional business in the economically integrated countries that comprise the EU. The purpose of this branch structure is to consolidate European assets into one corporation to achieve increased borrowing power within the EU, as well as limit the number of governmental agencies with primary regulatory authority over the business.
Finance and Credit Companies Play a Critical Role in Supporting International Trade Opportunities
As U.S. manufacturers and distributors expand their sales activities and operations around the world, it is critical that U.S. tax policy be coordinated with U.S. trade objectives, to allow U.S. companies in developed markets to operate on a level playing field with their foreign competitors. In emerging markets where competition in the financing business may be less fierce, U.S. tax policy should not hamper efforts to provide financing support for product sales. Significantly, U.S.-based multinationals currently account for only 22% of the world's output, roughly the same percentage as at the start of the 1980's.(see footnote 171) In this regard, one of the important tools available to U.S. manufacturers and distributors in seeking to expand foreign sales is the support of Finance and Credit Companies providing international leasing and financing services.
Page 534 PREV PAGE TOP OF DOC Segment 2 Of 2
U.S. manufacturers, in particular, include the availability of financing services offered by Finance and Credit Companies as an integral component of the manufacturer's sales promotion in foreign markets. For related manufacturing or other businesses to compete effectively, Finance and Credit Companies establish local country financial operations to support the business. As an example, the Finance and Credit Company affiliate of a U.S. auto maker establishes its operations where the parent company's sales operations are located, in order to provide marketing support.
In supporting the international sales growth of U.S. manufacturers and distributors in developed markets, Finance and Credit Companies are themselves forced into competition with foreign-owned companies offering the same or similar leasing and financing services. In addition to U.S. trade policy (as explained below in Section III of this statement) the U.S. tax regime plays an important role in the ability of Finance and Credit Companies to participate fully in the opportunities available in these markets. To the extent Finance and Credit Companies are competitively disadvantaged by U.S. tax policy, U.S. manufacturers and distributors either are prevented from competing with their counterparts or must seek leasing and financing support from foreign-owned companies operating outside the United States.
In emerging markets, U.S. tax policy should not unduly burden a Finance and Credit Company attempting to support affiliate sales. For example, where a local financing industry is incapable of supporting sales such as in India, Indonesia, or Russia Finance and Credit Company affiliates of U.S. auto makers sometimes accompany or precede the manufacturing or sales affiliate, to provide retail and wholesale financing of vehicle sales. Often, Finance and Credit Companies affiliated with the auto industry are the lenders of last resort (at non-usurious rates) to dealers selling an affiliate's cars.
The Imposition of a Current U.S. Tax on a Finance and Credit Company's Undistributed Active Financial Services Income Has an Anticompetitive Effect
Page 535 PREV PAGE TOP OF DOC Segment 2 Of 2
As an exception to the general rule of deferral, the Congress enacted the anti-deferral rules of Subpart F of the Code in 1962,(see footnote 172) to limit deferral to cases where the taxpayer is engaged in bona fide business activities. As originally enacted and as justified in subsequent amendments, Subpart F is aimed at ''mobile'' or ''tax haven income i.e., income that can easily be shifted to low-tax jurisdictions where the taxpayer has no significant business presence. Passive income is targeted because it is mobile and in certain cases can just as easily be earned in the United States. In this regard, the post-1962 legislative history of Subpart F affirms the long-standing tax policy goal of striking a reasonable balance between the need to guard against the potential for abuse and the ability of U.S. businesses to compete abroad. As explained more fully below, however, the current version of Subpart F upsets the balance that was reached in 1962 by discriminating against income earned by Finance and Credit Companies in the active conduct of a financial services business.
The Active Financial Services Income Derived by Finance and Credit Companies Is Inappropriately Treated in the Same Manner As Passive, Investment Income
There is no tax policy reason for treating active financial services income earned by a Finance and Credit Company differently from income earned by manufacturers. Although a Finance and Credit Company earns ''interest'' and ''rent'' through the conduct of an active financial services business, its income is treated as passive and subjected to the anti-deferral rules of Subpart F:
All interest income, including that arising from finance leases, conditional sales, and straight loans, is treated as Subpart F income, subject to two limited exceptions.(see footnote 173)
Page 536 PREV PAGE TOP OF DOC Segment 2 Of 2
Rental income earned on true, operating, leases is similarly taxable under Subpart F, subject to the limited ''active rent'' exception of Section 954(c)(2)(A). Under regulations interpreting the ''active rent'' exception to Subpart F, the availability of deferral often turns on whether a Finance and Credit Company happens to come within a safe harbor that requires active leasing expenses (exclusive of rent, depreciation and similar deductions that would be allowed to a domestic corporation by a Section other than Section 162) to be at least equal to 25% of leasing profits. Generally speaking, an efficient Finance and Credit Company leasing operation will fail to meet the limited safe harbor. The 25% safe harbor may be available in the start-up phase of a leasing business but as efficiencies are realized the 25% safe harbor becomes more difficult to attain. In addition, the 70% full inclusion rule of Section 954(b)(3)(B) often trumps the ''active rent'' exception.
1. The ''High Tax'' exception to Subpart F fails to serve the intended function of providing relief to business transactions that were not undertaken for the purpose of deferring U.S. tax. Finance and Credit Companies receive little relief under the Subpart F exception for passive income that has been subject to an effective foreign tax rate greater than 90 percent of the maximum U.S. corporate tax rate. Although a large part of the earnings of international leasing and financing companies are earned in high-tax jurisdictions, much of this income may not be subject to a high foreign tax rate on a current basis, due to tax accounting and other differences between the U.S. and foreign tax systems.
By way of example, many countries (such as Germany) provide tax incentives for capital investment, such as accelerated depreciation. In such a country, a leasing transaction entered into by a Finance and Credit Company may receive U.S. tax accounting treatment (slower depreciation and therefore higher earnings and profits than ''home country'' taxable income) that differs substantially from the treatment in the foreign taxing jurisdiction. As a result of timing differences between the amount of income reported for U.S. and foreign purposes, the ''high tax'' exception often will not provide relief from current taxation of a Finance and Credit Company's profits. Consequently, the Finance and Credit Company is placed at a competitive pricing disadvantage, because it is effectively denied the benefit of local accelerated depreciation made available to foreign competitors.
Page 537 PREV PAGE TOP OF DOC Segment 2 Of 2
2. In addition to the application of Subpart F, Finance and Credit Companies are subject to the regime for passive foreign investment companies (''PFICs''). The PFIC rules were enacted for the stated purpose of curtailing the use of foreign mutual funds to obtain deferral, but they can apply to any Finance and Credit Company whose active business assets (such as accounts receivable generated by consumer loans) necessarily generate the kind of income that is currently treated as passive. The PFIC rules are even more onerous than those of Subpart F because they impose a current U.S. tax on all of a PFIC's income, regardless of whether the income is passive in nature. Thus, for example, even if a Finance and Credit Company qualifies an item of income under the ''active rent'' exception to Subpart F, the PFIC rules can still eliminate deferral.
The PFIC rules unfairly discriminate against Finance and Credit Companies because they do not clearly provide a net operating loss ('' NOL'') regime similar to the ''active deficit'' rules found in Subpart F. If a Finance and Credit Company has a deficit in its earnings for the year, it generally will be unable to carry the loss forward to future years, even though its U.S.-owned banking competitors are entitled to use the Subpart F deficit regime to offset Subpart F earnings in future years. The rationale for the absence of an NOL rule under the PFIC regime viz., the intended impact on ''incorporated pocketbooks'' in tax havens and foreign mutual funds does not apply to the very active operations maintained by Finance and Credit Companies.
The PFIC rules were amended in 1993 to add the securities industry to a list of exceptions that already included banks and insurance companies. Thus, while the Congress has explicitly recognized the active nature of banking, insurance, and broker-dealer securities firms, Finance and Credit Companies remain outside of the PFIC exceptions for no apparent tax policy reason. In addition to the restoration of deferral for Finance and Credit Companies (discussed in detail in Section IV of this statement, below), current law should be amended to end the disparate treatment of banks and non-banking entities conducting substantially similar businesses, by providing an exception from the PFIC rules for Finance and Credit Companies.
Page 538 PREV PAGE TOP OF DOC Segment 2 Of 2
3. Concerns regarding the ''mobility'' of passive income should be addressed without impairing the international competitiveness of legitimate business operations. The legitimate business transactions executed by Finance and Credit Companies are plainly distinguishable from the type of tax-motivated incorporations that prompted the Congress to expand Subpart F and enact the PFIC rules in the Tax Reform Act of 1986. As explained by the staff of the Joint Committee on Taxation, the Congress acted on the belief that ''the lending of money is an activity that can often be located in any convenient jurisdiction, simply by incorporating an entity in that jurisdiction and booking loans through that entity, even if the source of the funds, the use of the funds, and substantial activities connected with the loans are located elsewhere.''(see footnote 174)
The active financial services income derived by Finance and Credit Companies is not susceptible to the kind of manipulation described as the basis for the 1986 amendments. Rather, as described above, Finance and Credit Companies are established, capitalized, operated, and managed locally for business, regulatory, and legal reasons. The cross-jurisdictional business that does occur (e.g., one Finance and Credit Company owned by an auto maker has branch activity within the economically integrated regions of the EU) is not dictated by U.S. tax costs. Finance and Credit Companies establish active operations in foreign countries in order to service their clients. These operations involve substantial investments and numbers of employees, and are not ''movable'' to take advantage of tax havens.
4. A Finance and Credit Company's active financial services business qualifies as an active trade or business for every other purpose of the Code. Statutory requirements for the ''active conduct of a trade or business'' are found both in Section 355 (providing tax-free treatment for certain reorganizations involving the division of one or more active trades or businesses) and Section 367 (providing tax-free treatment for incorporations and reorganizations involving foreign corporations). In general, outside of Subpart F, a corporation is treated as engaged in an active trade or business if its officers and employees carry out substantial managerial and operational activities. As described above (in section I.B.1 of this statement), Finance and Credit Companies perform active and substantial management and operations functions that constitute ''active'' businesses under both Section 355 and Section 367.
Page 539 PREV PAGE TOP OF DOC Segment 2 Of 2
5. Current law already provides a starting point for defining the active financial services income derived by Finance and Credit Companies. In 1993 testimony before a House Ways and Means Subcommittee regarding the PFIC exclusions for certain financial services entities that earn interest income by virtue of the nature of their business activities, the (then) Assistant Treasury Secretary for Tax Policy cited ''major administrative problems'' as the basis for distinguishing between the entities excepted from the PFIC rules and other sectors of the financial services industry. Both the Congress and the Internal Revenue Service have defined financial services entities to include Finance and Credit Companies, for purposes of the separate foreign tax credit (''FTC'') limitation on financial services income. The Conference Report on the Tax Reform Act of 1986 provided a general definition of a financial services entity as one that is predominately engaged in the active conduct of a banking, insurance, financing or similar business.(see footnote 175) In turn, the Internal Revenue Service (''IRS'') prescribed a bright-line test, defining a financial services entity as one that derives 80% or more of its gross income from active financing income.(see footnote 176) This test may require some adjustment for Finance and Credit Company purposes. One situation where an adjustment would be appropriate is where a Finance and Credit Company does not qualify as a financial services entity because it conducts a substantial business in operating leases.(see footnote 177) In that case, the operating lease business that precludes financial services entity status is clearly not passive.(see footnote 178) This active financing business should not fall outside the scope of any legislative solution directed toward Finance and Credit Companies. The same definition formulated to exempt a Finance and Credit Company's active financing income from Subpart F should also apply to provide an exception from the PFIC rules.
Deferral Is Necessary To Allow Finance and Credit Companies To Compete Effectively in Foreign Financial Centers.
Page 540 PREV PAGE TOP OF DOC Segment 2 Of 2
Deferral would advance competitiveness by insuring that Finance and Credit Companies engaged in business in a foreign country are taxed in a manner consistent with their foreign counterparts. Countries in which the parent companies of major financial institutions are organized generally refrain from taxing the active financing income earned by foreign subsidiaries. Thus, the lack of deferral places Finance and Credit Companies at a significant competitive disadvantage in any third country having a lower effective tax rate (or a narrower current tax base) than the United States (because the Finance and Credit Company will pay a residual U.S. tax in addition to the foreign income tax).
The lack of deferral hinders the ability of a Finance and Credit Company to bid competitively against its foreign counterparts. As explained more fully above, timing differences between the calculation of U.S. income and income taxable by a foreign country often result in Finance and Credit Companies being subject to residual U.S. tax on Subpart F income that represents a tremendous cash flow disadvantage. These disadvantages weaken a Finance and Credit Company's competitiveness, because in view of the relatively low profit margins in the international financing markets these tax costs must be passed on to customers in the form of higher financing rates. Obviously, foreign customers can avoid higher financing costs by obtaining financing from a foreign-controlled finance company that is not burdened by current home-country taxation, or in the case of Finance and Credit Companies financing third-party purchases of an affiliate's product purchasing the product from a foreign manufacturer offering a lower all-in cost.
The Ad Hoc Group of Finance and Credit Companies Urges the Reinstatement of an ''Active Financing'' Exception to Subpart F
Page 541 PREV PAGE TOP OF DOC Segment 2 Of 2
The ad hoc group of Finance and Credit Companies seeks legislation to address the anomalous treatment of the financial services industry under Subpart F, and the inexplicable omission of Finance and Credit Companies from the list of financial services entities that are currently exempted from the PFIC rules. This proposal can be appropriately implemented as a stand-alone amendment to the U.S. international tax regime (e.g., in the tax title of a Budget Reconciliation bill that includes other amendments to Subpart F) or as part of a more comprehensive reform package (such as H.R. 1690 and S. 2086, the International Tax Simplifications bills that were introduced in the House and Senate, respectively, during the last Congress).
Concerns about the use of controlled foreign corporations to route income through tax haven countries can be addressed by a limitation such as the provision that was included in S. 2086; that bill would provide an exception from Subpart F for active financing income, but only in the case of a corporation ''predominantly engaged in the active conduct'' of a financing business. For purposes of this rule, the definition of ''predominantly engaged'' would require the corporation to derive more than 70 percent of its gross income from transactions with unrelated persons, and more than 20 percent from unrelated persons located within the corporation's home country. Of course, other approaches are possible, consistent with the goal of developing reasonable rules that distinguish between a Finance and Credit Company that has an active business presence in its home country and a case where profits are merely isolated in a low-tax jurisdiction. In any case, particularly in view of the business reasons for using branch operations within the EU, it would be appropriate to allow for the use of branches that generate active financing income by providing an exception for qualified branches of Finance and Credit Companies.
The statutory limitation proposed in S. 2086 would allow for the case where a portion of a Finance and Credit Company's active financial services income is derived (through a branch or a separate entity) from transactions with unrelated persons within the same economic region, such as the European Union such a limited exception would be consistent with provisions of Subpart F that reflect concerns about income shifting to low-tax countries. The ''same country exception'' to Subpart F applies to dividends and interest received by a controlled foreign corporation from a related person organized and engaged in a trade or business in the same foreign country this is a circumstance where the U.S. tax would have been deferred on the active income out of which the dividends and interest are paid in any event. Similarly, income from services performed in a controlled foreign corporation's home country is excepted from Subpart F.(see footnote 179) In addition, the current taxation of foreign base company sales income is subject to exceptions where a controlled foreign corporation manufacturers or constructs the property sold, or the goods are intended for use or disposition in the home country. In the case of a financial intermediation business such as that conducted by a Finance and Credit Company, a similar exception should apply where the Finance and Credit Company originates a financial transaction in its own right.
Page 542 PREV PAGE TOP OF DOC Segment 2 Of 2
The ad hoc group of Finance and Credit Companies urges the House Ways and Means Committee to remedy the current categorization of a Finance and Credit Company's income as passive for Subpart F purposes, and to address the current unfairness in the PFIC rule that discriminates between ''licensed'' financial institutions (such as banks) and Finance and Credit Companies. The members of the ad hoc group would be happy to work with the House Ways and Means Committee to accomplish this important legislative goal.
(Footnote 81 return)
For legislative background of the provision see: H.R. 3838, as reported by the House Committee on Ways and Means on December 7, 1985, sec. 906; H. Rep. 99–426, pp. 638–641; H.R. 3838 as reported by the Senate Committee on Finance on May 29, 1986, sec. 303; S. Rep. 99–313, pp. 153–158 and H. Rep. 99–841 Vol. 11 (September 18 , 1986) pp. 314–316 (Conference Report).
(Footnote 82 return)
The American Land Title Association membership is composed of 2,000 title insurance companies, their agents, independent abstracters and attorneys who search, examine, and insure land titles to protect owners and mortgage lenders against losses from defects in titles. These firms and individuals also provide other real estate information services such as flood certification and tax services, employ nearly 100,000 individuals and operate in every county in the country.
(Footnote 83 return)
Most States follow the Federal income tax rules in imposing a State corporate income tax on corporations. For individual shareholders that own stock in corporations that operate in States with a high marginal tax rate, the result of this change to the DRD rules are magnified. For instance, assuming that the corporation and the corporate shareholder under the facts of the example above operate in high State taxing jurisdiction and pay an effective Federal and State tax rate of 40 percent, the corporate shareholder would only receive a $60 dividend and would pay $24 of tax on such dividend. The corporate shareholder would then distribute the $36 to its individual shareholders who, after paying a tax of 39.6 percent, would be left with only $21.74. The corporate earnings would have been subject to an effective income tax rate of 78 percent.
(Footnote 84 return)
See, Department of the Treasury, General Explanations of the Administration's Revenue Proposals, February 1997, at pp. 52–53.
(Footnote 85 return)
269 US 422 (1926).
(Footnote 86 return)
269 US at 441 (1926),
(Footnote 87 return)
Treas. Reg. § 1.446–1(c)(1)(ii). See also Treas. Reg. § § 1.451–1(a) and 1.461–1(a)(2)(i).
(Footnote 88 return)
United States v. General Dynamics Corp., 481 US 239 (1987).
(Footnote 89 return)
This proposal is described in Analytical Perspectives, Budget of the United States Government for Fiscal Year 1998 (Feb. 6, 1997), at pp. 50–51. The Treasury Department's general explanation of the proposal is reprinted in BNA Daily Tax Report (Feb. 9, 1997), at L–20.
(Footnote 90 return)
367 F.2d 794 (4th Cir. 1966).
(Footnote 91 return)
The post-spinoff combination may instead be effectuated by having P merge into D or C (or subsidiaries of D or C), with the P shareholders receiving D or C stock in exchange for their P shares.
(Footnote 92 return)
''Market Power'' generally is described as the ability of a single firm or a group of competing firms to control barriers to entry into a market, allowing them to raise prices above competitive levels and restrict output below competitive levels for a sustained period of time.
(Footnote 93 return)
According to the Treasury explanation, this exception would appear to protect only those stock ownership changes which result from stock exchange market trades or from a hostile takeover. If any prespinoff negotiations with respect to the reorganization occur prior to the spinoff, the ''unrelated transaction'' exception would be unavailable even though, at the time of the spinoff, a subsequent reorganization is not certain to occur.
(Footnote 94 return)
See, Rev. Rul. 68–603, 1968–2 C.B. 148; Rev. Rul. 70–434, 1970–2 C.B. 83; Rev. Rul. 78–251, 1978–1 C.B. 89; and Rev. Proc. 96–30, Appendix A, § 2.07, 1996–19 I.R.B. 8.
(Footnote 95 return)
See, Treas. Reg. § 1.355–2(c)(2)(iii)(E).
(Footnote 96 return)
See, Treas. Regs. § 1.355–2–(c)(1); 1.368–1(b).
(Footnote 97 return)
See, Prop. Treas. Reg. 1.368–1(e) (12/20/96) [eliminates requirement that acquired corporation shareholders continue to hold some minimum portion of acquiring corporation shares received in the reorganization]; and Prop. Treas. Reg. 1.368–1(d)(5) ( 1/2 1997) [permits successive post-reorganization transfers of the acquired corporation's assets into lower tier entities which are affiliated with but not indirectly controlled by the acquiring corporation].
(Footnote 98 return)
See, IRC § § 311 and 336, which now respectively impose corporate-level tax in connection with both liquidating and nonliquidating distributions of appreciated property to shareholders. Qualifying section 355 distributions of appreciated stock in a controlled subsidiary are generally exempted from corporate-level tax. See IRC § § 355 and 361(c).
(Footnote 99 return)
Whatever the merits of the administration's proposal, the statutory vehicle for implementing it, section 355(d), is already an incredibly complex and confusing provision. When enacted, it doubled the length of the then-existing section 355; and no Treasury regulations or other significant administrative guidance on it have yet been proposed or issued. The Morris Trust proposal would add still another column or two of statutory language to this behemoth provision. That hardly would be consistent with the undisputed need to simplify, rather than further complicate, the tax laws.
(Footnote 100 return)
These concerns are identified at pp. 51–53 of ''Description and Analysis of Certain Revenue-Raising Provisions'' (March 11, 1997), which was prepared by the staff of the Joint Tax Committee in connection with the March 12 hearing.
(Footnote 101 return)
Treasury has explicit statutory authority under section 337(d) to prescribe regulations that impose corporate-level tax with respect to specific transactions involving section 355 distributions believed to abuse the policy objectives of General Utilities repeal.
(Footnote 102 return)
Description and Analysis of Certain Revenue-Raising Provisions Contained in the President's Fiscal Year 1998 Budget Proposal, prepared by the staff of the Joint Committee on Taxation for a public hearing before the House Committee on Ways and Means on March 12, 1997, 105th Cong. 1st Sess. at 66 (1997).
(Footnote 103 return)
Id. (Emphasis added).
(Footnote 104 return)
Shipping and financial services income, which are both active income, were subjected to separate basket treatment in 1986, either because the income ''frequently'' bore little foreign tax or abnormally high foreign tax or was manipulated as to source. 1986 Blue Book at 863–64. The income from operating foreign gas pipelines is not more frequently subject to either abnormally high or low foreign tax than manufacturing income, nor is it manipulable as to source.
(Footnote 105 return)
The Investment Company Institute is the national association of the American investment company industry. Its membership includes 6,226 open-end investment companies (''mutual funds''), 443 closed-end investment companies and 10 sponsors of unit investment trusts. Its mutual fund members have assets of about $3.627 trillion, accounting for approximately 95 percent of total industry assets, and have over 59 million individual shareholders.
(Footnote 106 return)
All references to ''sections'' are to sections of the Internal Revenue Code.
(Footnote 107 return)
Treas. Reg. section 1.1012–1(e).
(Footnote 108 return)
For example, an investor holding 41 different blocks of shares would compute an average cost basis by adding together the purchase prices for each of the 41 blocks of shares and dividing by the number of shares owned. Each additional purchase would require an additional calculation, which would increase the likelihood of arithmetic error.
(Footnote 109 return)
In this case, because the RIC does not know which shares the taxpayer claimed on his or her tax return to have redeemed, the RIC does not know the cost basis of the remaining shares. For example, if a shareholder purchased 100 shares at each of three prices ($10, $11 and $12) and later redeemed 100 shares before the average cost program were implemented, the average cost of the remaining 200 shares would be: (1) $10.50, if the $12 shares had been redeemed, (2) $11, if the $11 shares had been redeemed or (3) $11.50, if the $10 shares had been redeemed.
(Footnote 110 return)
Any data that does not exist on a firm's current computer system (such as because it is stored only on paper or on paper and old computer tapes incompatible with the current system) would have to be inputted manually into the new system before cost basis calculations could be performed. Both the time commitment and the likelihood of error would be significant if manual input were required.
(Footnote 111 return)
Failures attributable to intentional disregard of the filing requirement are generally subject to a $100 per failure penalty that is not eligible for the $250,000 maximum.
(Footnote 112 return)
In the Conference Report to the 1989 changes, Congress recommended to IRS that they ''develop a policy statement emphasizing that civil tax penalties exist for the purpose of encouraging voluntary compliance.'' H.R. Conf. Rep. No. 386, 101st Cong., 1st Sess. 661 (1989).
(Footnote 113 return)
Merrill Lynch also endorses the comments submitted to the Committee on these provisions by the Securities Industry Association and PSA The Bond Market Association.
(Footnote 114 return)
Other antibusiness, antigrowth proposals include the Morris Trust proposal, the ''short-against-the-box'' proposal, and the average cost basis proposal. There is no inference of support for proposals not mentioned in this written statement.
(Footnote 115 return)
Analysis as of December 31, 1996.
(Footnote 116 return)
Given this data, even if one accepted the Treasury's assertion that probability of conversion in some way governed appropriate tax treatment, the proposal obviously addresses the wrong convertible security.
(Footnote 117 return)
See, Treasury's ''Reasons for Change'' described above on page 5.
(Footnote 118 return)
All section references are to the Internal Revenue Code of 1986, as amended.
(Footnote 119 return)
Significantly, Notice 94–47 was published in response to the issuance of instruments now referred to as MIPS.
(Footnote 120 return)
Unless otherwise noted, section references are to the Internal Revenue Code of 1986, as amended.
(Footnote 121 return)
The term Morris Trust comes from a tax case, Commissioner v. Morris Trust, 367 F.2d 794 (4th Cir. 1966) which found a spinoff to be tax free even though there was a prearranged merger and reorganization of the distributing company following the spinoff.
(Footnote 122 return)
See, Rev. Rul. 68–603, 1968–2 C.B. 148 (upholding the Morris Trust case); Rev. Rul. 76–527, 1976–2 C.B. 103 (upholding a ''reverse Morris Trust'' transaction where the spunoff subsidiary was a party to a subsequent reorganization); and Rev. Proc. 96–30 (which recognizes the valid business purpose of a Morris Trust transaction). Note that Rev. Proc. 96–30 was issued after the administration first introduced a Morris Trust Budget proposal.
(Footnote 123 return)
Statement of Donald C. Lubick, Acting Assistant Secretary (Tax Policy), Department of the Treasury, Hearing on the Education and Training Tax Provisions of the Administration's Fiscal Year 1998 Budget Proposal, House Ways & Means Committee (March 5, 1997).
(Footnote 124 return)
Congress ensured that REITs operate in that manner by instituting various ownership tests comparable to those applied in the identification of a personal-holding company. See I.R.C. sections 856(a)(5) and (a)(6).
(Footnote 125 return)
I.R.C. § 856(c)(4).
(Footnote 126 return)
I.R.C. § 857(b)(6).
(Footnote 127 return)
U.S. Department of Commerce, ''Survey of Current Business,'' April 1996.
(Footnote 128 return)
U.S. Department of Commerce, ''U.S. Multinational Companies: Operations in 1993,'' June 1995, at 39.
(Footnote 129 return)
''Continued robust exports by U.S. firms in a wide variety of manufacturers 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.'' Gary Hufbauer (Reginald Jones Senior Fellow, Institute for International Economics) and Dean DeRosa (Principal Economist, ADR International, Ltd.), ''Costs and Benefits of the Export Source Rule, 1998–2002,'' A Report Prepared for the Export Source Coalition, February 19, 1997.
(Footnote 130 return)
See, 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; J. David Richardson and Karin Rindal, ''Why Exports Matter: More!,'' Institute for International Economics and the Manufacturing Institute, Washington, DC, February 1996.
(Footnote 131 return)
See, Financial Executives Research Foundation, Taxation of U.S. Corporations Doing Business Abroad: U.S. Rules and Competitiveness Issues, 1996, Ch. 9.
(Footnote 132 return)
See Marsha Blumenthal and Joel B. Slemrod, ''The Compliance Cost of Taxing Foreign-Source Income: Its Magnitude, Determinants, and Policy Implications,'' in National Tax Policy in an International Economy: Summary of Conference Papers, (International Tax Policy Forum: Washington, DC, 1994).
(Footnote 133 return)
Id.
(Footnote 134 return)
Parts of the following discussion of the rules were abstracted from material prepared for the Export Source Coalition.
(Footnote 135 return)
In other words, the return for the second preceding tax year is recomputed with the newly available credit carryback, and to the extent that the foreign tax credits previously available in that year plus the foreign tax credits carried back to that year do not exceed the general limitation, the taxes carried back may be utilized in that year to reduce the U.S. tax paid in that year. If excess credits remain, the same procedures are followed for the first preceding tax year, and then the first succeeding tax year, the second succeeding tax year, and so on, until they are used up, or until the 5-year limitation causes them to ''expire.''
(Footnote 136 return)
The source of gross income derived from inventory property that is purchased by an exporter in the United States and sold outside the United States is determined under the ''title-passage'' rule of section 862(a)(6), which treats such income as derived entirely from the country in which the sale occurs. That is, such property sales generally produce foreign source income.
(Footnote 137 return)
Section 864 of the Code provides that ''produced property'' includes property that is ''created, fabricated, manufactured, extracted, processed, cured, or aged.''
(Footnote 138 return)
The second method is the ''Independent Factory Price Method'' or ''IFP Method;'' and, the third permits a method based on use of the taxpayer's own method of allocation made in its books and records with the IRS District Director's consent.
(Footnote 139 return)
For purposes of this example, a number of other U.S. tax rules, such as ''deferral'' and the ''subpart F'' rules, other credit limitations, and the like are ignored—they do not change the basic result, but serve to complicate the illustration.
(Footnote 140 return)
Moreover, the 50/50 source rule of present law can be viewed as having the advantage of administrative simplicity; the proposal to apportion income between the taxpayer's production activities and its sales activities based on actual economic activity has the potential to raise complex factual issues similar to those raised under the section 482 transfer pricing rules that apply in the case of transactions between related parties.'' Joint Committee on Taxation, ''Description and Analysis of Certain Revenue-Raising Provisions Contained in the President's Fiscal Year 1998 Budget Proposal,'' JCX–10–97, March 11, 1997.
(Footnote 141 return)
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.'' Hufbauer, DeRosa, Id., at 15.
(Footnote 142 return)
The Foreign Sales Corp. (''FSC'') provisions of sections 921 through 927 of the Code are one of the most important U.S. tax incentives for exports from the United States. These provisions were adopted to offset disadvantages to U.S. exporters in relation to more favorable tax schemes allowed their foreign competitors in the tax systems of our trading partners. These provisions encourage the development and manufacture of products in the United States and their export to foreign markets.
(Footnote 143 return)
The U.S. firms with excess foreign tax credits that use the Export Source Rule pay a ''blended'' tax rate of 17.5 percent on their export earnings—zero percent on half and 35 percent on half. U.S. firms can conduct their export sales through a FSC 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.
(Footnote 144 return)
The United States has in force some 48 Conventions for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion With Respect to Taxes on Income (''income tax treaties'') with various jurisdictions, not including other agreements affecting income taxes and tax administration (e.g., Exchange of Tax Information Agreements or Treaties of Friendship and Navigation that may include provisions that deal with tax matters). It has taken more than 60 years to negotiate, sign, and approve the treaties that form the current network. A number of new agreements are being negotiated by the Treasury Department. Nevertheless, the U.S. treaty network has never been as extensive as the treaty networks of our principal competitors. The U.S. treaty network covers only about 22 percent of the developing world, compared to coverage of 40 to 46 percent by the networks of Japan and leading European nations. This discrepancy has persisted for many years, even though the United States relies on the developing world to buy a far larger share of its exports than does Europe.
(Footnote 145 return)
Hufbauer, DeRosa, Id, at 1.
(Footnote 146 return)
O.E.C.D., Taxing Profits in a Global Economy: Domestic and International Issues (1991), pp. 147–149, 154, 460. See also, Financial Executives Research Foundation, Id., at 65.
(Footnote 147 return)
These systems are generally much simplier as well. See analysis of the systems of France, Germany, and Japan, Financial Executives Research Foundation, Id, at 92–93.
(Footnote 148 return)
For example, the income of the active business of financial service companies such as banks, finance companies, and the like was removed from deferral in 1986. The rationale of the change was to target operations of tax haven banks that had no real operations in the haven; but, the changes were sweeping, and our nation's commercial banks and finance companies were subjected overnight to significantly higher costs of capital for operations in all jurisdictions vis-a-vis their foreign competitors. The change had negative repercussions on these businesses. For example, one of our members advises that it was the owner of the fourth largest commercial bank in Switzerland (the largest non-Swiss owned bank), and that it was forced to dispose of its holding due to the increase in costs attributable to this change in U.S. tax law. The disposition was to foreign competition. Similarly, we are advised that the loss of deferral and resulting increase in cost of operations and cost of capital serve as an entry barrier to U.S. institutions attempting to acquire foreign banking interests in foreign markets.
(Footnote 149 return)
Perhaps the most aggregious example is the overlap between CFC and the PFIC rules. The CFC rules have been in the Code since the early 1960's (and need significant change in themselves), and the PFIC rules were enacted as part of the Tax Reform Act of 1986 to address perceived abuses in the taxation of widely held offshore foreign investment funds. The resulting statute, however, catches many active CFC's in its reach.
(Footnote 150 return)
Congress legislated changes in the treatment of oil and gas income, and related foreign tax credits, in the 1970's and 1980's. These changes reflected concerns about the relatively high tax rates in some foreign jurisdictions in which there was significant oil recovery, and also a concern over whether payments by the petroleum companies were in fact disguised royalties.
Under section 907(a), the amount of taxes on foreign oil and gas extraction income (''FOGEI'') may not exceed 35 percent (i.e., the highest U.S. marginal rate) on such income. Excess credits may be carried over like excess foreign tax credits in the general limitation basket. (FOGEI is income derived from the extraction of oil and gas, or from the sale of exchange of assets used in extraction activities.) In addition, under section 907(b), the Treasury has regulatory authority to determine that a foreign tax on foreign oil related income (''FORI'') is not creditable to the extent that the foreign law imposing the tax is structured, or in fact operates, so that the tax that is generally imposed is materially greater than the amount of tax on income that is neither FORI nor FOGEI. (FORI is foreign source income from: (1) processing oil and gas into primary products; (2) transporting oil and gas or their primary products, (3) distributing or selling these products, or (4) disposing of assets used in the foregoing activities.) To date, the Treasury has not exercised this authority; however, see the discussion below of the safe harbor rule of Treas. Reg. § 1.901–2A(e)(1).
Under section 954(g), foreign base company oil related income (an element of subpart F income not eligible for deferral) generally includes FORI other than income derived from a source within a foreign country in connection with either (1) oil or gas which was extracted from a well located in that foreign country (FOGEI); oil, gas, or a primary product of oil or gas which is sold by the foreign corporation or a related person for use or consumption within that foreign country, or is loaded in that country on a vessel or aircraft as fuel for that vessel or aircraft.
In addition, in 1983, the IRS promulgated the ''dual capacity'' regulations (Treas. Reg. § 1.901–2A). Since mineral rights in many countries vest in the sovereign, payments to the sovereign may take the form of royalties or other payments for the mineral or as taxes to the sovereign on the income represented by the production. To help resolve the possible controversy of whether such payment are royalties or creditable income taxes, the regulations provide that a taxpayer must establish under the facts and circumstances method 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. The remainder is a deductible rather than creditable payment (in the case of oil and gas products, a royalty). A ''safe harbor'' method is available under Treas. Reg. § 1.901–2A(e)(1), under which a formula is used to determine the tax portion of the payment to the foreign sovereign (e.g., the amount that the taxpayer would pay under the foreign country's general income tax law). 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 (the U.S. tax rate is considered the country's generally applicable income tax rate).
(Footnote 151 return)
See footnote 9.
(Footnote 152 return)
JCX–10–97, Id., at 62.
(Footnote 153 return)
A similar proposal was included in President Clinton's fiscal year 1997 budget.
(Footnote 154 return)
It is important to note that many of these errors occur as a result of incorrect information provided by the return recipients such as incorrect taxpayer identification numbers (TINs).
(Footnote 155 return)
The standard penalty for failing to file correct information returns is $50 per failure, subject to a $250,000 cap. Where a failure is due to intentional disregard, the penalty is the greater of $100 or 10 percent of the amount required to be reported, with no cap on the amount of the penalty.
(Footnote 156 return)
Statement of former IRS Commissioner Gibbs before the House Subcommittee on Oversight (February 21, 1989), page 5).
(Footnote 157 return)
OBRA 1989 Conference Report at p. 661.
(Footnote 158 return)
The increased penalties would not apply if the aggregate amount that is timely and correctly reported for a calendar year is at least 97 percent of the aggregate amount required to be reported for the calendar year. If the safe harbor applies, the present-law penalty of $50 for each return would continue to apply.
(Footnote 159 return)
For example, Form 1099–C, discharge of indebtedness reporting.
(Footnote 160 return)
If the corrected returns were filed after August 1, the penalties would be capped at $250,000 per plan.
(Footnote 161 return)
A definition of ''affiliated group'' which may be used for this purpose may be found in section 267(f) or alternatively, section 1563(a).
(Footnote 162 return)
Department of the Treasury, General Explanations of the Administration's Revenue Proposals, February 1997 at 63.
(Footnote 163 return)
Unless otherwise noted, references to a ''Section'' are to the Internal Revenue Code of 1986, as amended.
(Footnote 164 return)
See, generally, Bittker and Eustice, Federal Income Taxation of Corporations and Shareholders, 12.01[3] regarding ''General Theory for Tax-Free Treatment.''
(Footnote 165 return)
Treasury reg. sec. 1.355–2(b).
(Footnote 166 return)
See, Commissioner v. Morris Trust, 367 F. 2d 794 (4th Cir. 1966) (subsequent reorganization involving the distributing corporation); Rev. Rul. 68–603, 1968–2 C.B. 148 (where the Internal Revenue Service accepted the holding of the Morris Trust case); Rev. Rul 76–527, 1976–2 C.B. 103 (''blessing'' a ''reverse Morris Trust'' where the spunoff subsidiary was party to a subsequent reorganization); and Rev. Proc. 96–30 (issued on May 6, 1997, after the administration first unveiled the proposal in question, and explicitly recognizing the valid business purpose of a Morris Trust transaction).
(Footnote 167 return)
See, Statement of Donald C. Lubick, Acting Assistant Secretary (Tax Policy), Department of the Treasury, before the House Ways and Means Committee (March 5, 1997).
(Footnote 168 return)
The ruling did not address sales of debt or partnership interests, which are covered by the short-against-the-box legislation.
(Footnote 169 return)
''Subpart F'' consists of sections 951 through 964 of the Internal Revenue Code of 1986, as amended; except as noted, all references to ''sections'' herein are to the Internal Revenue Code.
(Footnote 170 return)
The ad hoc group on behalf of which this statement is submitted consists of: AT&T Capital, Ford Motor Credit, and GE Capital.
(Footnote 171 return)
See the summary of a National Bureau of Economic Research working paper published in Business Week (October 14, 1996), page 30 (citing economists, Robert E. Lipsey, Magnus Blomstron, and Eric D. Ramstetter).
(Footnote 172 return)
Excepted as noted, all references to the ''Code'' are to the Internal Revenue Code of 1986, as amended, and all references to '' Sections'' are to sections therein.
(Footnote 173 return)
The exceptions are for export financing interest from banking activities and interest paid by a related corporation, organized in the same foreign country as the recipient.
(Footnote 174 return)
General Explanation of the Tax Reform Act of 1986 (May 4, 1987) at p. 966.
(Footnote 175 return)
At II–571.
(Footnote 176 return)
Treas. Reg. Section 1.904–4(e)(3)(i).
(Footnote 177 return)
See, Treas. Reg. Section 1.904–4(e)(2)(i)(V).
(Footnote 178 return)
Treas. Reg. Section 1.904–4(b)(2)(i).
(Footnote 179 return)
See, Section 954(e)(1)(B).